Organisations often choose to lease long-term assets rather than buying them. The decision to lease is mainly based on certain factors like necessity, better financial terms, keep the assets off the balance sheet, or the lack of available funding. Operating lease and Finance lease are the two kinds of accounting methods for leases. Both kinds of leases are used for different purposes and results in differing treatment in accounting.
A leasing contract is an agreement in which the lessor (owner of the equipment) conveys to the lessee (user), the right to use the equipment in return for a payment over a particular period of time.
Finance lease is often used to buy equipment for the major part of its useful life. The goods are financed ex GST and have a balloon at the end of the term. Here, at the end of the lease term, the lessee will obtain ownership of the equipment upon a successful ‘offer to buy’ the equipment. Traditionally this ‘offer’ is the balloon amount.
An operating lease agreement to finance equipment for less than its useful life, and the lessee can return equipment to the lessor at the end of the lease period without any further obligation.
Operating Vs Finance leases (What’s the difference):
- Title: In a finance lease agreement, ownership of the property is transferred to the lessee at the end of the lease term. But, in operating lease agreement, the ownership of the property is retained during and after the lease term by the lessor.
- Balloon/residual amount: In finance lease agreement, there is a balloon/residual option for the lessee to purchase the property or equipment at a specific price. But, under an operating lease, the lessee does not have this option. The balloon/residual on a finance lease is set using ATO asset guidelines.
- Running costs & administration: Under an operating lease all running costs (servicing, registration, tyres, insurance etc) are included in the lease within the designated term and usage km with one set monthly repayment amount. Under a finance lease these are generally not included meaning there can be greater administration and price fluctuation for the lessee.
- Account treatment: Operating lease are treated as expenses (ie off balance sheet items) where as a finance lease is included as an asset for the lessee. Edit: the tax treatment for leases will change in 2019, with operating leases appearing on the balance sheets as liabilities. You can read more about these changes in our article here.
Check out our new ‘Operating vs Finance Lease’ video!
Which is better, finance or operating lease?
The answer to this question often depends on your particular situation.
Operating lease agreement reduces adminstration for the end user and allows them to simply hand the vehicle back at the end whilst paying one simple monthly repayment. These are generally efficient for organisations that are running at least a few cars due to the administration savings.
A finance lease on other hand will have more adminstration requirements and, depending on the type of asset and the ATO guidelines for the particular balloon, will have some additional resale risk for the lessee as you must ensure the balloon amount is reached at the end of the term.
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