In today’s time, companies do not directly incur the cost of financing the asset. Many businesses today choose leasing agreements. Thus, leases are becoming a popular source of alternative investments in India.
Before we dive deep into the differences between finance lease and operating lease, let us first understand the meaning of a lease contract.m
What is a lease contract?
In a lease, the lessor (the asset's owner) buys the item and grants the lessee (the asset's user) a limited time of usage in exchange for regular payments, also known as the lease fees. The lease deed contains a list of the lease's terms and restrictions.
Types of leases
Now, let us talk about the different types of leases. There are two types of leases: a finance or capital lease and an operating lease. When an asset is passed to the lessee under a finance lease, the risk and rewards are also transferred. This is in contrast to an operating lease, where the risks and benefits are passed along with the asset.
An operating lease uses assets but does not want to list them in the accounting records.
A finance lease and an operating lease differ significantly. The former cannot be terminated during the primary lease period, whilst the latter may be terminated by the lessee.
Let us elaborate a little more on this.
Long-term, non-cancellable leases are known as finance leases or capital leases. It is less of a lease and more of a financial arrangement. In circumstances other than leasing, a company must either borrow money or use its own capital to finance its assets. However, if a company's capital is insufficient to purchase the asset, it will have to borrow money or pursue other options, such as leasing.
A finance lease is nothing more than the lessor financing the asset while also collecting interest on their investment.
An operating lease is one where the lessor buys the asset and rents it to the lessee for a brief and limited term. In contrast to a finance lease, a service lease is one in which the lessor also offers a few other related services in addition to the leased assets. The lessor retains ownership and liability for the asset and is not reliant on a single lessee to pay the whole cost of the asset.
When the asset isn't used frequently, the lessee or user typically prefers an operational lease. Over the course of the operating lease, various users will use the asset. The asset is leased from the lessor along with the necessary services.
Let us understand this with an example.
For e.g.- Company X might occasionally need a projector to give its employees and personnel special training. It makes no sense for Company X to purchase the projector when it is available for rental if they only use it once or twice throughout the entire year. It will be less expensive than purchasing it.
Hence, Company X can buy it through Operational Lease.
Differences between Finance Lease and Operating Lease
Let us discuss some of the major differences between finance lease and operating lease.
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