Are you renting a property or equipment for your business?
Accounting for a lease can be tricky given the recent changes in accounting for these transactions.
Now, you can still account for a lease in two ways—as an operating lease or a capital lease.
Operating Lease Vs. Capital Lease
The main difference between an operating lease and capital lease involves the party who assumes the risk of ownership.
In an operating lease, you only have the right-to-use the property or equipment. The lessor still owns the leased property.
Compare that to a capital lease. With a capital lease, you assume the risk of ownership. As a rule, you need to consider the lease as a capital lease in the following cases:
- Property ownership transfers from the owner to you after the end of the lease term.
- You have the option to purchase the asset and you are reasonably certain to exercise such an option.
- The lease term is for the remaining economic life of the property or equipment except if the lease begins near the asset’s economic life.
- All payments for the leased asset including any guaranteed residual value is equal to or is higher than substantially all of its fair.
- You leased a specialized asset that will hold no future value after the lease term.
Changes in Recording Leases
New accounting standards changed the accounting method for lease transactions.
In previous years, an operating lease will not appear in the balance sheet. You only needed to record a balance sheet item for a capital lease. However, ASC 842 changed the accepted method for recording an operating lease.
Now, you need to record a right-of-use (ROU) asset in your balance sheet whether you have an operating lease or a capital lease. However, there is an exception.
Is your operating lease term 12 months or less?
Under the new accounting rule, you are not required to record an asset if the lease term is 12 months or shorter. This means, that if you are using Quickbooks, you can still apply the old accounting method for a short term lease by doing these steps:
- On the upper right corner of your screen, choose the plus (+) sign.
- Under Suppliers click on Expenses.
- Select Payee. It should be the name of your lessor or the company renting out the property or asset. If the name is not on the dropdown list, click on +Add. Input the name of the Payee, the Account Type, and Currency and then Save.
- Choose the account you use to make payments.
- Input the date of payment.
- Enter the Payment Method.
- Go to the next section, Account details. Under Account, choose Rent or another account you use to record your rent payments and add a Description.
- Input your rental payment and indicate any applicable taxes.
- Click Save.
How do I record a lease for LONGER than 12 months?
Again, you need to identify whether the lease is an operating lease or a capital lease.
Accounting for an Operating Lease
At the beginning of the lease, record the right-of-use asset in an appropriate account. You may have to set up a new account for the leased asset and lease liability in Quickbooks first. After setting up the appropriate accounts, do these steps:
- Click on the Create icon ⨁.
- In the Other column, choose Journal Entry.
- Add the relevant asset account for Operating Lease- Right-of-Use asset. Debit the present value of your lease payments.
- Choose the applicable liability account and input the present value of your lease payments.
When you make a rent payment, make a debit entry to Lease Liability and credit cash.
You need to make another entry to recognize the Lease Expense in a separate transaction with a debit to the expense account and a credit to Lease Liability and the Right-of-Use asset.
When the lease term ends, your lease liability and right-of-use asset should have a balance of zero.
Accounting for a Capital Lease
Like an operating lease, you need to record the right-of-use asset using the same method as above. Add a journal entry with a debit to the Right-of-Use asset and a credit to Lease Liability.
At the end of every period, you need to recognize and Amortization Expense against the Right-of-Use asset. When you pay rent payments, you also need to make a debit to the Interest Expense and Lease Liability and a credit to cash.
You can compute the interest expense by multiplying the applicable rate to the outstanding balance of your lease liability.
Lease Accounting Can Be Confusing
Unless the term of your lease is 12 months or less, you can charge rent payments to expense right away. However, if you are leasing property for more than a year, it would be best to consult a bookkeeper to help you with the process.
Take note that this guide only covers the basics of accounting for a lease. Your business may have a different way of accounting for these assets for tax purposes, so it would be best to consult your tax advisor.