We have often heard about the terms 'finance lease' and 'operating lease' in our daily lives, especially if you read the finance section of the newspaper. Although they might seem as the same thing, they are actually very different in structure. This article helps differentiate the two types of leases.

Terms defined

The lessee is the person who leases the asset. The lessor is the person who leases the asset to the lessee.

Finance Lease

A finance lease is a type of lease where the lessor has transferred the risks and rewards of ownership to the lessee. This includes maintenance of the asset and the risk of obsolescence. The lessee would have to bear these risks of ownership of the asset. In a finance lease, the lessee would pay an amount of lease payments which covers all or most of the cost of the asset to the lessor. The lessee would also have use of the asset for most of its useful life. A finance lease would usually give the lessee an option to purchase the asset after the lease term at a discounted price. A finance lease is not easily cancellable. Even if it was, there would be high penalties for cancellation. An example of a finance lease is the lease of a production machine by a company. The company would have to be responsible for the maintenance of the machine.

Operating Lease

An operating lease on the other hand, is a lease where the lessor retains ownership of the asset. This means that the risk and rewards of ownership has not been transferred to the lessee. The lessor is liable for maintenance payments on the asset. After the lease period, the asset would still have a substantial residual value left. The lease period is also usually a minor part of the asset's useful life. An operating lease is also easily cancellable given a short notice. An example of an operating lease is the lease of computers by a company. The company does not need to pay for repairs of the computer and does not need to worry that the computers being obsolete as the lessor would be the one responsible for the computers.

Classification under Accounting Standards

The accounting standards have specific criteria for the classification of finance and operating leases. A finance lease would be classified as an asset (the leased asset) and liability (the lease payments) whereas an operating lease would be classified as an operating expense which goes to the profit and loss statement.

Under the accounting standards, there are four criteria to help classify the type of lease. First, is whether the ownership of the asset is transferred to the lessee at the end of the lease period. Second, is whether the lessee has an option to purchase the asset at a discount after the lease period. Third, is whether the lease term covers more than 75% of the asset's useful life. Fourth, is whether the present value of lease payments exceeds 90% of the cost of the asset. If most of the answers to these questions are 'yes', then the lease is classified as a finance lease.

Correct classification of leases is important as they will affect the financial statement of the company. This will affect the solvency and liquidity of the company, debt to equity ratio of the company and its capital structure. A wrong classification would mislead the investors into believing that the company's financials are better than it seems. For example, if the company classified a finance lease as an operating lease, they would understate their liabilities, which is the obligation to pay the lease payments. It is important for investors to understand the terms and conditions of the lease so that they can determine the substance of the lease (whether finance or operating) and assess the company's financial standing. This can be done through proper disclosures by the company in the notes to the accounts.