The lease is a finance agreement in which lessor (owner of the asset) purchases the asset and let the lessee (user of the asset) use the asset for a limited period against periodic payments, i.e. lease rentals. The terms and conditions of the lease are written in the lease deed. Finance or capital lease and operating lease are two types of lease. Finance Lease is a lease in which the risk and rewards are transferred to the lessee with the transfer of the asset. Unlike Operating Lease, in which the risks and rewards are not transferred to the lessee with the transfer of the asset.
Therefore, the lease is an alternative to buying the asset out of owned or borrowed funds. One of the major difference between a finance lease and an operating lease is, the former cannot be canceled, during the primary lease period, whereas the latter can be canceled by the lessee.
Content: Finance (Capital) Lease Vs Operating Lease
|Basis for Comparison||Finance Lease||Operating Lease|
|Meaning||A commercial arrangement in which the lessor allows the lessee to use the asset for the maximum part of its economic life against payment of rentals is known as finance lease.||A commercial arrangement in which the lessor allows the lessee to use the asset for a term smaller than the economic life of the asset against the payment of rentals is known as operating lease.|
|Nature||Loan Agreement||Rental Agreement|
|Lease Term||The lease term of finance lease is longer as compared to operating lease.||The lease term of operating lease is short.|
|Risk Bearing for obsolescence||Rests with the lessee||Rests with the lessor|
|Transferability of risk and rewards||From the lessor to the lessee, with the transfer of asset.||Does not transfers from the lessor to the lessee, with the transfer of the asset.|
|Cancellation of the lease||Only on the happening of certain specified event.||Can be done|
|Tax Benefit||Depreciation and finance charges are allowable as a deduction to lessee.||Lease rent is allowable as a deduction to lessee.|
|Cost of Repairs and Maintenance||Are to be borne by the lessee.||Are borne by the lessor.|
|Bargain Purchase Option||The lease contains an option where the lessee can purchase the equipment at the price less than the Fair Market Value.||No such option in this regard|
Definition of Finance (Capital) Lease
An agreement in which the lessor allows the lessee to use a particular asset, for a fixed term which covers the major part of the economic life of the asset, without the transfer of title but with the transfer of risk and rewards is known as Finance Lease. It is also known as the capital lease.
In a finance lease, the ownership of the asset is transferred to the lessee when the lease term expires. The lessee has the option to buy the asset at a nominal amount i.e. a price which is less than the fair market value of the asset. The lease returns the full payout, i.e. principal (cost) plus interest thereon of the asset, in a single lease. The present value of Minimum Lease Payments (MLP) at the beginning of the lease agreement is more than or equal to the total Fair Market Value of the asset leased.
The finance lease is non-cancellable in nature i.e. it can be canceled only if: the lessor allows or the happening of any contingent event or the lessee enters into a lease agreement with the Lessor for the same asset. However, if the Lessee cancels the lease agreement any losses incurred to the lessor will be borne by the lessee.
Definition of Operating Lease
An agreement in which the lessee is allowed to use an asset with the permission of the lessor, for a limited term which is smaller than the economic life of the asset, without the transfer of title, risk and reward is known as Operating Lease. An Operating lease is more like a rental agreement, and that is why the rental payments for the use of the asset are charged a rental expense in the Profit and Loss Account in the books of the Lessee.
At the end of the operating lease, the asset is neither transferred to the lessee nor he has the right to purchase the asset at a price less than the Fair Market Value of the asset. The leased asset is transferred to the lessor at the expiry of the lease term. There is no security that the lessor will get the complete payout regarding the cost and return of the asset as the same asset is leased again and again by the lessor to many customers. The operating lease is cancellable in nature and so, it can be canceled by any of the parties.
Key Differences Between Finance (Capital) Lease and Operating Lease
The following are the major differences between finance (capital) lease and operating lease:
- The lease agreement in which the risk and rewards are transferred with the transfer of an asset is known as Finance Lease. The lease agreement in which the risk and rewards are not transferred with the transfer of the asset is known as Operating Lease.
- Finance Lease is a sort of loan agreement in which the lessor plays the role of financier. As opposed to the Operating Lease, which is similarly like a rental agreement.
- Finance Lease is for the long term as it covers the maximum part of the life of the asset. Unlike, Operating Lease, which is for a shorter period.
- An Operating lease is more flexible as compared to the Finance Lease.
- In the finance lease, the ownership of the asset is transferred to the lessee at the end of the lease term, by paying a nominal amount which is equal to the fair market value of the asset. Conversely, in operating lease, there is no such kind of option.
- In Finance Lease, the lessee bears the risk of obsolescence whereas in Operating Lease the lessor bears the risk for so.
- Any cost for repairs and maintenance will be borne by the lessee in the finance lease, but the cost of repairs and maintenance will be borne by the lessor in operating lease.
Nowadays many business concerns enter into these lease agreement because the company does not have directly to bear the cost of the financing the asset. Therefore, the finance lease and operating lease are getting popular. One of the best advantages of these lease agreement is that the depreciation and interest charges are tax deductible in nature, and so they are allowable as deduction. Similarly, the lease rentals are also tax deductible in case of the operating lease and hence they are allowed as deduction.