How to account for operating and finance leases

How to account for operating and finance leases

In leasing, one party to the contract (the lessor) gives the other party (the lessee) the use of a specific item in exchange for fixed installment payments for a contractually agreed-upon leasing period. This is a good solution for entrepreneurs because it is not necessary to have an adequate (and often high) capital of money to purchase a particular item. In the case of expensive equipment such as computer hardware or kitchen equipment in a restaurant, this solution will certainly work. Entrepreneurs are faced with two types of leasing, namely operating and finance. Read the article to the end to find out how operating and finance leases are accounted for.

Operating Lease

In this form, the leased item is included in the assets of the lessor (e.g., the leasing company). In turn, the monthly lease instalments are tax-deductible for the lessee. VAT is added to each lease instalment.
VAT is added to each lease instalment. Therefore, in this form of leasing, there is no obligation to pay the VAT in full at the beginning of the lease agreement. The initial payment, which may be taken as a one-off payment, may also be included in the tax deductible costs. The sum of payments agreed in the contract, less the VAT due, must be at least the same as the initial value of the fixed assets. After the end of the agreement, the lessee has the right to buy the used object.

Operating lease

How are operating and finance leases accounted for? – Operating lease

With this form of lease agreement, an entrepreneur must bear in mind that the leased item will become part of the lessee’s assets. Therefore, unlike in the case of the operating lease, the lessee is obliged to make depreciation deductions. And this is the element that differentiates both types of leasing. In addition, the lessee may include only the interest part of the lease instalment as a deductible cost. The VAT tax, on the other hand, has to be paid in full in advance together with the first instalment, just after the receipt of the object. Additionally, the lessee becomes the owner of the object of lease automatically after the last instalment is paid (contrary to operating lease). As far as the initial payment is concerned, there is also a different principle here. In the financial lease, the entrepreneur does not bear costs connected with this fee.

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