Important Differences Between Finance (Capital) Lease and Operating Lease

Finance (Capital) Lease

Finance lease, also known as capital lease, is a type of lease agreement that allows a lessee (the borrower) to use a specific asset for a period of time, in exchange for regular lease payments. The finance lease agreement is a long-term lease agreement, typically with a duration of more than one year, where the lessee has the option to purchase the leased asset at the end of the lease term.

In a finance lease, the lessee is treated as the owner of the asset for accounting purposes, and the leased asset is recorded on the lessee’s balance sheet as an asset and liability. The lease payments are also treated as a combination of principal and interest, and the lessee depreciates the leased asset over its useful life.

Features of Finance Lease:

1. Ownership: In a finance lease, the lessee has the option to purchase the leased asset at the end of the lease term, and the lessee is responsible for the maintenance and repair of the leased asset.
2. Long-term lease: Finance lease agreements are typically long-term lease agreements with a duration of more than one year.
3. Purchase Option: The lessee has the option to purchase the leased asset at the end of the lease term. The purchase option can be a nominal amount or the fair market value of the asset.
4. Financing: Finance lease is a type of financing arrangement, where the lessor (the lender) provides financing to the lessee (the borrower) to acquire the leased asset.
5. Fixed Payments: The lease payments in a finance lease are fixed and are made over the lease term.

Advantages of Finance Lease:

1. Off-balance sheet financing: The finance lease agreement allows the lessee to use the asset without it being recorded as a liability on the balance sheet.
2. Tax Benefits: The lease payments made under the finance lease agreement are treated as tax-deductible expenses.
3. Cash flow: The finance lease agreement provides a predictable cash flow for the lessee, as the lease payments are fixed and made over the lease term.
4. Asset ownership: The lessee has the option to purchase the leased asset at the end of the lease term, and the asset becomes the property of the lessee.

Disadvantages of Finance Lease:

1. Higher Costs: The interest rates in finance leases are usually higher than other forms of financing, which can result in higher costs for the lessee.
2. Maintenance and repair: The lessee is responsible for the maintenance and repair of the leased asset, which can add to the overall cost of the lease.
3. Limited Flexibility: The finance lease agreement is a long-term agreement, and the lessee may not be able to terminate the agreement or return the asset before the end of the lease term.

Operating Lease

An operating lease is a type of lease agreement where the lessee (the borrower) obtains the right to use a specific asset for a limited period of time, in exchange for regular lease payments. In an operating lease, the lessor (the lender) retains ownership of the asset and is responsible for maintenance and repairs during the lease term.

Features of Operating Lease:

• Short-term lease: Operating leases are typically short-term leases with a duration of less than one year.
• No Ownership: The lessee does not have the option to purchase the leased asset at the end of the lease term, and the asset remains the property of the lessor.
• Maintenance and Repairs: The lessor is responsible for maintenance and repairs during the lease term, which can be an advantage for the lessee.
• Fixed Payments: The lease payments in an operating lease are fixed and made over the lease term.
• Off–balance sheet financing: The operating lease agreement does not record the leased asset as a liability on the lessee’s balance sheet.

Advantages of Operating Lease:

• Flexibility: The short-term nature of an operating lease provides flexibility to the lessee, as they can upgrade to newer assets without a long-term commitment.
• Lower Costs: The lease payments in an operating lease are typically lower than the payments in a finance lease or outright purchase of the asset.
• No ownership: The lessee does not bear the risk of asset depreciation or obsolescence, as they do not own the asset.
• Maintenance and Repairs: The lessor is responsible for maintenance and repairs during the lease term, which can save costs for the lessee.

Disadvantages of Operating Lease:

• Limited Control: The lessee does not have control over the asset, and the lessor may impose usage restrictions or limit alterations to the asset.
• No Ownership: The lessee does not have the option to purchase the leased asset, which can be a disadvantage if they require the asset for a longer period.
• Higher Costs: Over a longer period, the total cost of operating leases can be higher than the total cost of purchasing or financing the asset outright.

Key Differences Between Finance (Capital) Lease and Operating Lease

Important Differences Between Finance (Capital) Lease and Operating Lease

Here are some of the important differences between finance (capital) lease and operating lease:

1. Ownership of asset: In a finance lease, the ownership of the asset transfers to the lessee at the end of the lease term, while in an operating lease, the ownership remains with the lessor.
2. Duration of lease: A finance lease typically covers the useful life of the asset, while an operating lease is usually shorter than the useful life of the asset.
3. Purchase option: A finance lease usually includes a purchase option at the end of the lease term, while an operating lease may or may not include a purchase option.
4. Transfer of risk and rewards: In a finance lease, the lessee assumes the risk and rewards of ownership of the asset, while in an operating lease, the lessor retains the risk and rewards of ownership.
5. Maintenance and repairs: In a finance lease, the lessee is typically responsible for maintenance and repairs, while in an operating lease, the lessor is typically responsible for maintenance and repairs.
6. Tax treatment: In a finance lease, the lessee can claim tax benefits as the owner of the asset, while in an operating lease, the lessor can claim tax benefits as the owner of the asset.
7. Accounting treatment: In a finance lease, the lessee records the leased asset as an asset and the lease obligation as a liability on the balance sheet, while in an operating lease, the leased asset and lease obligation are not recorded on the balance sheet.

Similarities Between Finance (Capital) Lease and Operating Lease

Both finance (capital) lease and operating lease are types of lease agreements that allow a lessee to use an asset owned by a lessor for a specified period of time. Here are some similarities between the two types of leases:

1. Both types of leases involve a lessor who owns the asset and a lessee who uses the asset.
2. Both types of leases specify a period of time during which the lessee can use the asset.
3. Both types of leases may involve periodic rental payments made by the lessee to the lessor.
4. Both types of leases require the lessor to maintain ownership of the asset throughout the lease term.
5. Both types of leases can provide the lessee with tax benefits.
6. Both types of leases may require the lessee to return the asset to the lessor at the end of the lease term.

Laws governing Finance (Capital) Lease and Operating Lease

In India, the laws governing finance (capital) lease and operating lease are as follows:

1. The Indian Contract Act, 1872: This act governs the lease agreements in India, including finance and operating leases. It lays down the rules and regulations for the creation and enforcement of lease agreements.
2. The Companies Act, 2013: This act applies to all companies registered under the Companies Act, 2013, and provides for the regulation of financial transactions including leasing. The act prescribes rules and guidelines for the accounting and financial reporting of lease transactions by companies.
3. The Income Tax Act, 1961: This act governs the taxation of lease transactions in India. It provides for the tax treatment of lease payments made by the lessee and the income earned by the lessor from the lease.
4. The Reserve Bank of India Act, 1934: This act regulates the banking and financial sector in India. It provides for the regulation of lease transactions by banks and financial institutions.
5. The Securities and Exchange Board of India (SEBI) Regulations: SEBI regulates the securities market in India and has prescribed regulations for the disclosure and reporting requirements for lease transactions involving listed companies.
6. The Goods and Services Tax (GST) Act, 2017: This act governs the taxation of goods and services in India, including lease transactions. It provides for the levy and collection of GST on lease rentals and other charges.