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Revealed: The pros and cons of a finance lease and an operating lease

by , 28 August 2013
When you buy an asset, you have two choices. You can buy it outright or as an operating lease or a finance lease. You need to know the consequences of both so you can structure an agreement that'll help you save yourself time, money and effort. Here are the pros and cons of a finance lease and an operating lease.

There are two basic types of lease:

  1. A finance lease: A lease agreement that transfers all the risks and rewards of ownership of the leased asset to you, the buyer, and
  2. An operating lease. A straightforward rental agreement where you'd return the goods at the end of the contract.

There is a difference between the two. And choosing the right one will help you save your business money.

Let's take a closer look at the pros and cons of a finance lease and an operating lease.

Discover the difference between a finance lease and an operating lease

The advantages of a finance lease:

  • You have full rights to sell, alter or do whatever you want with the asset.
  • You stand to benefit from any increases in the fair value of the asset. For example, if you buy a property via a finance lease and the value of the property increases substantially, the gain accrues to you.
  • Only the interest expense portion of the lease installment decreases profit and loss.
  • With a finance lease, the assets on the Statement of Finance Position (balance sheet) are increased by the value of the asset says the Practical Accountancy Loose Leaf.

The disadvantages of a finance lease:

  • You'll be responsible for the repairs and maintenance of the asset.
  • You'll carry any losses due to damage or a decrease in fair value of the asset.
  • A finance lease may increase the liabilities on the Statement of Finance Position. This may affect how possible funders analyse your business for giving you credit.
  • There's a disadvantage when compared to an outright sale. The person supplying the asset will still have some control and say over what you do with the asset.
  • Your company's return on assets ratio will be lower than if the lease was an operating lease. The ratio should be as high as possible. According to the Practical Accountancy Loose Leaf, with a finance lease, the value of the assets increase and in exchange decrease the return on asset ratio compared to a calculation where there are no assets and only an operating expense. The total expenses can also increase because the lessee's responsible for repairs, maintenance, and insurance. The depreciation and interest expense will affect the earnings amount.

The advantages of an operating lease:

  • The agreement's usually for a shorter and more flexible period which reduces the business' risk. The business will be more flexible and will have fewer long-term commitments.
  • The return on assets ratio is more favourable than with a finance lease. This is due to the fact that no assets will be accounted for (so the entity is generating profits without using an asset) and the earnings will also be less because no additional expenses like depreciation and running costs will be accounted for.
  • The maintenance costs relating to the asset won't be your responsibility.
  • You won't carry the risk of losses due to damage (within specific contract boundaries) and decreases in fair value.
  • There'll be less stringent credit requirements as you're not buying the asset, you're only paying rent.
  • No additional liabilities will be recognised on your Statement of Financial Position, this reduces the risk of obtaining further funding for other business needs.
  • There'll be no interest expense in profit and loss relating to the lease. This improves the interest coverage ratio (an important ratio used by debt providers when they do credit assessment and decide whether to lend money to your business).

Disadvantages of an operating lease:

  • You won't get full ownership or control of the asset and your use of the asset will be restricted subject to the terms and conditions in the lease agreement.
  • You won't stand to gain if the asset increases in value.
  • Your monthly lease payment will be inflated to reimburse the lessor. They'll still bear the risks of ownership of the asset.
  • If there are any financial incentives such as initial cash refund or an initial 'rent free period', the benefit of these are shown on the income statement as the operating lease expense is shown as an equalised period expense. This means you won't show the result of this benefit in your financial statements immediately. It'll be split over the total lease term in smaller amounts every year.
  • The equalisation of the lease expense can be complex and cumbersome to calculate. If you make a mistake with this, your financial statements will be misstated and may result in the auditors giving a modified audit opinion. This would damage the suppliers' and clients' perceptions of your business.

So which lease should you choose?

It all depends on your budget and your company's needs. Knowing the difference between a finance lease and an operating lease will help you structure an agreement that'll help you save time and money.



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