Finance Lease vs. Operating Lease

What is a Finance Lease?

A finance lease, sometimes referred to as a capital lease, essentially transfers ownership risks and rewards to the lessee. 

In practice, this means the leased asset appears on your organization's balance sheet as a liability and a corresponding asset. 

Common scenarios where finance leases are appropriate include long-term property agreements or heavy equipment usage where eventual ownership or significant usage rights transfer.

Key characteristics of an Operating Lease

• Asset appears on the balance sheet.
• Liability recognized for lease payments.
• Depreciation and interest expenses impact financial statements.

Why the Distinction Matters

Proper classification is essential for accurate financial reporting and compliance with accounting standards such as GASB 87 and ASC 842. Misclassification can lead to audit issues and financial inaccuracies, complicating your organization's budgeting and financial planning processes.

Understanding the difference between finance and operating leases helps ensure transparency, regulatory compliance, and informed financial decisions for your organization.

Advantages and Disadvantages

Finance Lease

Advantages:

• Builds equity in the asset over time
• Suitable for long-term or high-value assets
• Predictable costs with asset ownership benefits

Disadvantages:

• Greater impact on financial statements (assets and liabilities)
• Requires depreciation tracking and interest expense recognition
• Less flexibility due to being difficult to terminate early

Operating Lease

Advantages:

• Off-balance sheet treatment in some cases (depending on standard)
• Greater flexibility for short-term or upgradeable assets
• Simple expense recognition process

Disadvantages:

• No equity or ownership benefits
• Can be more costly over time for long-term use
• May result in higher total cost if asset is retained beyond initial term
  

What’s important here?

A finance lease transfers the benefits and risks of ownership, appears on the balance sheet, and impacts depreciation and interest expense, whereas an operating lease is essentially a rental agreement impacting operating expenses without significantly affecting your balance sheet. 

Correct lease classification is essential for maintaining accurate financial statements and regulatory compliance in public finance sectors.