Accounting for Leases: Operating vs Finance Leases

Operating Lease vs Finance Lease: The Main Difference

A finance lease transfers substantially all the risks and rewards connected with ownership to the lessee. These include risks such as damage, loss of value and technological obsolescence, as well as benefits from using the asset or changes in its value. An operating lease does not transfer substantially all these risks and rewards to the lessee.

The contract’s name does not decide the classification. An agreement called a rental can still be a finance lease if the lessee carries most of the ownership risks.

Which Lease Standard Applies in India?

The business’s financial reporting framework determines which lease standard it must follow. It is not a choice that can be made separately for each contract.

Accounting Standard 19

AS 19, Leases applies to entities that prepare accounts under the Accounting Standards framework. Under AS 19, both lessees and lessors classify a lease as finance or operating. It does not cover:

• leases for exploring or using natural resources;
• specified licences for films, patents, copyrights and similar rights; or
• agreements to use land.

It does cover hire-purchase agreements that allow the hirer to obtain ownership after meeting the agreed conditions.

Indian Accounting Standard 116

Ind AS 116 applies to entities reporting under Ind AS. It became effective for annual reporting periods beginning on or after 1 April 2019. Under Ind AS 116:

• most lessees record a right-of-use asset and lease liability; and
• lessors continue to classify leases as finance or operating.

A right-of-use asset represents the lessee’s right to use the leased asset. A lease liability represents the payments the lessee is required to make. The current standard and its amendments are included in the Institute of Chartered Accountants of India Ind AS Compendium for 2025-26 .

Does the Contract Contain a Lease?

Before classifying a lease, check whether the contract actually gives the customer control over an asset. Under AS 19, a lease exists when one party gives another party the right to use an asset for an agreed period in return for payment, whereas Ind AS 116 uses a more detailed test. Ask:

1. Is a specific asset identified?
2. Does the customer obtain substantially all of the economic benefits from using it?
3. Does the customer decide how and for what purpose it will be used?

For example, a contract giving a business exclusive control over a specified delivery vehicle can contain a lease. A contract requiring a transport company to deliver a set number of parcels is a service when the transport company controls the vehicles and delivery process.

How AS 19 Classifies a Lease

AS 19 classifies a lease based on its economic substance. The following situations would normally lead to a lease being classified as a finance lease:

• ownership transfers to the lessee at the end of the lease;
• the lessee has a purchase option that is reasonably certain to be exercised;
• the lease term covers the major part of the asset’s economic life;
• at the start of the lease, the present value of the minimum lease payments amounts to at least substantially all of the asset’s fair value; or
• the asset is so specialised that only the lessee can use it without major changes.

Notes: 

1. Here, lease term means the non-cancellable period of the lease plus any further period the lessee is reasonably certain to continue it. 
2. Economic life is the period the asset is expected to be economically usable. 
3. Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s-length transaction. 
4. Minimum lease payments are the payments included in the lease calculation under AS 19.

Other contract terms can also indicate a finance lease. For example, the lessee can bear losses arising from cancellation or gains and losses caused by changes in the asset’s residual value. AS 19 looks at the overall substance of the arrangement rather than prescribing fixed percentage thresholds.

Lease classification is made when the lease begins. A later change in an estimate does not change the classification. If the parties change the lease terms, other than through renewal, in a way that would have changed the original classification, AS 19 treats the revised agreement as a new agreement.

How a Lease Is Recorded

AS 19 Finance Lease

At the start of a finance lease, the lessee records an asset and liability at the asset’s fair value. If the fair value is higher than the present value of the minimum lease payments, the present value is used instead.

The discount rate is the rate implicit in the lease when it can be determined. Otherwise, the lessee uses its incremental borrowing rate.

Each lease payment is divided between the finance charge and repayment of the lease liability. If ownership is not expected to transfer, the asset is depreciated over the shorter of its useful life and the lease term.

AS 19 Operating Lease

Operating lease payments are recorded as an expense evenly over the lease term unless another method better reflects how the benefit from the asset is received. For example, if total rent for a 3-year lease is ₹3,00,000, the expense is normally ₹1,00,000 per year, even if the amount actually paid differs from year to year.

