Finance leases and operating leases are two common types of lease arrangements that businesses encounter. With the introduction of the ASC 842 accounting standard, the classification and treatment of leases have evolved. In this blog post, we will delve into the distinctions between finance (capital) leases and operating leases and discuss how ASC 842 impacts the accounting for these lease types.
What is a finance lease?
A finance lease, also known as a capital lease, is a type of lease agreement in which one party, typically a lessor, allows another party, the lessee, to use and control a specific asset for an extended period of time in exchange for lease payments. A finance lease is structured so that the lessee essentially assumes many of the economic benefits and risks associated with owning the leased asset.
Under ASC 842, what was previously called a operating lease is now referred to as a finance lease, but the fundamental concept remains the same. The key change is that, like capital leases, finance leases must now be recorded on the balance sheet as a right-of-use (ROU) asset and a lease liability.
Key characteristics of a finance lease
- Ownership transfer: Finance leases often include an option for the lessee to purchase the asset at the end of the lease term for a nominal amount, commonly referred to as the “bargain purchase option.”
- Long-term commitment: Finance leases are generally long-term agreements, often spanning a substantial portion of the asset’s useful life. They are typically structured to match the asset’s economic life.
- Risk and rewards: In any lease, the lessee usually takes on the risks and rewards associated with the leased asset. This includes responsibilities like maintenance, insurance, and any potential residual value.
- Accounting treatment: In financial accounting, finance leases are recorded on the lessee’s balance sheet as both an asset and a liability. This is because the lessee is considered to have acquired a significant portion of the economic ownership of the asset.
What is an operating lease?
An operating lease is a type of lease agreement in which one party, known as the lessor (the owner of the asset), allows another party, the lessee, to use and control a specific asset for a defined period of time without transferring ownership of the asset. Operating leases are often used for short-term or non-core assets and typically have more flexibility compared to capital leases.
Key characteristics of an operating lease?
- Short-term: Operating leases are generally short-term agreements, covering a fraction of the asset’s total economic life. They do not typically extend for the entire useful life of the asset.
- Ownership retained: In an operating lease, the lessor retains ownership of the leased asset throughout the lease term. The lessee does not usually have the option to purchase the asset at the end of the lease period.
- Maintenance and risk: The lessor is typically responsible for maintaining the asset and bearing the risks associated with ownership, such as changes in the asset’s value.
- Accounting treatment: From an accounting perspective, operating leases are generally not recognized as assets and liabilities on the lessee’s balance sheet. Instead, lease payments are typically recorded as operating expenses.
Finance leases vs. operating leases
Lease term
Finance leases are typically long-term and are recorded on the lessee’s balance sheet as both assets and liabilities. They often span most of the asset’s useful life. In a finance lease, the lessee often has the option to purchase the asset at the end of the lease term through a “bargain purchase option”, and they take on the risks and rewards of ownership. In contrast, operating leases are usually short-term, with the lessor retaining ownership of the asset throughout the lease term. These leases generally don’t allow for purchasing the asset at the end.
Ownership and risks
In a finance lease, the lessee assumes many of the economic benefits and risks associated with owning the leased asset. This includes taking responsibility for maintenance and insurance, as well as possibly purchasing the asset at the end of the lease term. On the other hand, with operating leases, the lessor retains ownership and the risks and rewards of ownership remain with them. The lessee is only entitled to use the asset for a specified period, with no responsibility for ownership risks.
Accounting treatment
Under ASC 842, both finance leases and operating leases must now be recorded on the lessee’s balance sheet as right-of-use (ROU) assets and lease liabilities. However, the accounting for each type of lease differs. Finance leases result in the amortization of the asset and interest expense being recognized separately over the lease term, reflecting the lessee’s assumption of ownership. Operating leases are treated differently, with lease payments being recognized as a single expense on the income statement, generally on a straight-line basis over the lease term.
End-of-term option
A key feature of finance leases is that the lessee often has the option to purchase the leased asset at a bargain price at the end of the lease term. This reflects the lessee’s assumption of ownership risks. In operating leases, there’s generally no purchase option. The lessee returns the asset to the lessor at the end of the lease, and the lessor retains all rights to the asset.
