Recording an operating lease vs. a capital lease

You may come across both operating and capital leases during your day-to-day business.

An operating lease is any lease that isn’t a capital lease. It doesn’t transfer all of the benefits and risks related to the property ownership to the lessee. Operating leases are generally short term, and are only acquired for a fraction of the equipment’s useful life.

A capital lease transfers all of the risks and benefits of ownership to the lessee. It’s a balance sheet lease and, generally, a long-term agreement. A lease must meet four criteria to be considered a capital lease:

1. The lease conveys ownership to the lessee at the end of the lease term.
2. The lessee has the option to purchase the assets at the end of the lease term. The lease documentation may refer to this as the “bargain price option” or “BPO.”
3. The lease term is 75 per cent or more of the asset’s economic life.
4. The present value of the rents, using the lessee’s incremental borrowing rate, is 90 per cent or more of the asset’s fair market value.

Under 1 and 2, the most common criteria, you’d enter the lease as a regular capital asset purchase and set up the balance of the lease payments owed as a loan. Ask your accountant to provide direction if your lease falls under either of the last two criteria.

Record GST when you record the lease payments, not when you enter the capital asset.

Enter an operating lease as a straight expense. You don’t have to follow special rules. On your tax return, the total amount will be combined with other rent payments made throughout the year.

Treat a capital lease the same way as a loan, but instead of listing it with your loans, set up a separate section for leases payable.

When you make your capital lease payment, you may need to pay interest on top of the principal and GST. Split up the expenses, if possible.

Last updated on August 31, 2016 by FCC AgExpert