Currently, leases are broadly classified into two categories. Despite the fact that there are a great number of permutations and derivatives of a lease, most of the time they are referred to as either finance leases, also known as capital leases, or operating leases.

The distinctions between the two are often ambiguous and up to interpretation, but in this post, we will look at the practical differences between the two and attempt to simplify what can be a difficult area of leasing. Lessees must be familiar with the leases they hold and the ways in which those leases will be accounted for financially under the new lease accounting rules.

It is important to keep in mind that the two main international accounting bodies, the FASB for the United States and the IASB for Europe, use somewhat different criteria for classifying the various kinds of leases. These definitions are essential when it comes to lease accounting, but for day-to-day operations, the interpretations are very well interchangeable.

Finance Lease

When purchasing equipment for the majority of its useful life, finance leasing is often employed as a payment method. The purchase price of the products does not include the GST, and there will be a balloon payment due at the conclusion of the period.

After the lease period ends, the lessee has the option to "purchase" the equipment for an agreed-upon price. This offer is traditionally understood to refer to the balloon amount. Although individuals may get into finance leases, this kind of leasing is typically reserved for businesses.

Operating Lease

An operational lease agreement is used to finance equipment for a length of time that is less than the equipment's useful life. At the conclusion of the lease term, the lessee is free to return the equipment to the lessor without incurring any further obligations. Only those who already have a business number may sign operating leases.

What's the Difference Between Operating Leases and Finance Leases?

At the conclusion of the lease period under a finance leasing arrangement, the lessee is given the title to the leased property and becomes the legal owner of it. On the other hand, in the case of an operating lease arrangement, the lessor retains ownership of the property during the length of the lease as well as after it expires.

The Balloon or Remaining Balance

The lessee has the option, known as a balloon payment or residual option, to acquire the property or equipment at the end of a finance lease contract for a predetermined price. On the other hand, if the lease is an operational lease, the lessee does not have access to this choice. When determining the balloon payment or residual value on a financing lease, the ATO asset standards are used.

Running Costs & Administration

In the case of an operational lease, all of the operating expenses are bundled into the lease for the agreed-upon duration, with a single, predetermined sum to be repaid each month. Because they are often not included in a financing lease, the lessee may be subject to increased levels of administration and price volatility over the lease term.

Account Treatment

The tax treatment of leases was modified in 2021 with the introduction of accounting standard ASC 842. As a result of this change, operating leases are now included on the balance sheet as liabilities and as expenses for the right to use the leased property, whereas in the past they were excluded from the balance sheet.

Why Select One Sort of Lease Over Another?

This is a difficult subject, and each asset investment has to be evaluated on its own so that the organization may choose the kind of financing that will provide the greatest return on investment for the business. However, there are two major factors to consider: the nature and expected lifetime of the asset and the accounting treatment of the leased asset.

For instance, operating leases are convenient for consumers since they need just one monthly payment in addition to the asset's full purchase price upfront. As a result of the reduced need for administration, they are often cost-effective for businesses that are in charge of at least a few of the same assets.

Finance leases, on the other hand, entail extra paperwork and may increase the lessee's resale risk depending on the nature of the leased item and the applicable ATO criteria for the balloon payment's timing.

Final Thoughts

If the lessee is responsible for both the risks and the potential benefits associated with ownership, the kind of lease being discussed is known as an operating lease rather than a financing lease. Because of the possibility of subjectivity surrounding this matter, the lease contract must be thoroughly examined.