Difference between Operating Lease and Financial Lease (Equipment Leasing)

An operating lease is akin to a rental agreement where the lessor retains ownership and usually handles maintenance of equipment, whereas a financial lease is more like a financed purchase where the lessee takes on the benefits and risks of ownership and the asset and liability are reflected on the lessee’s balance sheet.

This article analyses the difference between operating lease and financial lease to help you clarify the best options in equipment leasing.

Introduction: Operative Lease vs Financial Lease

In the world of equipment finance, the terms “operating lease” and “financial lease” (also known as “capital lease”) are thrown around quite frequently.

These terms refer to the two main leases businesses use to acquire assets, usually equipment and vehicles, without the large upfront costs typically associated with outright purchases.

Understanding the fundamental differences between operating and financial leases is crucial for financial planning, reporting, tax considerations, and overall business decision-making.

Understanding Equipment Leases

Before we delve into the distinctions, let’s establish a common understanding of a lease. A lease is a contract that allows one party (the lessee) to use an asset owned by another (the lessor) in return for specified payments over an agreed period.

Equipment leases are used when businesses need specific movable assets but do not want or cannot buy them outright.

The lessee benefits from the asset’s use, and the lessor gains the benefits of the lease payments. However, the devil, as they say, is in the details, and the manner in which these benefits are distributed and recorded can vary significantly between an operating lease and a financial lease.

Operating Lease

An operating lease, also called a “service lease”, is a contract that allows a business to use the equipment for a short period, usually less than the asset’s full economic life.

The lessee returns the equipment to the lessor at the end of the lease term with no option to purchase it. It’s similar to a long-term rental agreement.

Under an operating lease, the lessor maintains asset ownership and is generally responsible for maintenance, insurance, and taxes, although the specifics can vary based on the lease agreement.

In financial reporting, operating lease expenses are treated as operating expenses on the income statement. The lease does not affect the balance sheet significantly as neither an asset nor a liability is recorded – essentially, it’s “off-balance sheet” financing.

Operating leases can appeal to businesses because they often have lower lease payments than financial leases and offer flexibility if the asset is needed only for a short period or is likely to become obsolete quickly.

Financial Lease

On the other hand, a financial lease (or capital lease) is more akin to a purchase agreement financed through monthly payments.

The term of a financial lease usually spans most of the equipment’s useful life. In many cases, the lessee can purchase the equipment at the end of the lease term, often for a nominal amount.

Under a financial lease, the lessee assumes many of the risks and rewards of ownership, such as maintenance costs and the potential for an increase in asset value. On the lessor’s end, once the lease is signed, they have a guaranteed income stream but may have fewer responsibilities for the equipment.

From a financial reporting perspective, a financial lease is treated as an asset and a liability on the balance sheet. The present value of future lease payments is recorded as a liability, while the leased asset is recognized as an asset.

The lease payments are split between interest expense (which goes on the income statement) and lease liability reduction (which affects the balance sheet).

Key Difference between Operating Lease and Financial Lease

To sum up the main differences between the two types of leases:

• Asset Ownership: In an operating lease, the lessor retains asset ownership. In contrast, a financial lease essentially transfers the risks and benefits of ownership to the lessee.

• Term Length: Operating leases typically span a shorter term, often less than the asset’s useful life. Financial leases usually cover most, if not all, of the asset’s economic life.

• Financial Reporting: Operating leases are usually “off-balance sheet” and treated as operational expenses. Financial leases are “on-balance sheets,” with the leased asset and the corresponding liability recognized on the balance sheet.

• Maintenance and Costs: In most operating leases, the lessor bears the responsibility for maintenance, insurance, and taxes. For financial leases, these responsibilities are generally borne by the lessee.

• Purchase Option: Operating leases do not typically include an option to purchase the asset at the end of the lease. In contrast, financial leases often include a purchase option.

Operating Lease vs Financial Lease

What is the typical duration of an operating lease vs financial lease?