Advantages and disadvantages of finance and operating leases
When choosing between finance and operating leases, it’s important to understand the key advantages and disadvantages of each. Both types of leases offer unique benefits and drawbacks, depending on your company’s financial goals and lease needs.
Advantages of finance leases
- Ownership-like benefits: Lessees can purchase the asset at the end of the lease term, typically at a bargain price.
- Long-term use: Often more suitable for long-term asset usage, covering most or all of the asset’s useful life.
- Tax benefits: Amortization and interest expenses may be tax-deductible.
- Asset control: Lessees assume control and responsibility for the asset, including maintenance.
Advantages of operating leases
- Off-balance sheet treatment (under ASC 840): Historically, operating leases were not recorded on the balance sheet (under older standards), providing a “lighter” balance sheet.
- Flexibility: Typically shorter in duration, making it easier to adjust to changing business needs.
- Lower upfront costs: No large purchase option or asset acquisition costs at the end of the lease.
- Simplicity: Easier to account for, with straightforward lease expense recognition.
Disadvantages of finance leases
- Higher financial liability: Requires recording both an asset and a liability on the balance sheet, impacting financial ratios.
- Maintenance and responsibility: The lessee is responsible for the upkeep and maintenance of the asset.
- Complexity: Accounting for finance leases can be more complex, particularly for businesses with multiple assets.
Disadvantages of operating leases
- Less control over the asset: The lessee does not own the asset, limiting long-term control and potential gains.
- No option to purchase: Operating leases generally do not offer a purchase option at the end of the term.
- Possible higher overall cost: Over the long term, lease payments may exceed the asset’s value, especially if the lease term extends.
- Impact of ASC 842: Operating leases are now recorded on the balance sheet under ASC 842, affecting the company’s liabilities and financial ratios.
How does ASC 842 impact lease classification?
Under the previous ASC 840 standard, capital leases were categorized as financing arrangements and were recorded on the balance sheet, while operating leases were treated as a right to use the asset and remained off-balance sheet. However, this off-balance sheet accounting approach led to concerns, prompting the transition to the ASC 842 standard.
ASC 842 mandates that both finance leases and operating leases be recognized on the balance sheet. This change ensures greater transparency in lease accounting.
- In ASC 842, finance leases are now considered right-of-use assets, categorized as intangible assets. Instead of being expensed, these assets are amortized over their useful life. Finance leases also entail the recognition of separate interest expenses, which decline over time as the lease liability decreases.
- Similar to finance leases, operating leases under ASC 842 involve the recognition of right-of-use assets as intangible assets. However, the key distinction lies in expense recognition. Operating leases are expensed using a straight-line method, where lease payments are evenly distributed over the lease term. This results in a consistent lease expense throughout the lease duration.
What is the expense profile for operating vs. finance leases?
The expense profile for finance leases differs from that of operating leases. Finance leases have higher expenses in the initial months and progressively decrease as the lease term progresses. On the other hand, operating leases maintain a constant expense level throughout the lease duration.
Understanding the differences between finance (capital) leases and operating leases is essential for businesses navigating lease accounting under ASC 842. With both types of leases now recognized on the balance sheet, organizations can provide more transparent financial reporting. By grasping the nuances of these lease classifications and their respective expense profiles, businesses can comply with accounting standards and make informed decisions regarding lease arrangements.
How can lease software help manage finance and operating leases?
Managing both finance and operating leases can be complex, especially with evolving standards like ASC 842. Visual Lease simplifies this process by automating lease classification, tracking lease terms, and ensuring compliance with accounting standards. The lease accounting platform offers features such as automated lease data entry, flexible configurations, and powerful integrations with major financial systems. These capabilities help businesses manage their right-of-use (ROU) assets and liabilities effectively, generate accurate financial reports, and stay ahead of lease modifications or renewals. Discover how Visual Lease can transform your lease management — request a demo today!
