Operating Lease – Definition and How It Differs From a Finance Lease

Abey Francis

The International Accounting Standards Committee defines an Operating Lease as “any lease other than a finance lease”.

An Operating Lease has the following characteristics:

  • The lease term is significantly less than the economic life of the equipment.
  • The lessee enjoys the right to terminate the lease at short notice without any significant penalty.
  • The lessor usually provides the operating know-how, suppliers, the related services and undertakes the responsibility of insuring and maintaining the equipment in which case an operating lease is called a ‘wet lease’. An operating lease where the lessee bears the costs of insuring and maintaining the leased equipment is called a ‘dry lease’.

From the features of an operating lease, it is evident that this form of a lease does not shift the equipment-related business and technological risks from the lessor to the lessee. The lessor structuring an operating lease transaction has to depend upon multiple leases or on the realization of a substantial resale value (on expiry of the first lease) to recover the investment cost plus a reasonable rate of return thereon. Therefore, specializing in operating leases calls for an in-depth knowledge of the equipment’s per se and the secondary (resale) market for such equipment’s. Of course the prerequisite is the existence of a resale market. Given the fact that the resale market for most of the used capital equipment’s in our count~ lacks breadth, operating leases are not in popular use. But then this form of lease ideally suits the requirements of firms operating in sun rise industries which are characterized by a high degree of technological risk.

Following are illustrative situations where a lease will be regarded as an operating lease:

  • If the lease has a cancellable period, during which rentals forming more than 10% in present value terms of the fair value of the asset are received;
  • If part of the rentals are contingent or conditional, and such rentals form more than 10% in present value terms of the fair value of the asset;
  • If the lessor relies upon unguaranteed residual value, and such value forms more than 10% in present value terms of the fair value of the asset;
  • If the lessor relies upon guaranteed residual value, but such value is guaranteed by a third party, and such third-party-guaranteed residual value forms more than 10% in present value terms of the fair value of the asset – in this case, the lease will be regarded as a financial lease for the lessor but an operating lease for the lessee;
  • If the lessor’s IRR and the lessee’s incremental borrowing rate differ: the lease may be a financial lease for the lessor and an operating lease for the lessee

Differences between Finance Lease and Operating Lease

There are several distinguishing factors that define the difference between finance lease and operating lease.

Finance Lease

  • Risks and rewards of ownership are transferred to, and borne by, the lessee. This includes the risks of accidental ruin or damage of the asset (although these risks may be insured or otherwise assigned). Thus damage that renders an asset unusable does not exempt the lessee from financial liabilities before the lessor.
  • The goal of the lessee is either to acquire the asset or at least use the asset for most of its economic life. As such, the lessee will aim to cover all or most of the full cost of the asset during the lease term and therefore is likely to assume the title for the asset at the end of the lease term. The lessee may gain the title for the asset earlier, but not before the full cost of the asset has been paid off.
  • The lessor retains legal ownership for the duration of the lease term, though the lessee may or may not buy out the leased asset at the end of the lease, with the lessor charging only a nominal fee for the transfer of asset to the lessee.
  • The lessee chooses the supplier of the asset and applies to the lessor for funding. This is significant because the leasing company that funds the transaction should not be liable for the asset quality, technical characteristics, and completeness, even though it retains the legal ownership of the asset. The lessee will also generally retain some rights with respect to the supplier, as if it had purchase asset directly.
Operating Lease

  • Economic ownership with all corresponding rights and responsibilities are borne by the lessor. The lessor buys insurance and undertake responsibility for maintenance.
  • The goal of the lessee is usage of the leased asset for a specific temporary need, and hence the operating lease contract covers only the short-term use of the asset. Further, the duration of an operating lease is usually much shorter than the useful life of the asset.
  • It is not the lessee’s intention to acquire the asset, and lease payments are determined accordingly. In addition, an asset under an operating lease may subsequently be rented out.
  • The present value of all lease payments is significantly less than the full asset price.

The asset of finance lease is being disclosed on the balance sheet and the asset of operating leases disclosed in the notes. Under the operating lease, lessee is not obligated to report the operating leases assets and liabilities on their balance sheet but rather in the footnotes, which will provide financial statement users an inaccurate account of a company’s outstanding expenses, forcing them to estimate the off-balance sheet obligation, which often leads to over estimations, while the finance operating is the leased assets shall be included in the lessee’s asset and the depreciation should be calculated within the service period. The related assets and liabilities of finance lease have to reflect in the balance sheet. Furthermore, the ownership of the operating lease is with the lessor, while the ownership of financial lease is the lessee, which means the risk and rewards of operation lease is with the lessor, but for financial lease is with the lessee. Most companies like operating leases, because operating leases can increase returns on assets ratios and not decrease the earnings with depreciation expenses, moreover, the value of these lease asset is hard to calculate.

Related posts:

  1. Finance Lease – Definition and Features
  2. Types of Finance Lease Agreements
  3. Why Wealth Maximization is Considered to be Better Operating Goal?
  4. Lease vs Hire Purchase
  5. Lease vs Buy Decision – Meaning and Analysis
  6. Lease Financing in Lessor’s View Point
  7. Operating Economies through Mergers
  8. An Overview of Computer Operating Systems (OS)

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