There are two types of leases - Operating Lease and Finance Lease. Here is a detailed explanations of both with practical examples.
First of all we need to understand what is lease. Lease is an agreement where a legal owner of an asset (lessor) conveys to an another party, who is the lessee, the right to use an asset for an agreed period of time, in return for a payment or series of regular payments (also known as lease rent). For example, Mr. X allows Mrs. Z to use his car for a period of six months, at a payment of Rs. 10,000 per month. Here Mr. X is the lessor, Mrs. Z is the lessee, Rs. 10,000 is the lease rent per month and six months is the lease term.
A lease which transfers substantially all the risks and rewards that are incident to ownership of an asset is termed as financial lease. The title of asset may or may not be eventually transferred in the case of finance lease.
There are several factors which determine if a lease is Finance Lease or not. Those indicators are as follows:
The lease transfers ownership of the asset to the lessee by the end of the lease term;
The lessee has the option to purchase the asset at lower price than the fair value of asset, and at the inception of the lease, it is obvious that the option will be exercised.
The leased asset is of specialized nature such that only the lessee can use it without major modifications being made.
The lease term is for the major part of the economic life of the asset;
At the inception of the lease, present value of the minimum lease payments amounts to at least substantially all the fair value of the asset.
If any of these criteria is satisfied then the lease is termed as Finance Lease.
Example of Finance Lease - Suppose A, manufacturer of supercomputers, leases a supercomputer to Company B. The economic life of the computer is 5 years and the lease term is 4 years. The supercomputer is specifically architectured by A for the use of Company B and it can't be used by other companies without further modification. Also the fair value of the supercomputer after 4 years is Rs. 200,000. And Company B has the option to purchase the computer at Rs. 80,000. The total lease payment amounted to Rs. 1600,000 whose present value is Rs. 1300,000.
The lease by A to Company B is surely a Finance lease as it satisfies all the conditions as explained in the five points.
A lease in which a lessor grants access to the lessee to use his assets for a specific time period, which is substantially less than the economic life of the asset, in return of periodic payments is called Operating Lease. It is to be noted that the lessee doesn't has the option to buy the asset at the end of the lease term in case of an operating lease. In simple words, it can be said that any lease which doesn't fall under the criteria of Finance lease as explained above, is an Operating Lease. If the five factors explained in Finance Lease don't hold true, then the lease becomes an Operating Lease.
Example of Operating Lease - Lets suppose Mr. C deals in superbikes, whose economic life is 8 years. He leases out one of his superbikes to Mr. D for a period of 1 year at Rs. 8,000 per month. This case turns out to be an Operating Lease, because the lease term and rent is way less than the economic life and economic value of the superbike respectively. Moreover, Mr. D doesn't has the option to buy the superbike at the end of lease period.