Operating Lease vs Financial Lease: What's the Difference?

By Indeed Editorial Team

Published 13 November 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Organisations can choose to lease large assets instead of buying them. Operating lease vs financial lease are two accounting methods for managing leases, both with their own benefits and outcomes. If you work in finance, knowing about the two types of lease agreements can help you decide which is more beneficial for your employer. In this article, we describe what operating and financial leases are, explain the key differences between the two, provide guidelines for deciding which could work for the company that employs you and answer some FAQs.

Related: What Is Business Financing? (With Types of Funding)

What is an operating lease vs financial lease?

An operating lease vs financial lease contract are two types of arrangements between a lessor, who owns the equipment, and the lessee, who uses the equipment. The lessee pays the owner of the equipment an agreed figure over a stipulated period. In exchange, the lessor grants the lessee rights to use the equipment. Here are two ways to finalise a basic leasing arrangement to suit different business purposes:

Operating lease

An operating lease is a means of financing equipment for a period shorter than its useful life. The business uses the equipment for the duration of the lease period and returns it at the end of the contract. Once the equipment goes back, there's no further obligation for the lessee. Only organisations with an Australian Business Number are eligible to use operating leases.

Financial lease

A financial lease is a way to buy equipment for most of its useful life. Financing for assets excludes goods and services tax and includes a balloon payment at the end of the leasing term. On payment of the remaining amount, the lessee becomes the owner of the asset.

Related: 20 Important Financial Terms for Every Professional to Know

10 differences between an operating lease and a financial lease

While there are many similarities between the two types of leases, they're different in defining ways, such as the following:

1. Accounting effect

When it comes to presenting the two types of leases on an organisation's accounting system, they reflect differently and create different results on the financial statements. A financial lease appears in the same way as a loan. As the lessee is the owner, the equipment or vehicle appears on the balance sheet. An operating lease works like a rental agreement. The lease payments are operating expenses. As the lessee has no ownership of the asset, the equipment or vehicle won't reflect on the balance sheet.

Related: FAQ: What Is the Purpose of a Balance Sheet? (And More FAQs)

2. Type of contract

A financial lease is a long-term contract, which some may call a loan agreement. An operating lease is a short-term contract, which some may know as a rental agreement. Both types of contracts carry benefits that suit different types of organisations.

3. Equipment maintenance

Under a financial lease, the lessee takes care of and maintains the asset at their own expense. They also carry the risk of obsolescence. Under an operating lease, the obligations to maintain and care for the asset belong to the lessor, who also carries the obsolescence risk.

4. Balloon or residual amount

A financial lease agreement comes with an option for the lessee to purchase the asset at the end of the contract term. The cost of the property or equipment is a specific price that both parties negotiate at the start of the contract. An operating lease doesn't give the lessee an option of purchasing the asset, which returns to the lessor at the end of the contract.

5. Running costs and administration

An operating lease includes all running costs, which combine in a single, set, monthly payment amount for the full term of the contract and the repayment. This amount is stable and won't fluctuate throughout the lease term. A financial lease differs, as the administration and running costs are for the lessee's account. These costs may include items such as:

  • Asset registration (for vehicles)

  • Repair and maintenance

  • Consumables, like fuel for a vehicle or toner or ink for printers

  • Insurance

  • Lease reporting

Related: Guide to Business Administration vs Business Management

6. Tax implications

Both types of leases offer tax benefits in different ways. When leasing under an operating lease, the lease rent is tax-deductible. With a financial lease, the tax deductions are the depreciation and the financing costs.

Related: What Is Income Tax? (Definition and Examples of Income Tax)

7. Contract cancellation

There's no cancellation for a signed financial lease agreement during the initial contract period. If you cancel this type of lease at a later stage in the contract, there's typically an early termination fee payable. You can cancel an operating lease during the introductory period of the contract.

8. Contract nature

While both are leases, a financial lease is usually a long-term commitment. Individuals call this type of lease a loan agreement or loan contract. An operating lease, or rental agreement or rental contract, is a short-term arrangement.

9. Type of asset

As they're typically long-term arrangements, financial leases tend to apply to larger assets. This often includes buildings, heavy machinery, aircraft, railway wagons, motor vehicles or ships. For the lessor, a financial lease is the utilisation of money, as they finance the asset and earn interest on their investment.

Operating leases are short-term by nature. They often apply to smaller assets, such as coffee dispensers, laptops, projectors, photocopiers, printers or computers. For the lessor, the items of equipment they rent are assets on their balance sheet and depreciate every year.

Related: What Are Asset Management Tools? (And Tips for Choosing One)

10. Ownership transferability

Signing a financial lease transfers ownership of the asset to the lessee, along with the responsibility to maintain and care for it. Under an operating lease, the asset remains the lessor's property. The lessor retains the duty of caring for the asset and ensures it's well-maintained.

Choosing between an operating and financial lease

Both types of leases have benefits that are more suitable for different situations. A financial lease can have more administration requirements but is an option for an organisation that intends to purchase the equipment but doesn't have the finance available immediately. Opting for a financial lease gives it the use of the equipment over the time it can build up the capital. If you want to own the asset at the end and look after your own administration running expenses, this may be the route to choose.

Operating leases offer flexibility to organisations that frequently replace or update their equipment. This type of lease requires minimal administration for an organisation to make use of the asset. The organisation's commitments involve paying monthly repayments. At the end of the term, it hands the equipment back. This arrangement can be ideal for an organisation that makes use of many assets, such as running a fleet of cars. It gives the organisation the means of having access to the equipment necessary for running its operations, with no large amount of capital to invest before trading.

Related: How to Create a Financial Plan (Definition and Tips)

Financial and operating lease FAQs

Consider reviewing the following FAQs about lease agreements:

What types of equipment or assets are available for leasing?

Any type of business-related equipment is available for leasing, depending on what sector the business operates in. This includes performing and non-performing assets. The following are a few examples:

  • Agricultural vehicles and equipment

  • Information technology (IT) equipment

  • Gym and exercise equipment

  • Point-of-sale (POS) systems

  • Security systems

  • Mining vehicles and equipment

What happens at the end of a financial lease agreement?

After the primary rental period, the monthly payments typically cover the cost of the asset plus any generated income. An asset may often be close to the end of its lifespan. The lessee can choose whether to:

  • Enter into a secondary lease period and keep using the asset

  • Sell the asset and keep a portion of the income

  • Return the asset

Can you customise the equipment or asset?

Under a financial lease, there are usually fewer restrictions, and customisation may be possible. Your lease agreement may specify whether the lessor allows you to customise the asset. Equipment under an operating lease is less likely to allow customisation, as the lessee returns it at the end of the agreement.

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