Organizations usually select to lease assets instead of making a purchase, this is specifically true for assets used for the long term. The choice to lease is primarily based on specific factors such as need, better economic conditions, keep the asset detail from the balance sheet, or insufficient funds to make a purchase. The types of accounting methods for leases are Finance Lease or Leasing Finance and Operating Lease. Both leases are being used for distinct reasons and lead to different treatment in the accounting process.
Leasing Finance Vs Operating Finance
What is a Leasing Contract?
An agreement between the lessor and the lessee, where the owner of the equipment (lessor) transmits to the user (lessee), the right to utilize the equipment for a specific amount of payment over a certain time period.
What is Leasing Finance or Finance Lease?
Finance lease OR Leasing finance is normally used to purchase equipment or assets for the significant portion of its valuable life. The equipment is funded under an accounting term GST (Goods and Services Tax) and still have a balloon (a residual amount) at the term’s end. At this stage, the lessee will acquire ownership over the equipment after an ‘offer to buy’ the equipment had been successful. The balloon amount is the ‘offer’ proposed to the lessor.
What is an Operating Lease?
An operating lease is an agreement between the lessor and the lessee to finance the equipment for less than the determined useful life of the asset. At the end of the lease term, the lessee could return the equipment assuming no further obligation to the lessor.
Difference Between Finance Lease and an Operating Lease?
Finance Lease | Operating Lease |
| At the end of the lease term, the ownership of the equipment is transferred to the lessee. | At the end of the lease term, the ownership of the property is retained by the lessor. |
| There is an option for the lessee to buy the equipment at the end of the lease term. The balloon or the residual amount is the price set as ‘offer to buy’. The ATO (Australian Taxation Office) asset guideline helps determine the specific balloon or residual amount. | The lessee does not have an option to purchase the equipment after the lease term. |
| Running costs are not included which means greater administration and possible price fluctuation that the lessee will have to assume as responsibility. | All running costs which include servicing, registration, insurance, and etc. are packaged in the lease contract within the set term agreement. This also includes the monthly repayment amount. |
| A finance lease is treated as an asset for the lessee | Operating lease is treated as expenses. Changes will occur in 2019 where all operating leases will appear as liabilities in the balance sheet. |
Which is a better route for a business, Finance Lease or Operating Lease?
A better route depends on the business’ specific circumstance. While finance lease and an operating lease has its own pros and cons, here are the most obvious that you can consider in your decision.
Operating Lease offers reduced administrative responsibilities of the lessee and allows them to return the equipment at the end of the lease term while paying a fixed monthly payment as agreed upon in the contract. This route is ideal for businesses that are running a few pieces of equipment as a result of administration savings.
Finance Lease will have to assume more administrative responsibilities. Also, the lessee will have to face additional resale risks when comes a time that the business decides to sell the property in the future. The positive aspect of the finance lease is that the lessee can assume ownership of the property depending on the success of the ‘offer to buy’.
Still confused on what route to take in financing your business? Talk to an Intellichoice business loan specialist today and let us guide you in understanding what your business needs.
