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Capital Lease - Equipment (JE's and FS)

Lease contract - equipment

  • Cost : $5,500.00
  • Term: 5yr - indicator capital lease (useful life)
  • Buy out price: $10.00 - indicator capital lease (bargain purchase option)
  • Periodic rent amount : $136.51 + tax $17.75 = $153.23
  • Lease start date: August 1, 2019

Website - amortization schedule: https://www.amortization-calc.com/business-loan-calculator/

I plugged in: Interest rate - 17% (seems high), Term - 5yrs, Cost - $5,500.00, & Date - Aug 1 2019

2019: Interest $381.00 & Principal $302.00

For tax
5 pmts in 2019 (Aug - Dec)
DT Equipment Rental $136.51
DT HST $17.75
CT Bank $154.26
Equipment lease payment (5 of these in 2019)

DT Interest Expense $381.00
CT Equipment Rental $381.00
Reclassify equipment rental to interest expense at year-end

For accounting (Financial Statements)

DT Equipment $5,500.00
CT Lease Liability $5,500.00
Record Equipment capital lease

DT Amortization Expense $458.33
CT Accumulated Amortization $458.33
Amortization on equipment 20% and 5/12 year Aug - Dec ($5500 x 0.2 x 5/12)

Thoughts on the above journal entries and impact the balance sheet? Is there a rule of thumb/threshold/materiality amount for which a lease like this (Equipment is $5,500) should be treated differently?

If it is a capital lease for accounting purposes, it should be treated as a capital asset for tax purposes - not as a rental. The tax treatment should agree with the factual terms of the agreement.

I think it’s a good starting point to ask the client what their intention is - do they plan to keep the asset at the end of the lease? If not, I wouldn’t bother to capitalize something under $10,000. If it is a larger asset (i.e. $100,000+), I would spend the time to go through all the criteria and figure out if it should be capitalized no matter what the client’s intention is.

17% interest is not high for a leased asset. Banks don’t like to loan money on small amounts like this, so the business usually has two options - pay cash or lease. For larger assets, the choice between a loan or a lease is often determined by the business’s credit history/rating - if they can’t get a loan (i.e. lower interest rate), they must lease (i.e. higher “interest” costs).

Don’t forget, if you are capitalizing, you must amortize the lease liability:
DR Lease Liability $302
DR Interest Expense $381
CR Bank(etc) 683

Thus, for tax purposes, the client will have deductions for CCA and interest expense.
Alternatively, if it is an operating lease, the client will have only rental expense.

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@NiceGuy
Beware of the technicalities of your lease facts. There are lots of facts and gotcha’s such as available for use.

A) List all of the relevant conditions for amortization such as those in the references below.
B) Summarize your facts. If the facts do not meet the conditions for amortization, then you must expense. If you expense the lease payments then you must comply with the interest rules.
C) Review with CRA resource officer on the business line and/or a CPA. GST rulings may help. A GST Trust Examiner will certainly have an opinion on this matter. I have had a concrete batch mix disallowed as asset and the GST on the payments disallowed even though this was an outright purchase because the payments were not made in full. Only $300K of the $400K purchase price was paid. Interest on the balance kept piling up. In the end, the asset was returned to retire the loan. The payments were deemed to be an expense with no GST included. The additional amounts were deemed to be interest expense only in lieu of sufficient documentation to the contrary. In this case the cement mixer had been purchased from Quebec and delivered to the First Nations reserve. Title was never considered to have been transferred since the equipment had not been paid in full. Upon return of the equipment, the difference between the Fair Market Value and the payments was considered to be a combination of penalties and interest expense. Although GST was calculated in error on the invoice, no GST claim could be made because the item was deemed to GST exempt for a First Nations proprietor with delivery to the reserve.

Types of leases.

Capital lease.

Capital Lease

A Capital Lease is one which transfers substantially all of the risks and benefits of ownership of the leased property to the lessee, and may be your best choice if long-term equipment ownership is your goal. According to the Canadian Institute of Chartered Accountants handbook, a lease will be treated as a Capital Lease (i.e. be categorized on your balance sheet as a long-term liability, interest expense on your income statement) if it meets any of the following criteria:

  • Title passes automatically to the lessee at the end of the lease term;
  • The lease contains a bargain purchase option (i.e. less than Fair Market Value, anywhere from $1 to 10% of the original equipment cost);
  • The lease term is greater than 75% of the estimated economic life of the leased property;
  • The present value of the minimum lease payments is greater than 90% of the leased property’s Fair Market Value at the inception of the lease.

Operating Lease.
An Operating Lease is any lease that is not a Capital Lease, and does not transfer substantially all of the benefits and risks related to the ownership of property to the lessee. As such, Operating Leases are generally used for short term equipment lease, and can work to the lessee’s benefit for tax purposes as the payments may be deducted as an operating expense. An operating lease is considered to be an “off-balance sheet” liability, allowing the lessee to acquire equipment for just a fraction of the useful life of the asset, although it typically contains a provision to purchase the equipment at the end of the lease for Fair Market Value. Additional services, such as maintenance and insurance may be provided by the lessor.

I would do the following:

  1. Review the lease agreement in full to determine the nature of the lease.

For a fuller explanation of CCA and ownership reference this CRA Folio under the topic “Ownership”, section 1.21 to 1.37.

  1. How to expense an lease.
    Although this reference is based on vehicle lease for proprietorship this is a good starting point for small corporations as well.

"If you entered into a lease agreement, you can choose to treat your lease payments as combined payments of principal and interest. However, you and the person from whom you are leasing have to agree to treat the payments this way.
In this case, we consider that you:

  • bought the property rather than leased it
  • borrowed an amount equal to the [fair market value (FMV)]
    You can deduct the interest part of the payment as an expense. You can also claim capital cost allowance on the property.

You can make this choice as long as the property qualifies and the total FMV of all the property included in the lease is more than $25,000."

You can make this choice as long as the property qualifies and the total FMV of all the property included in the lease is more than $25,000. For example, a combine or fishing boat, leased with a FMV of $35,000 qualifies. However, office furniture and vehicles often do not qualify.

To treat your lease this way, file one of these forms with your income tax return for the year you make the lease agreement:

  • T2145 - Election in respect of the leasing of property.
  • T2146, election in respect of assigned leases or subleased properties.
  1. Presribed interest rate.

How to calculate prescribed interest rates for leasing rules.

  1. Capitalize the buyout if and when title transfers, or, when it is deemed to have transferred.

  2. Consider Fair Market Value as well as buyout cost when adding the asset.

CRA asset additon cost vs fair market value

The Canada Revenue Agency ( CRA ) says that fair market value " is usually the highest dollar value you can get for your property in an open and unrestricted market and between a willing buyer and a willing seller who are knowledgeable, informed, and acting independently of each other."

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Thank you both @dominique.dabolczi @Nezzer I really appreciate your replies!
Have a great evening