Question

What is the difference between a financial and operating lease? Under what circumstances would you use one versus the other? When owning versus leasing projections have a very slight difference in total costs, which method would you recommend and why?

Answer 1

Answer:

The lease is an agreement whereby one party i.e. lessor transfer to another party i.e. lessee the right to use of an asset for a payment or a series of payment.

Types of Lease:

Finance Lease: Whenever lessor transfer significant risk & reward incidental to ownership of assets, the lease is called finance lease.

Condition of Finance lease:

• If the Fair value of leased assets is equal to substantially equal to the present value of Minimum Lease paid.
• If lease life covers a major part of the economic life of leased assets.
• If at the end of lease period assets is automatically transfer to the lessee.
• When the nature of assets is such that it can not be used other than by lessee without any major modification.
• If at the end of the lease period, assets are transferred to the lessee at a price significantly lower than the market price.

All other leases other than Financing lease is classified at operating lease.

When owning versus leasing projections have a very slight difference in total costs, then we recommend it as financing lease as it's the fair value of assets is equal to or substantially equal to the present value of Minimum lease paid.