When comparing the asset finance options available for businesses, finance leases and operating leases are two of the most popular choices. And while both forms of finance have a lot of overlap in their structure and function, there are key differences that provide unique benefits and challenges depending on your financial strategy, asset needs, and long-term goals.
0
min read
Both involve paying a company – known as the lessor – to let you – the lessee – use a certain asset or piece of equipment for a certain term, which could be months or years, depending on the lease type or the asset. It’s in the finer details of these leases that these approaches differ.
To make it easier for SMEs who might be confused, we’ll break down the key differences, pros and cons, practical examples, and essential considerations for each lease type to help you make an informed decision that aligns with your business objectives.
A finance lease, often likened to a long-term hire purchase, allows businesses to use an asset over a lease term with the option to purchase at the end. Essentially, this approach gets you pretty close to the benefits of owning the asset without upfront purchase costs.
Key characteristics of finance leases:
An example could be a construction company leasing a bulldozer on a finance lease. They can use the asset for projects – generating revenue to fund the lease – and eventually own it after the lease term, saving long-term costs associated with frequent rentals.
An operating lease functions more like renting, where you use the asset for a period but don’t gain ownership rights. Operating leases typically suit businesses needing assets for short-term or limited purposes, often with lower monthly payments than finance leases.
Key characteristics of operating leases:
These can be handy in areas where the state of technology changes quickly. For example, an IT consultancy may lease laptops on an operating lease, ensuring they always have the latest technology without the need to handle asset disposal or maintenance.
If you want equipment and don’t want to front the cost right away, both operating leases and finance leases can work – however, the right choice will depend on the type of equipment, the terms involved and also how you want to account for the asset.
IFRS 16 requires all leases over 12 months to appear on the balance sheet as a "right-of-use asset" and lease liability. This is an important consideration for businesses, as both finance and operating leases will impact financial statements. FRS 102, however, retains the distinction, allowing operating leases to be off-balance-sheet and preserving the traditional treatment of operating leases as rental expenses.
Choosing between a finance lease and an operating lease hinges on understanding the asset’s role in your business, your financial goals, and how each lease type aligns with your accounting needs. With finance leases, you’re building towards ownership, potentially saving long-term, while operating leases offer flexibility, lower risk, and simpler off-balance-sheet financing.
Finance leases and operating leases differ primarily in terms of ownership and responsibility. With a finance lease, you have the option to buy the asset at the end of the term, and you're typically responsible for maintenance. Operating leases, however, don’t offer ownership, and maintenance is often included in the lease agreement, making them ideal for short-term use or assets prone to rapid obsolescence.
Under IFRS 16 and FRS 102, both finance leases and certain operating leases appear on the balance sheet, but they differ in tax treatment and accounting impact. Finance leases are recorded as both an asset and a liability, while operating leases may be recorded as an off-balance-sheet expense, depending on the duration and specific terms.
Finance lease payments are generally written-off, with both the asset and liability recognised on the balance sheet, affecting taxable income differently than operating leases. Operating leases are treated as a rental expense, which can reduce taxable income immediately, especially beneficial for SMEs needing flexibility.
For example, if a business leases a vehicle on a finance lease, it will use it for most of its useful life and may eventually buy it. An operating lease on the same vehicle would allow the business to use it temporarily without ownership and includes maintenance costs.
IFRS 16 introduced a new requirement for operating leases longer than 12 months to be recorded on the balance sheet, increasing transparency. This accounting shift means that, similar to finance leases, operating leases now show up as a "right-of-use" asset and corresponding liability on financial statements.
Under FRS 102, finance leases are capitalised on the balance sheet, showing the asset as owned in substance, whereas operating leases may remain off-balance-sheet as rental expenses. This distinction helps certain SMEs maintain a leaner balance sheet with fewer reported liabilities.
The choice depends on your business goals. If you plan to use the asset long-term, a finance lease might be better, as it leads toward ownership. For short-term needs or rapidly depreciating assets, an operating lease offers flexibility and lower initial costs.
In aviation, aircraft operating leases are popular, allowing airlines to rent planes without ownership, offering flexibility for fleet upgrades. In contrast, finance leases allow an airline to eventually own the aircraft, often chosen when longer-term use and residual value are critical.
For a finance lease, the asset and liability are recognised on the balance sheet, with lease payments split into interest and principal. For an operating lease, payments may be recorded as rental expenses, depending on lease length and applicable accounting standards like IFRS 16.
Sources
