What is a lease? Explain the difference between an operating lease and a finance lease?
Week 1 Discussion 1: What is a lease?-Sample Solution
The Differences between Financial and Operating Leasing
Leasing refers to the method companies or businesses use to finance their assets whereby the lessee agrees to pay agreed amounts of money for using a piece of equipment from the lesser. The contract agreement ensures that the lessor receives regular payments for a specific period while guaranteeing the lessee’s continuous use of the equipment throughout the leasing period. Merrill (2020) explains that two types of leasing exist, financial/capital and operating leasing. Financial leasing involves a commercial lease in which a lessor legally owns an asset and rents it out to the lessee based on an agreed-upon period, usually on a long-term basis. On the other hand, an operating lease is like a traditional renting relationship in which the lessor rents out the asset on a short-term basis without transferring its ownership to the lessee. Also, Merrill (2020) illustrates that companies recognize assets leased out under operating terms as rent expenses in their balance sheets and as the cost of sales in financial statements. In contrast, payments for equipment leased under financial terms are recognized as amortization or interest expenses.(Lease Explained Essay Example)
Moreover, Merrill (2020) observes that the risks associated with these asset financing differ. Lessors are responsible for the risks and benefits associated with the equipment, including maintenance and repair costs in operating leasing. On the other hand, in financial leasing, the lessee is responsible for the equipment risks, including its maintenance costs. Furthermore, finance leasing contracts are within the asset’s lifespan, allowing the lessee to make balloon payments to keep the asset at the end of the leasing period. On the other hand, operating leases do not consider the asset’s lifespan and attract periodic payments until the end of the contract period, whereby the lessor reclaims custody of the asset (Merrill, 2020). Lastly, financial leasing doesn’t allow the lessee or lessor to cancel the contract in primary terms, while operating leasing allows them to cancel the contract during the primary period.(Lease Explained Essay Example)
Merrill, T. W. (2020). The economics of leasing. Journal of Legal Analysis, 12, 221-272. https://doi.org/10.1093/jla/laaa003