Finance lease and Operating lease

What

is

the

difference

between

Finance

BPT

lease

and

Operating lease?
Even though the lessor is the rightful owner of the asset and most
often owners are responsible to bear any loss and obtain economic
benefits associated with the asset but sometimes the risks and
rewards associated with the assets are transferred to another
person by the owner himself without transferring the title of
ownership of the asset. Same is the case with the finance lease.
Remember
In
simplest
words, transfer
of
risks
and
rewards MEANS transfer of control of the asset. And from the
definition and recognition principle of the asset we understood that
it is the control of the asset that is important and not the
ownership of the asset that determines the rightful person to
report the asset in his books of account.
And from this we can understand that under finance lease the
risks and rewards (control) of the asset are transferred to lessee
therefore, lessee will write the asset in his books even though he is
not the owner.
But under operating lease risks and rewards (control) of the
asset are NOT transferred therefore, the lessor, who is the owner of
the asset, will write the asset in his books of accounting.
What is risk?
Risk is simple the risk of bearing the losses connected with the
asset or lease agreement. For example the person who is
responsible for the following losses or expenses is the person who
is bearing the risks:

person responsible for upkeep of asset i.e. repairs or

person responsible for securing the asset i.e. insurance
premium or
the person who will bear the loss in case asset is stolen
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possible losses from idle capacity

devaluation in asset because of technological obsolescence

fluctuations
conditions

in

returns

because

of

changing

economic

What is reward?
Reward simply means economic benefits that can be rendered
from the asset. For example the person who is responsible for the
following benefits is person enjoying the benefits from the assets:

earning revenue profitably

constructed by using the asset

by

selling

goods

produced,

earning rental income by letting or sub-letting the asset

appreciation in the value of asset (revaluation gain)

appreciation in the residual value (sales value) of asset

SUBSTANTIAL
OWNERSHIP!

Risks

and

Rewards

INCIDENTAL

to

Substantial means significant or in other words almost all of

them. Incidental to ownership means something that is primarily
associated with the ownership. So we understood that almost
all of such kinds of risks and rewards that primarily resulted from
the ownership of the asset must be transferred to constitute
atransfer of control. And it is the control that determines the
type of lease agreement.
Care must be exercised in categorizing the risks and rewards as
connected with the ownership. Not every reward and risk is
incidental to ownership. There are only few risks and rewards
which determines the control of the asset and if substantial
amount of those risks and rewards is transferred only then a lease
will be treated as finance lease. For example, a lessee may earn
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revenue by using the asset but he may not have the right to
recognize revaluation gain of the asset.

Hire purchase (HP) or leasing

Hire purchase (HP) or leasing is a type of asset finance that allow
firms or individuals to possess and control an asset during an
agreed term, while paying RENT or INSTALLMENTS covering
depreciation of the asset, and interest to cover capital cost.
Assets are defined as anything of monetary value that is owned by
a firm or an individual. Assets listed on a firms balance sheet can
include tangible items such as inventories, equipment and real
estate, as well as intangible items such as property rights or
goodwill.
Leases differ from term lending in that the lessee does not
have ownership rights to the asset. At the end of the lease
contract, the lessee usually has a choice of extending the lease,
returning the asset, or introducing a buyer for the asset. Some
leasers are entitled to a refund of 95% of the sale proceeds when
they introduce a buyer. The refund amount will depend on the
contract between the original leaser and lessee.
HP is a financing solution suitable for businesses wishing to
purchase assets without paying the full value immediately. The
customer pays an initial deposit, with the remainder of the balance
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and interest paid over a period of time. On completion, ownership

of the asset transfers to the customer.
It is important to note that the accounting and tax treatment of
leases varies according to the type of lease it is. For example, as a
finance lease is accounted for as a loan funding the asset, the tax
treatment follows the legal form of the transaction which is the
hiring of an asset. More specifically, the treatment of capital
allowances differs, and tax treatment should be taken into
consideration when deciding how to finance an asset purchase.
Common use
The use of HP or leasing is particularly common in industries
where expensive machinery is required, such as construction,
manufacturing, plant hire, printing, road freight, transport,
engineering
and
professional
services.
It is also used to finance other capital requirements of a business
for example:
smaller items
cars
photocopiers.
The asset provider usually dictates this type of linked finance.
Costs
There are two main costs that need to be considered:
interest rate charged for financing. Rates are favourable to
assets with higher resale value (ie machinery, agricultural
equipment, vehicles etc). Assets that are considered soft due
to their low resale value (ie printers, vending machines, office
furniture etc), will be given less favourable rates
fees charged by the financing company for loan processing
and administrative work meeting conditions. For example, a
car purchased on HP may need servicing at regular intervals
and from a pre-approved workshop.
Timeframe
An HP or leasing facility can normally take up to a week to
complete, depending on the size and complexity of the deal.
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Advantages
HP or leasing allows companies to control and deploy assets
without significant drain on working capital
fixed-rate funding makes budgeting easy as the lessee has
clear sight of future expenditures
flexibility of repayment structuring is available to allow for
seasonal business (eg one repayment a year), and to reduce
monthly outlay by factoring in a balloon payment at the end
of the term
leasing prevents the risk of an assets value depreciating
quickly and provides flexibility to enter into a new contract at
the end of the original leases fixed term
financing asset purchases can be more tax efficient than
standard-term loans due to lease payments being booked as
expenses. Although asset depreciation also provides tax
benefits, the useable lifetime of the asset will vary depending
on the asset and on local regulation
high accessibility of financing for businesses due to the
financing being secured with the leased asset and the asset
being owned by the financing company
in certain circumstances there is maintenance included within
the terms of the agreement.
Disadvantages
total sum of capital payments for HP or leasing will be higher
than the full payment on the asset purchase
administrative complexity and costs will be greater if any
covenants are applied to the arrangement. For example,
updates on change of equipment locations
if the business changes its strategy, resulting in the leased
asset no longer being useful, there can be early termination
charges or restrictions on subleasing.
Other options
The right finance for your business section of the site gives
examples of financial structures that are suitable for different
trading types and sizes of business.

Finance lease and Operating lease

BPT

HP or leasing is a medium- to long-term solution to support the use

of an asset for a certain period of time. An alternative is a bank
loan, which allows firms to purchase an asset and have immediate
ownership of it.