Finance Lease vs Operating Lease Explained with Accounting Basics

 One of those areas that appear straightforward at first glance – the use of an asset for a fee – but the accounting rules can get complicated very easily. It's really a question of who -- in fact -- owns the asset, rather than in form.

After you get that concept, the rest should fall into place.

Financial Lease

A financial lease (also known as a finance lease) is a lease that is considered more like ownership. The liability and value of the asset are primarily borne by the lessee, even if the title of the property does not pass to him or her right away.

This in practice, entails the business keeping the asset on their balance sheet. An Asset and a Liability for the obligation to pay a Lease.

Operating Leases

Operating leases are more akin to leasing. The asset remains under the ownership of the lessor and the lessee pays for the asset for a set period of time.

In the past, these were not included on the balance sheet and the lease payment were treated as expenses. This has somewhat changed recently with the new accounting standards, but in the context of classification, it should still be remembered.

Finance Lease vs Operating Lease

The main difference between finance lease versus operating lease is the control and risk.

If the lease obtains most of the risks and rewards of ownership — such as the use of the asset, the right to buy the asset, or covering most of the life cycle of the asset — it is more likely to be a finance lease.

If it's a short term and the asset will be returned to the owner with most of its value, then it's likely an operating lease.

Financial Lease Accounting

Under financial lease accounting, the lease is considered to be a company's financing of the acquisition of the asset.

The asset will be depreciated and the interest on the debt will be an expense. As time goes on, the liability reduces as the payment is made.

Operating Lease Accounting

With operating lease accounting, attention is directed towards the expense associated with the leases. Usually the expenses are recognized over the term of the lease.

Newer standards result in more leases being recorded as assets on the balance sheet, but the expense matches the usage of the asset instead of ownership.

Lease Classification Finance vs Operating

The length of the lease, whether or not ownership of the asset is transferred, whether or not there are purchase options, and whether or not the asset's value is covered are the factors that determine the classification of leases.

Don't focus on any one rule, it's more of a general rule. When evaluating whether the arrangement is a purchase or a rental, accountants consider how the arrangement is used.

Conclusion

Leases are not only about the use of assets, they're about the way the use of the asset is financially represented.

After gaining an understanding of the difference between ownership like and rental like arrangements, the classification and accounting treatment begins to make a lot more sense.