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 defines an operating lease as ‘a lease other than a finance lease’. So we need to start with understanding what a finance lease is.
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 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.
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.
Operating leases are an off-balance sheet arrangement and finance leases are on balance sheet.
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.