• Finance lease or operating lease

Finance lease or operating lease? What is the difference?

How to tell the difference between a finance lease and an operating lease

The world of asset finance and contract hire and leasing isn’t always as clear as it could be. And one of the frequent areas of confusion we come across is understanding the difference between a finance lease and an operating lease. Let’s try to explain…

Generally accepted accounting practice (both SSAP 21 and IAS 17) defines an operating lease as ‘a lease other than a finance lease’.  So we need to start with understanding what a finance lease is.

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What is a finance lease?

A finance lease is a way of providing finance – effectively a leasing company (the lessor or owner) buys the asset for the user (usually called the hirer or lessee) and rents it to them for an agreed period.

A finance lease is defined in Statement of Standard Accounting Practice 21 as a lease that transfers

“substantially all of the risks and rewards of ownership of the asset to the lessee”.

Basically this means that the lessee is in a broadly similar position as if they had bought the asset.

The lessor charges a rent as their reward for hiring the asset to the lessee.  The lessor retains ownership of the asset but the lessee gets exclusive use of the asset (providing it observes the terms of the lease).

The lessee will make rental payments that cover the original cost of the asset, during the initial, or primary, period of the lease.  There is an obligation to pay all of these rentals, sometimes including a balloon payment at the end of the contract.  Once these have all been paid, the lessor will have recovered its investment in the asset.

The customer is committed to paying these rentals over this period and, technically, a finance lease is defined as non-cancellable although it may be possible to terminate early.

At the end of the lease

What happens at the end of the primary finance lease period will vary and depends on the actual agreement but the following are possible options:

–       the lessee sells the asset to a third party, acting on behalf of the lessor

–       the asset is returned to the lessor to be sold

–       the customer enters into a secondary lease period

When the asset is sold, the customer may be given a rebate of rentals which equates to the majority of the sale proceeds (less the costs of disposal) as agreed in the lease contract.

If the asset is retained, the lease enters the secondary period.  This may continue indefinitely and will come to an end when the lessor and lessee agree, or when the asset is sold.

The secondary rental may be much lower than the primary rental (a ‘peppercorn’ rental) or the lease may continue on a month by month basis at the same rental.

Operating Lease

In contrast to a finance lease, an operating lease does not transfer substantially all of the risks and rewards of ownership to the lessee.  It will generally run for less than the full economic life of the asset and the lessor would expect the asset to have a resale value at the end of the lease period – known as the residual value.

This residual value is forecast at the start of the lease and the lessor takes the risk that the asset will achieve this residual value or not when the contract comes to an end.

An operating lease is more typically found where the assets do have a residual value such as aircraft, vehicles and construction plant and machinery.  The customer gets the use of the asset over the agreed contract period in return for rental payments.  These payments do not cover the full cost of the asset as is the case in a finance lease.

Operating leases sometimes include other services built into the agreement, e.g. a vehicle maintenance agreement.

Ownership of the asset remains with the lessor and the asset will either be returned at the end of the lease, when the leasing company will either re-hire in another contract or sell it to release the residual value.   Or the lessee can continue to rent the asset at a fair market rent which would be agreed at the time.

Accounting regulations are under review, however at the current time, operating leases are an off balance sheet arrangement and finance leases are on balance sheet. Edit – for those accounting under International Accounting Standards, IFRS16 will now bring operating lease on balance sheet – read more about IFRS16 here.

Summary

Finance lease v operating lease

 

The classification of a lease as either a finance lease or an operating lease is based on if the risks and rewards of ownership pass to the lessee. This can be subjective and it is important that the leasing contract is carefully reviewed.

So, it turns out that giving a simple explanation isn’t that simple! If there’s anything you think needs clarifying further or you have any questions, please get in touch.

You may also be interested in:

Hire purchase or outright purchase – is one right for you?


9 Comments

  1. Pet April 23, 2018 at 11:20 am - Reply

    Thank you very much, I find it reach. But in the operating lease would you call it rent like when you pay for one year House rent.

    • Catherine Dawson May 1, 2018 at 4:24 pm

      It’s similar, yes. And lease payments are often referred to as rentals.

  2. Mokhethi May 24, 2017 at 4:23 am - Reply

    The leasee has an option to purchase that asset at the end of the lease term

    • Catherine Dawson May 24, 2017 at 10:25 am

      Under UK structures, ownership can not pass to the lessee. This is possible with other funding structures such as contract purchase.

  3. Robert Eggleston July 17, 2013 at 7:43 am - Reply

    Dear Karma, Thank you for your question. I think the first thing to say is that your best bet is to get advice from your auditors/accountants. The second thing to say is that I have seen different advice from different auditors/accountants (so I suspect that there is a degree of subjectivity to this).

    There are a number of factors which determine whether something is capable of being treated as an operating lease or finance lease.

    2 key issues are: (a) whether the lease transfers “substantially all the risks and rewards of ownership” to the lessee; and (b) whether the lease is for substantially all of the useful working life of the equipment.

    So I suspect that in your example, if at the end of 4 years a lessor was carrying a genuine residual exposure in the equipment of 25% and its margin return was dependent upon recovering that residual investment then it would satisfy the first test above (bear in mind the old SSAP21 90/10 rule).

    It may not satisfy the second test but this may not be fatal to you. You would need to look at things like the return conditions, the inherent rate charged over the 4 year term, the ability of the lessor to use the equipment in another environment (i.e. whether the equipment was made to the order of the lessee and has no real practical application elsewhere).

    It would be good to have an idea of the equipment to which you refer.

    Hope this helps

    Robert Eggleston

  4. Karma July 16, 2013 at 10:11 am - Reply

    In case of Operating Lease, what would be the maximum length of the lease period. I know it should be less than useful life of the equipment.
    If the useful life of the equipment is 5 years, could you do a 4 years Operating lease? According to some advise I have recieving you can only go upto p 75% of the useful life of the equipment. Which would be 3 years & 9 months and therefore doing a 4 year lease wouldn’t qaualify as Operating lease. Is this correct?
    Thanks,
    Karma

  5. […] in force. Currently leases are classified as either a capital (typically a finance lease) or an operating lease, with the latter not being required to be shown on a lessees’ balance sheet. The IASB and […]

  6. Robert Eggleston May 8, 2013 at 9:12 am - Reply

    Joaquin, many thanks for leaving a comment. Under UK accounting rules, title to equipment does not transfer at the end of a finance lease. Indeed, there is a risk that, if a leasing company makes that commitment (at the inception of a lease) it effectively creates a lease purchase transaction. The result of that would be to shift the right to claim writing down allowances and also change the tax relief that could be claimed (under a finance lease you can, providing you pay UK corporation tax, set the rental off against the tax liability but with lease purchase can only set the interest off against tax). It would be common at the end of the lease term to agree a secondary rental (often called a “peppercorn”). I understand that a Capital Lease in the USA has a different treatment.

  7. Joaquin Gual May 8, 2013 at 8:25 am - Reply

    Good explanation.
    Nevertheless in the case of the finance lease I don’t understand you don’t clearly state that at the end of the lease period the lessee becomes the owner of the asset??. Just from the moment he pays the last rental.

    I am glad to follow leasing experts as you.
    Congratulations

    Joaquin Gual

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