Introduction
What is a lease?
A lease is a legal agreement where one person pays another person to use their property for a specific period. This property can be anything whether it is a house an apartment, a car, or any other equipment. The lessee gets to use the property and the lessor still owns it.
Here the lessie usually pays the rent and takes care of the equipment during the lease period and after the lease ends the lessee has to return the asset to the lessor until and unless the lease gets renewed or extended.
Now the article begins with the two types of lease, financial lease and operational lease.
What are Financial lease and operational lease
Financial lease-
In this type of lease, the company rents an asset like equipment or a vehicle from a leasing company for their useful life. It’s like a long-term payment plan. The company using the assets takes on most of the responsibilities of ownership like maintenance and insurance and the lease payments are spread out over a long period.
Operational lease-
In this type of lease, the company rents an asset, like equipment, a car, or office space, from a leasing company for a shorter period than its useful life. It’s like renting something for a short term with the option to return it when you’re done. (Maglio, Roberto, Valerio Rapone, and Andrea Rey)
Structure of Financial lease and Operational lease
The key structures of financial lease and operational lease are-
For the financial Lease
Long-Term financial goals: In this, the financial lease covers most of the asset’s useful life, spanning several years
Lessee Responsible: They are responsible for maintenance, taxes, and insurance which is related to assets. They make regular lease payments which may include interest and repayment.
Ownership-like benefits: The lessee has the right to use the assets as if they own them. The assets are recorded in the lessee’s balance sheet on both sides, the assets side as well as the liability side.
End of lease option: The lessee has the option to purchase at the nominal price as well as at the fair market price. On the alternative side, the lease can be extended or the asset can be returned to the lesser.
Depreciation and interest: The lessee may account for depreciation of the asset and interest expense in their financial statement.
For Operational Lease
Short-Term agreement: Operational leases are for a shorter duration where it is significantly lesser than the asset price.
Lessor Responsibility: They handle the maintenance, insurance, and taxes from all sides. They retain the ownership of assets through lease terms.
Lease payments: They make lease payments that consider operational expenses and are fully deductible in the period that occurred.
Flexibility and no ownership transferred: at the end of the lease term the lessor returns the asset to the Leasor. They may extend the lease term for using the assets but they can’t buy the assets.
Off-Balance sheet: These leases are not recorded in the balance sheet and the lease payments are traded as rental expenses.
The difference between a financial lease and an operational lease
Financial lease- The lessee effectively assumes most of the risks and benefits of ownership. The lessee is responsible for maintenance, insurance, and taxes associated with the leased asset. Additionally, the lessee often has the option to purchase the asset at the end of the lease term for a nominal amount, reflecting a transfer of ownership.
It generally cover a significant portion of the asset’s useful life. The lease term is structured to amortize the cost of the asset over its useful life and often extends close to or beyond the asset’s expected economic life.
Financial leases are typically treated as liabilities on the lessee’s balance sheet, with the leased asset recognized as an asset. The lessee depreciates the leased asset over its useful life, and interest expense is recognized on liability.
Operational lease-
The lessor retains ownership of the asset throughout the lease term. The lessor is responsible for maintaining and insuring the asset, and the lessee typically doesn’t have the option to purchase the asset at the end of the lease term. The lessee’s obligations are more towards renting the asset for a specific period.
It covers a shorter period compared to the asset’s useful life. They are typically structured to cover a fraction of the asset’s useful life, providing lessees with the flexibility to upgrade or replace assets frequently.
It is often treated as operating expenses rather than capitalized on the balance sheet. Lease payments are recognized as rental expenses over the lease term, without recognizing the leased asset or liability on the balance sheet.
Advantages and Disadvantages of Financial lease and Operational lease
Financial lease
Advantages
.The lessee enjoys many benefits of ownership, such as the ability to use the asset for its entire life or potentially benefit from any appreciation in the asset’s value.
.Financial leases provide a means of financing high-value assets without requiring a large initial capital outlay, preserving the lessee’s capital for other uses.
.Lease payments may be tax-deductible as operating expenses and depreciation expenses can be claimed, providing potential tax advantages.
.Lease terms can often be structured to match the cash flows and needs of the lessee, including options for purchase at the end of the lease term.
Disadvantages
.The lessee bears most of the risks and responsibilities associated with ownership, including maintenance, insurance, and potential obsolescence.
. If the leased asset depreciates more rapidly than anticipated or becomes obsolete, the lessee may face losses or difficulties in the disposal of the asset.
.Financial leases typically cover a significant portion of the asset’s useful life, which may result in a long-term commitment for the lessee.
. Financial leases require complex accounting treatment, including recognizing the leased asset and liability on the balance sheet and calculating depreciation and interest expenses.
Operational lease
Advantages
.Operational leases provide flexibility for lessees, allowing them to use assets for shorter periods without the long-term commitment associated with ownership.
. Since operational leases are often treated as operating expenses rather than capitalized on the balance sheet, they do not impact the lessee’s financial ratios or debt-to-equity ratios significantly.
. The lessor typically retains ownership and responsibility for maintenance, insurance, and obsolescence, reducing the lessee’s risk exposure.
.Lease payments are predictable and can be budgeted as operating expenses, simplifying financial planning for the lessee.
Disadvantages
.Operational leases may result in a higher total cost of asset usage compared to financial leases, as the lessee pays for the convenience of flexibility and off-balance-sheet financing.
.Since the lessor retains ownership, the lessee has limited control over the asset and may face restrictions on modifications or subleasing.
.Unlike financial leases, the lessee does not benefit from ownership-related advantages such as potential appreciation in asset value or the ability to use the asset for its entire useful life.
. If the lessee wishes to continue using the asset beyond the lease term, they may face increased costs or renegotiation with the lessor.
Examples
Now let’s look at some examples of Financial lease and Operational leases:
For example, the company manufactures equipment that costs around $500,000 instead of buying it outright. company A enters the leasing company B
Here the lease term is 5 years
The monthly payment is $9,000
Instead of spending $500,000 upfront to buy the equipment, Company A leases it from Company B.
Now, Company A pays $9,000 each month to use the equipment.
Company A has the option to purchase the equipment for a nominal fee at the end of the lease term.
Then, company A is responsible for the maintenance which depreciates the equipment for tax purposes.
It’s known as a capital lease typically a form of capital financing lease
Here in the operational lease, it is typically shorter-term and more toward renting.
For example, company C needs the office for printers and copies for its day-to-day operations. Then Company C will buy the lease from Company D.
Here the lease term is 2 years
The monthly payment is $1,000
Then the equipment is returned to Company D at the end of the lease term.
company D is responsible for the maintenance and servicing of equipment
Here in the operational lease, it is typically shorter-term and more toward renting.
Conclusion
In a financial Lease, any risk, asset or return transfers to the lessee and the time period is shorter and in an operational lease the ownership is with the lessor and the lease period is longer. Different companies have different demands and also give a deep understanding of risk and return. In this, it gives brief information about the ownership and the transfer of lease from one organization to another.
Companies seeking to preserve capital, maintain off-balance sheet financing, and prioritize flexibility that favours operational leases. Those who are looking to capitalize on ownership-like benefits, and potentially lower overall costs over the assets’ life and tax advantages prefer a financial lease.
The decision should align with the companies with broader strategy taking into consideration the impact on financial statements, tax implication, and operational requirements. These leasing options offer unique benefits and challenges that must be carefully weighted to optimize companies’ financial and operational performances.
