When accounting for leases, there are 2 main types of leases you will come across:
- Operating Leases
- Finance Leases
Finance leases may sometimes be referred to as “capital” leases.
It is very important to distinguish which category a particular lease falls into, as under FRS102, there are different accounting treatments for each. Generally, it is quite easy to determine which category a lease falls into by reviewing the lease agreement that is in place.
The Main Differences
The main difference between an operating lease and a finance lease is the nature of the ownership of the underlying asset. Generally, an operating lease would be classed more as a rental since the asset is essentially being rented from the lessor so that the lessee can use the asset without worrying about the upkeep and maintenance costs of the asset. With a finance lease, the lessee has a much greater responsibility to maintain the asset and carry out repairs if necessary and thus, under a finance lease the lessee holds more of the “risk and rewards” related to having the asset in their possession.
Also, at the end of a finance lease, the ownership of the asset will normally be transferred to the lessee or the lessee will at least be given the option for this to happen. Under an operating lease, there is no intention within the lease agreement that the lessee will ever actually own the asset and this is a large distinguishing factor between the two types of leases.
What do the Accounting Standards Say?
Under the new IFRS standard, IFRS 16, all leases are to be accounted for in the same manner, regardless of whether they are operating or finance leases.
It is a bit more tricky under FRS102 since the accounting treatment varies. There is a published list within FRS102 that helps users to distinguish a finance lease from an operating lease. This list contains 8 items, some of which are more subjective than others and even if a lease does not fit all 8 of the criteria it would still be classed as a finance lease. Below is a summary of the key indicators from this list:
The ownership of the asset transfers to the lessee at the end of the lease – As mentioned above, if the ownership of the leased asset is due to be transferred to the lessee at the end of the lease, then it is classed as a finance lease.
The length of the lease matches the expected useful life of the asset – Regardless of whether the ownership of the asset is due to transfer at the end of the lease, the finance lease classification could still apply if the length of the lease is practically the same as the useful economic life of the asset
The assets are so specialized that they are only of use to the lessor – If a leased asset has been adapted in a way that is only usable for the operations of the lessee – for example, if a truck had been adapted to carry a certain type of furniture that a business manufactures and was unable to be used for anything else unless it had work done to it, this would be classed as a finance lease.
Almost all finance leases will be identified by one of the 3 indicators above. However, if you require further guidance surrounding the FRS102 finance lease indicators, this can be found here.
Common Real Life Example
An extremely common real life where the difference between an operating lease and a finance lease comes into play is related to car finance.
Many people believe car leasing and car finance are interchangeable terms however this is not the case.
- Car leasing is effectively the long-term rental of a car which allows a driver to gain access to a new car every few years. Monthly installments will be paid for the use of the car however there is no intention for the lessee to ever own the car. This is an operating lease
- Car financing allows a driver to extend the purchase of a car over a longer period – essentially allowing them to buy a car without a large upfront payment in cash. A car finance agreement (often referred to as a PCP (personal contract purchase) and will end with the lessor having the option to make a final payment to fully purchase the car. This is a finance lease.
The disclosure of an operating lease within a company’s financial statement now only applies to accounts made under FRS102 – for leases with break clauses please see this guide.
