The difference between a finance lease and an operating lease
/What is a Finance Lease?
A finance lease designation implies that the lessee has purchased the underlying asset, even though this may not actually be the case. In this arrangement, the risks and rewards associated with the leased asset are shifted to the lessee, while the lessee also gains ownership of the asset at the end of the lease term.
What is an Operating Lease?
An operating lease designation implies that the lessee has obtained the use of the underlying asset for only a period of time. An operating lease has the following features:
Short duration. The lease term is typically shorter than the asset's useful life.
No ownership transfer. Ownership of the asset remains with the lessor throughout and after the lease term.
Maintenance and risk. The lessor often retains responsibility for maintenance, insurance, and the risks of obsolescence.
Lease payments. Treated as operating expenses and accounted for on the income statement.
Comparing a Finance Lease and Operating Lease
A lessee should classify a lease as a finance lease when any of the following criteria are met:
Ownership transfer. Ownership of the underlying asset is shifted to the lessee by the end of the lease term.
Ownership option. The lessee has a purchase option to buy the leased asset, and is reasonably certain to use it.
Lease term. The lease term covers the major part of the underlying asset’s remaining economic life. This is considered to be 75% or more of the remaining economic life of the underlying asset. This criterion is not valid if the lease commencement date is near the end of the asset’s economic life, which is considered to be a date that falls within the last 25% of the underlying asset’s total economic life.
Present value. The present value of the sum of all lease payments and any lessee-guaranteed residual value matches or exceeds the fair value of the underlying asset. The present value is based on the interest rate implicit in the lease.
Specialization. The asset is so specialized that it has no alternative use for the lessor following the lease term. In this situation, there are essentially no remaining benefits that revert to the lessor.
When none of the preceding criteria are met, the lessee must classify a lease as an operating lease.
When the lessor is a government entity, the underlying asset may be a more substantial facility, such as an airport, where it is impossible to determine an economic life or the fair value of the asset. For these reasons, such leases should be considered operating leases. All of the following conditions should apply before a lease from a government entity is considered an operating lease:
Ownership. The underlying asset is owned by a government entity, and ownership cannot be transferred to the lessee.
Nature of the asset. The underlying asset is part of a larger facility, such as an airport, and is a permanent structure that cannot be moved.
Termination right. The lessor has the right to terminate the lease at any time.