Finance Lease and Operating Lease

Definition: The Finance Lease and Operating Lease are the very common form of lease agreements that an individual goes for. The lease is an agreement wherein the lessor grant rights to the lessee to use lessor’s property in exchange for certain periodic payments.

Finance Lease:  The Finance Lease or Capital Lease refers to the agreement wherein the lessee gets the ownership of the asset before the lease expires. Simply, the finance lease is the type of lease wherein the lessor transfers all the risks and rewards associated with the asset to the lessee before the lease agreement expires.

The lease is said to be the finance lease if it satisfies the following requirements:

• Once the lease is expired, the lessee can purchase an asset at a bargain price.
• The lessee gets the ownership of the asset after the lease expires.
• The lease term is at least 75% of the estimated economic life of the asset.
• The present value of lease payment is at least 90% of the asset’s value.

Operating Lease: The Operating Lease is the type of lease where the lessor does not transfer all the risks and rewards related to the asset to the lessee when the lease expires. The term of operating lease is very small as compared to the finance lease and following are the main features of the operating lease that make if different from other leases:

• The lease term is considerably less than the economic life of the equipment.
• The lessee can terminate the lease even at the short notice and without any significant penalty.
• When the ownership along with the risk and rewards lies with the lessor and is responsible for insuring and maintaining the equipment, the lease is said to be a “wet lease”. Whereas, when the lessee bears the cost of insurance and maintenance of the equipment, the operating lease is called as a “dry lease”.

Thus, the basic difference between the finance lease and operating lease is that in the case of the former the lessor substantially transfers all the risks and rewards related to the assets to the lessee whereas, in the latter form, no substantial transfer of risks and rewards of ownership are transferred to the lessee.