Strategic Financial Management · Leasing Decisions

Types of Leases: Finance Lease vs Operating Lease

Updated 11 October 2026 · Fact-checked

A lease is a contract where the lessor lets the lessee use an asset for rentals over a period, while ownership stays with the lessor. The main types are finance lease, operating lease, sale and leaseback, and leveraged lease. To answer, classify by who bears risks and rewards of ownership, then state the consequences.

Understand Introduction to Leasing and Types of Leases

A lease is an agreement in which the owner of an asset, the lessor, gives the right to use it to another party, the lessee, for an agreed period in return for periodic payments called lease rentals. The lessee gets the use of the asset without paying its full price upfront. This is why leasing is treated as a source of finance as well as a way to use assets.

The key question in classification is: who bears the risks and rewards of ownership? If they pass substantially to the lessee, the lease is a finance lease. If they stay with the lessor, it is an operating lease. Classification depends on the substance of the deal, not the name given in the contract.

A finance lease is long term and usually non-cancellable. The lease term covers most of the asset's economic life. The lessee typically maintains and insures the asset. The lessor recovers its investment plus a return through the rentals, so it is a full-payout lease. An operating lease is shorter than the asset's life, often cancellable, and the lessor may bear maintenance and obsolescence risk. The lessor recovers its cost by leasing the asset repeatedly. Computers, vehicles and construction equipment are common examples.

In a sale and leaseback, a firm sells an asset it already owns to a lessor and leases it back at once. The firm gets cash and keeps using the asset. Example: a company sells a factory machine to a leasing company for cash and takes it back on lease. In a leveraged lease, three parties are involved: the lessor, the lessee and a lender. The lessor puts in only part of the cost as equity. The rest is a loan from the lender, usually non-recourse to the lessor and secured on the asset and the rentals. Leveraged leases suit very costly assets such as aircraft and ships.

How Ind AS 116 treats these in the books is a reporting matter. For SFM, focus on the concept, the types, and the finance decision they represent.

Key rules to remember

Classification test: Risks and rewards of ownership substantially with lessee → Finance lease; otherwise → Operating lease; Decide by substance. Indicators: lease term covers most of asset life, ownership or purchase option at a low price, non-cancellable, lessee bears maintenance.
Leveraged lease structure: Asset cost = Lessor's equity + Lender's loan; Three parties. Lender usually has recourse only to the asset and rentals, not to the lessor's other assets.
Sale and leaseback cash effect: Cash inflow to seller-lessee = Sale price; then outflow = periodic lease rentals; Use of the asset continues without a break.

How to solve Introduction to Leasing and Types of Leases questions

Use this method for any descriptive or MCQ question on the types of leases.

1Identify the parties: lessor, lessee, and any lender or third party.
2Check who owned the asset first. If the user sold it to the lessor and took it back, it is sale and leaseback.
3Check for a lender funding most of the cost with the lessor putting in a smaller equity share. That points to a leveraged lease.
4Otherwise test risks and rewards: lease term versus asset life, cancellability, who maintains and insures, any purchase option.
5Classify as finance or operating and give the reason from the facts in the question.
6State the consequences: financing effect, cost, risk of obsolescence, who bears maintenance.
7Close with a clear one-line conclusion tied to the case.

Quickest way: Three-question lease classifier

When to use it: Use in MCQs and case scenarios where you have under two minutes per question.

Q1: Did the lessee sell the asset to the lessor first? If yes, sale and leaseback.
Q2: Is a lender financing most of the cost? If yes, leveraged lease.
Q3: Is the lease long, non-cancellable and covering most of the asset's life, with the lessee bearing upkeep? If yes, finance lease; if short, cancellable and lessor bears upkeep, operating lease.

Common mistakes in Introduction to Leasing and Types of Leases

Classifying a lease by its name in the contract.
Students trust the label instead of the facts.
Fix: Classify by substance: look at who bears the risks and rewards of ownership.
Saying ownership always transfers in a finance lease.
Confusing finance lease with hire purchase.
Fix: Legal title may stay with the lessor. What passes is substantially all risks and rewards, with or without title transfer.
Calling every three-party lease a leveraged lease.
Missing the defining feature.
Fix: A leveraged lease needs a lender funding a large part of the cost, usually without recourse to the lessor.
In sale and leaseback, treating the seller as no longer using the asset.
Focusing on the sale and forgetting the lease back.
Fix: The seller becomes the lessee and keeps using the asset. The gain is cash and liquidity.
Saying operating leases are always cancellable and short.
Overstating a typical feature as a rule.
Fix: Say they are usually shorter than asset life and often cancellable. The test is that risks and rewards stay with the lessor.

Worked examples

Example 1

Shreya Textiles owns a machine. It sells the machine to Bharat Leasing Ltd for cash and immediately takes it back on a 5-year lease, paying yearly rentals. Name the type of lease, identify the lessor and lessee, and state one benefit for Shreya Textiles.

Show the solution

Shreya Textiles owned the machine and sold it to the lessor, then leased it back.
This is the defining feature of a sale and leaseback.
Bharat Leasing Ltd is the lessor, as it now owns the machine. Shreya Textiles is the lessee.
Benefit: Shreya releases cash tied up in the machine and keeps using it without interruption.

Answer: Sale and leaseback. Lessor: Bharat Leasing Ltd. Lessee: Shreya Textiles. Benefit: cash is released while the machine stays in use.

Example 2

Nilgiri Air leases an aircraft costing ₹100 crore. The lessor invests ₹30 crore of its own funds and borrows ₹70 crore from a bank, with the loan secured on the aircraft and the rentals only. Identify the lease type, and compute the lessor's equity share of the cost.

Show the solution

Three parties are involved: lessor, lessee Nilgiri Air, and the lending bank.
The lender funds most of the cost and has recourse only to the asset and rentals.
This matches a leveraged lease.
Equity share = 30 ÷ 100 = 30%. Debt share = 70 ÷ 100 = 70%.

Answer: Leveraged lease. The lessor's equity is 30% of the cost, ₹30 crore, and the bank funds the other 70%.

Exam tips

In case scenarios, quote the facts that decide the classification, such as lease term, cancellability and who maintains the asset.
Write differences between finance and operating lease as a two-column style list of points: term, cancellation, maintenance, risk, recovery of cost.
Know one real-life example for each type; examiners like application.
Leveraged lease is often asked in short notes. Mention three parties, partial equity, non-recourse loan and costly assets.
This topic leads into lessee and lessor evaluation numericals, so be ready to link the type of lease to the rental calculation.

Practice questions from Leasing Decisions

Introduction to Leasing and Types of Leases in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Introduction to Leasing and Types of Leases: frequently asked questions

What is the difference between finance lease and operating lease?

In a finance lease, the lessee bears substantially all risks and rewards of ownership. The lease is long, usually non-cancellable and covers most of the asset's life. In an operating lease, the lessor keeps these risks, the term is shorter and the lease is often cancellable.

What is sale and leaseback with an example?

The owner of an asset sells it to a lessor and leases it back at once. For example, a company sells its plant to a leasing firm and pays rentals to keep using it. It releases cash without losing use of the asset.

What is a leveraged lease?

It is a lease with three parties: lessor, lessee and lender. The lessor funds only part of the cost and borrows the rest, usually on a non-recourse basis. It is common for very costly assets like aircraft and ships.

Who is the lessor and who is the lessee?

The lessor owns the asset and gives it on lease. The lessee uses the asset and pays the lease rentals.