Lease accounting: operating vs. finance

Leasing is a common way of financing assets, but how it is accounted for depends on the type of contract. The difference between an operating and a finance lease determines whether or not you carry the asset on your balance sheet.

Two basic types of lease

Lease accounting differs depending on whether it is an operating or a finance lease. The key is who bears the risks and rewards associated with the asset and whether ownership passes to the lessee at the end.

The entire accounting and tax treatment follows from this difference, so it is important to determine the type of lease correctly right when the contract is signed.

Operating lease

An operating lease is by its nature close to a rental. The asset remains with the lessor and the lessee merely uses it in return for regular instalments, which are recognised directly as expenses.

When the contract ends, the asset is usually returned to the lessor. This type is suitable mainly for short-term use or for assets that are replaced quickly, such as a vehicle fleet.

• the asset is not on the lessee’s balance sheet
• instalments go directly to expenses
• suitable for short-term use

Finance lease

With a finance lease, the lessee actually takes on the risks and rewards and usually acquires ownership at the end. The asset is therefore recorded in the lessee’s books and depreciated, with part of each instalment representing interest.

• the asset is recorded and depreciated by the lessee
• the principal and interest portions of the instalment are distinguished
• suitable for acquiring assets for the long term

How the type affects the accounts

The choice of lease type affects the balance sheet, the amount of expenses and the tax base. An operating lease simplifies record-keeping, whereas a finance lease brings the asset directly into the company.

The decision should therefore be based on the real need and on what you intend to do with the asset, not just on a comparison of the total price of the lease.

What to watch out for

Study the lease contract carefully, especially the transfer of ownership, the instalment schedule and the obligations regarding insurance and servicing.

Check the tax treatment of the lease for the current period, as the rules may change. If anything is unclear, it is advisable to consult an accountant before signing.

Lease versus loan

Leasing is not the only way to finance assets. The alternative is a traditional loan, where you own the asset from the start and repay the borrowed funds.

The decision between a lease and a loan depends on the costs, the availability of financing and how you want to record the asset. It is worth comparing the total cost of both options, including interest and fees.

• lease – financing tied to a specific asset
• loan – you own the asset from the start
• decision based on total costs and needs

What to keep in mind in your accounting

Whichever type of lease you choose, what matters is keeping thorough records of the instalments and correctly distinguishing their components. With a finance lease, you also need to keep track of the depreciation of the asset.

Errors in lease accounting show up in both expenses and the tax base, so it is worth preventing them with proper records and a clear instalment schedule.

What to consider before signing the contract

Before signing, go through the entire lease contract and do not focus only on the amount of the monthly instalment. The fees, the conditions for early termination and the obligations regarding insurance and servicing also matter.

Ask for an overview of the total costs of the lease over the entire term. Only this summary will show you the real cost of the financing and allow you to compare offers with each other and with the alternative of a loan.

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Frequently asked questions

What is the main difference between an operating and a finance lease?

With an operating lease, the asset remains with the lessor and the instalments go to expenses; when the lease ends, the item is usually returned. With a finance lease, the lessee records and depreciates the asset and usually acquires ownership of it at the end.

Which lease is more advantageous for a company?

It depends on your intention. If you only need the asset temporarily and want simple record-keeping, an operating lease is a good fit. If you want to own it in the long term, a finance lease tends to be more advantageous. Check the tax implications for the period in question.