Final answer:
Shorter term leases, such as operating leases, are rental agreements where the lessor retains ownership of the asset. Longer term leases, called financing leases or capital leases, are purchase agreements where the lessee has almost all the risks and rewards of ownership. These leases are treated differently in terms of ownership, duration, accounting treatment, flexibility, and total cost.
Step-by-step explanation:
Shorter term leases, such as operating leases, are typically used when a company wants to use an asset for a shorter period of time, usually less than the asset's useful life. These leases are more like rental agreements and do not transfer ownership of the asset to the lessee. On the other hand, longer term leases, called financing leases or capital leases, are used when the lessee wants to acquire and use an asset for a longer period of time, often for the asset's entire useful life. These leases are more like purchase agreements and transfer most of the risks and rewards of ownership to the lessee.
There are several differences between operating and financing leases:
- Ownership: With an operating lease, the lessor retains ownership of the asset and the lessee simply rents it. With a financing lease, the lessee has almost all the risks and rewards of ownership and is treated as the owner of the asset for accounting and tax purposes.
- Duration: Operating leases are usually shorter term, ranging from a few months to a few years, while financing leases are longer term, often lasting for the useful life of the asset.
- Accounting Treatment: Operating leases are treated as off-balance-sheet items, meaning they do not appear on the lessee's balance sheet. Financing leases, on the other hand, are treated as assets and liabilities on the lessee's balance sheet.
- Flexibility: Operating leases offer more flexibility as they can be easily terminated or renewed. Financing leases, on the other hand, are generally more difficult to terminate or modify.
- Total Cost: The total cost of financing leases is usually higher than operating leases, as financing leases involve the transfer of ownership and the lessee bears more responsibility for maintenance and other costs associated with the asset.