Finance Lease or Operating Lease - What is the Difference?

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. 

Finance Lease

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. 

Operating Lease

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. 

• In a finance lease, the lessor gives the lessee permission to utilise the latter's asset without making regular payments over a longer length of time. In contrast, an operating lease is a type of lease in which the lessor gives the lessee access to an asset in return for recurrent payments over a certain time.
• An asset purchase option is provided in a finance lease at the conclusion of the agreed-upon time frame. There is no such offer in the case of an operational lease.
• A finance lease is one that demands accounting system recording. An operating lease, on the other hand, is a concept that does not require recording under any accounting system; for this reason, it is also referred to as "off the balance sheet lease."
• Ownership is transferred to the lessee under the finance lease. Ownership does not pass to the lessee under an operating lease.
• An agreement/contract for a finance leasing is known as a loan agreement. On the other hand, a rent agreement or contract is the legal document that governs an operating lease.
• Tax deductions for depreciation and loan expenses are available with finance leasing while rent payments are tax deductible under the operating lease.

Conclusion

Built on the concept of multiple leasing for multiple assets, this new mode of alternative investing is something that you can try to diversify your portfolio. You can start with a very small investment amount of ? 10,000 only and earn up to 21% pre-tax IRR. This low risk short term investment is worth investing in. Connect with Grip today to check out all their interesting investment products.