An operating lease typically covers a short-term period, often significantly less than the full economic life of the equipment.

Depending on the asset and the lessee’s needs, this could range from a few months to a few years. It’s well-suited for assets that quickly become obsolete, such as technology equipment.

On the other hand, a financial lease is a long-term commitment, often spanning most, if not all, of the asset’s useful life.

This could mean several years to a decade or more, especially for durable equipment with a long lifespan. It’s advantageous when the lessee plans to use the equipment substantially or desires to own it eventually.

In an operating lease, since the lessor retains ownership, they usually handle significant upkeep, although minor maintenance might be the lessee’s responsibility as defined in the lease agreement. Therefore, they usually assume responsibility for maintenance, repairs, insurance, and associated costs.

In a financial lease, this transfer of responsibilities and ownership occurs because a financial lease is more akin to a financed purchase agreement. The lessee takes on ownership’s benefits and risks, including equipment maintenance and repair.

However, these are general guidelines, and responsibilities can vary based on specific terms in the lease agreement. It is essential for both lessors and lessees to understand these responsibilities before entering into a lease agreement.

On the other hand, financial leases are usually long-term and cover most of the equipment’s useful life. Upgrading equipment under a financial lease can be more complicated and potentially costly.

The lessee essentially takes on the benefits and risks of ownership, including dealing with the equipment’s obsolescence. However, some financial leases may include upgrade provisions, but this is less common.

Thus, if frequent upgrades are a priority, operating leases are typically a better choice due to their flexibility and shorter terms.

How does accounting differ between operating leases and financial leases?

Accounting for operating lease and financial lease differ significantly, primarily in how they are recorded in the company’s financial statements.

For operating leases, the lessee simply recognizes the lease payments as an operating expense on the income statement over the lease term. The lease does not significantly impact the balance sheet, as neither an asset nor a liability is recorded, effectively making it an “off-balance sheet” financing.

For example, if a company leases a piece of machinery for two years at $10,000 per year, it would simply report an annual expense of $10,000 on the income statement for each lease year.

In contrast, a financial lease is treated more like a purchase financed by a loan. The leased asset is recorded as an asset, and the present value of future lease payments is reported as a liability on the lessee’s balance sheet.

The lease payments are split between interest expense (which goes on the income statement) and lease liability reduction (which affects the balance sheet). Suppose a company enters a five-year financial lease for machinery worth $100,000 with annual payments of $25,000.

The company would initially record the machinery as an asset and $100,000 as a liability on its balance sheet. Each $25,000 payment would then be split between reducing this liability and recording an interest expense.

The choice between operating lease and financial lease has implications for a company’s reported financial position, profitability, and cash flow, making it a strategic decision.

How does equipment depreciation work in an operating lease vs financial lease?

In an operating lease, the lessee doesn’t record the leased equipment as an asset on its balance sheet; thus, no depreciation is recorded by the lessee. The lessor, who retains ownership of the equipment, records the asset on their balance sheet and handles the depreciation.

For instance, if a company leases a truck worth $50,000 under an operating lease for five years, the lessee wouldn’t record the truck as an asset or handle its depreciation. The lessor would do this instead.

In contrast, under a financial lease, the lessee effectively assumes the owner’s role and therefore records the leased equipment as an asset on its balance sheet. As a result, the lessee is responsible for accounting for the equipment’s depreciation over its useful life.

For example, if a company enters into a seven-year financial lease for a machine worth $70,000, it would record the machine as an asset and depreciate it over its useful life. The company will record a depreciation expense of $10,000 each year if the machine’s useful life is seven years.

Which equipment lease type is generally considered “off-balance sheet financing”?

The lease type generally considered as “off-balance sheet financing” is the operating lease. In an operating lease, the lessee does not record the leased asset as an asset on its balance sheet.

Similarly, the obligation to make future lease payments is not recognized as a liability. Instead, the lease payments are recognized as operating expenses in the period they are paid.

