Accounting for Leases, Operating Lease vs Financing Lease

Trust is not a profitable option when it comes to business. Landlords, creditors, and others will require a company to put its money or other assets where its mouth is by signing a lease. This legally binding document outlines the terms of the agreement, including the amount of rent, length of the lease, and other important details.

What is a lease

A lease is a contract between a lessor and a lessee, in which the lessor agrees to provide the use of an asset to the lessee for an agreed-upon period. The lessee agrees to make periodic payments to the lessor during the term of the lease.

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For example, a company might lease a factory from a landlord. The company would agree to make periodic payments to the landlord, and in exchange, the landlord would agree to provide the use of the factory to the company for the term of the lease.

Types of leases

There are mainly two types of leases.

  1. Operating lease

Operating leases are leases in which the lessor provides the use of an asset to the lessee, but the ownership of the asset remains with the lessor. Operating leases are typically used for short-term rentals, such as equipment rental or office space rental.

  1. Financing lease

Financing leases are leases in which the ownership of the asset is transferred from the lessor to the lessee. The lessee makes periodic payments to the lessor, and at the end of the lease term, the asset belongs to the lessee. Financing leases are typically used for long-term rentals, such as car leases or real estate leases.

Operating lease vs Financing lease

The key difference between operating leases and financing leases is that with operating leases, the lessor bears the risks and rewards associated with ownership of the leased asset, while with financing leases, these risks and rewards are transferred to the lessee.

Operating leases are typically used for short-term leases of less than five years, while financing leases are used for longer-term leases of more than five years.

Both leases have their benefits and drawbacks, so it’s important to understand both types before making a decision. It mainly depends on the needs of the business as to which type of lease is more advantageous.

Examples of operating and financing leases

Operating leases are usually used for plant and machinery, office equipment, vehicles, and other short-term assets. Financing leases are typically used for land, buildings, and other long-term assets.

Some examples of operating leases include

  • A one-year lease on a car
  • A three-year lease on office equipment
  • A five-year lease on a warehouse

Some examples of financing leases include

  • A ten-year lease on a building
  • A twenty-year lease on a land

Conclusion

Leasing is not a new concept, it has been around for centuries. In its most basic form, a lease is a contract between two parties in which one party agrees to provide the use of an asset to the other party for an agreed-upon period. Leasing can be beneficial if used correctly. Understanding the concept would be helpful to make sound business decisions.

Further questions

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