Ind AS 116 Lessee Accounting

At the start of most leases, the lessee records a lease liability for the present value of future lease payments and a right-of-use asset representing its right to use the leased asset.

Depending on the contract, the right-of-use asset also includes payments made in advance, certain direct costs and expected restoration costs. Lease incentives received from the lessor reduce this amount.

After the lease starts, the lessee records depreciation on the right-of-use asset and interest on the lease liability. The total expense is usually higher in the earlier years because interest is charged on a larger outstanding liability.

Ind AS 116 allows a simpler expense-based treatment for leases of 12 months or less with no purchase option and for leases of low-value assets. 

Ind AS 116 does not specify a fixed rupee amount for a low-value asset. Examples of low-value assets include telephones, small office furniture and basic computer equipment. Cars do not qualify as low-value assets.

Lessor Accounting

A lessor records a finance lease as an amount receivable from the lessee and recognises finance income over the lease term. For an operating lease, the lessor keeps the asset in its accounts, continues to depreciate it and recognises lease income over the lease term.

Worked Example: Three-Year Machine Lease

Sharma Engineering leases a machine on the following terms:

The lease covers 3 of the machine’s 4 years of economic life.

The present value of the payments is:

₹1,00,000 ÷ 1.10 + ₹1,00,000 ÷ 1.10² + ₹1,00,000 ÷ 1.10³

= ₹90,909 + ₹82,645 + ₹75,131

= ₹2,48,685

The present value is approximately 99.5% of the machine’s fair value of ₹2,50,000. The lease also covers 3 of the machine’s 4 years of economic life. Together, these factors indicate that substantially all the risks and rewards connected with ownership transfer to the lessee. The lease is therefore a finance lease under AS 19. 

Entry at the Start of the Lease

Lease Liability Schedule

(Figures are rounded to the nearest rupee)

Because ownership does not transfer, the asset is depreciated over the 3-year lease term:

₹2,48,685 ÷ 3 = ₹82,895 per year

Entries for Year 1

Under Ind AS 116, the depreciation relates to the right-of-use asset.

Income Tax, TDS and GST

Accounting treatment does not automatically decide tax treatment.

Income-Tax Depreciation

The Income-tax Act, 2025 came into force on 1 April 2026. Under section 33 , depreciation generally applies to qualifying assets owned wholly or partly by the taxpayer and used for business or professional purposes.

Recording a right-of-use asset under Ind AS 116 does not automatically make the lessee the owner for income-tax purposes.

Section 33(6) separately covers qualifying expenditure on structures, renovation, extensions or improvements made to a business building held under a lease or another right of occupancy.

TDS on Rent

For rent paid or credited to a resident, section 393 of the Income-tax Act, 2025 provides the following main rates:

Here, a specified person includes companies, firms and other non-individual payers, as well as individuals or Hindu Undivided Families (HUFs) above the prescribed business or professional turnover limits. 

The payer’s category, the payee’s residential status, available exemptions and the time of deduction must be checked before applying TDS.

GST Treatment

Under the Central Goods and Services Tax Act, 2017 :

• giving someone a right to use goods without transferring ownership is a supply of services
• leasing or renting immovable property is a supply of services; and
• an agreement under which ownership passes after full payment is treated as a supply of goods.

The GST rate, place of supply, invoice treatment and input tax credit must be checked separately.

Recording Lease Entries in BUSY

In BUSY accounting software , businesses can create separate ledgers for the leased asset or right-of-use asset, lease liability, depreciation, finance charge and lease expense. This helps keep lease-related entries clearly separated and makes it easier to match the outstanding liability with the payment schedule.

Conclusion

The name of an agreement does not determine its accounting treatment. The correct treatment depends on whether AS 19 or Ind AS 116 applies and on the rights and obligations created by the contract. Clear classification and a properly maintained payment schedule help prevent errors in assets, liabilities, finance charges and depreciation. Tax and GST treatment should be reviewed separately before the entries are finalised.