This is in contrast to a financial lease, where the leased asset and the present value of future lease payments are recorded on the lessee’s balance sheet as an asset and a corresponding liability, respectively.

However, it’s worth noting that accounting standards have been evolving worldwide, with many jurisdictions moving towards requiring more leases to be reported on the balance sheet.

Despite these changes, the distinction between operating leases (often off-balance sheets) and financial leases (on-balance sheets) remains fundamental.

How does the choice between an operating lease and financial lease affect a company’s EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a commonly used measure of a company’s operating performance. Choosing between an operating lease and a financial lease can significantly impact its EBITDA.

In an operating lease, lease payments are treated as operating expenses. Therefore, they are deducted before arriving at EBITDA. This means that a company using operating leases will typically have a lower EBITDA than if it used financial leases, all else being equal.

In contrast, a financial lease is treated more like a purchase financed with debt. The lease payments are split between interest (deducted after EBITDA is calculated) and principal reduction.

The part of the lease payment that reduces the principal does not impact the income statement, whereas depreciation of the leased asset (a non-cash expense) reduces the net income but not the EBITDA. Therefore, companies using financial leases may report higher EBITDA compared to if they used operating leases.

Investors and analysts should know this when comparing companies with different leasing strategies. EBITDA should be used with other measures to provide a more complete picture of a company’s financial performance.

Can a company terminate an operating lease or financial lease early?

As a general rule, it is typically more challenging to terminate a financial lease early without incurring substantial penalties, as it is essentially a financing contract.

Operating leases often have more flexibility and may allow for early termination under certain conditions, albeit potentially with penalties or fees. The lease agreement should clearly stipulate the conditions and costs of early termination.

It’s also worth noting that the lessor might be willing to negotiate early termination terms in some situations, especially in challenging economic times or if they can re-lease the equipment quickly.

Is the cost of insurance included in the lease payments for the operating lease and financial lease?

In an operating lease, the lessor typically retains the risk of ownership, so they usually handle insurance, and the cost may be built into the lease payments. The lessor’s insurance generally covers the asset itself, but lessees may still need to secure their insurance for liability reasons.

Conversely, in a financial lease, the lessee assumes many benefits and risks of ownership, similar to a financed purchase. This generally includes the responsibility for insurance coverage, and the insurance cost is usually over and above the lease payments.

However, it is essential to carefully review the lease agreement, as these are general practices, and specific terms can vary. The lease agreement should clearly state who is responsible for insurance and how costs are allocated.

Which type of equipment lease is typically used for high-value, long-life equipment: operating lease or financial lease?

Financial leases are typically used for high-value, long-life equipment. These leases are usually long-term agreements that cover a substantial part, if not all, of the asset’s useful life.

A financial lease is particularly suited to high-value equipment that a company plans to use over a long period. Financial leases often include options to buy the equipment at the end of the lease term, making them a good fit for companies aiming for eventual ownership.

In contrast, operating leases are often preferred for lower-value or rapidly depreciating assets or when the company only needs the equipment for a short period.

Conclusion: Operating Lease vs Financial Lease

Using an operating lease or financial lease can significantly affect a company’s financial planning, reporting, and overall financial health. Both options have advantages and disadvantages, depending on a company’s specific circumstances and needs.

While this article provides an overview, the complexity of equipment leasing makes it crucial for businesses to seek professional advice when negotiating and signing equipment lease agreements.

By understanding the fundamental differences between operating lease and financial lease, businesses can make more informed decisions that align with their strategic goals and financial capabilities.

References

• Dan Dhaliwal, Hye Seung Lee, and Monica Neamtiu, Journal of Accounting, Auditing & Finance, “The impact of operating leases on firm financial and operating risk.”
• Peter W. Schroth, The American Journal of Comparative Law, “Financial leasing of equipment in the law of the United States.”
• Stewart C. Myers, David A. Dill, and Alberto J. Bautista, The Journal of Finance, “Valuation of financial lease contracts.”

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