A financial lease is a lease that lets an entity borrow an asset for a long period of time, such that the length of the lease is essentially equal to the life of the asset taken on lease, and the company capitalizes the assets in its book. A financial lease is also known as a capital lease.
How does Financial lease work?
Basically, the lessor takes the asset on behalf of the lessee and gets compensated by the rental payments that are paid by the lessee during the days of the lease. The ownership of the asset is with the lessor, but the lessee gets exclusive right to use the asset in the way desired. Generally, these types of contracts are entered into when the lessee doesn’t want to bother about the condition of the asset at end of the contract.
The lessor does not have to bear the cost of maintenance, repair, insurance, etc. they earn from the interest they earn on the rental payments.
At the end of the lease, the lessee has the option to purchase the asset at a price which is lesser than the value of the asset at the end of the contract.
What is the difference between an operating lease and financial lease?
- In Operating lease, the ownership of the asset is retained during and after the lease term ends, whereas in a financial lease the ownership of the asset is passed on to the lessee at the end of the lease
- In an operating lease, there are fewer administration requirements as the lessee does not have to worry about the resale value of the asset, which happens in a financial lease. The lessee buys the asset at the end of the lease term at a balloon price and has the risk of price fluctuations when he wants to resale it
- The operating lease payments are deducted as expenses from the Income statement and cash is reduced on the assets side of the BS as the payment is made, whereas the financial lease is shown on the assets side of the BS of the lessee
- The running costs (servicing, repairs, etc.) are constant in an operating lease whereas there are price fluctuations in a financial lease