Accounting 101: Understanding Operating Leases
By Julie King | June 30, 2009
Should you lease or should you buy?
While the basic concept of a lease is fairly well understood, there are a number of factors you should take into account when considering this financing option. To better understand the ins and outs of operating lease financing we spoke with David Powell, president of the Canadian Finance & Leasing Association.
What is an operating lease?
It is important to understand that there are actually two types of leases, operating and capital, which are substantially different from an accounting and tax viewpoint. The biggest difference lies in ownership.
You don't own the equipment when you secure an operating lease. Instead, the lessor purchases the equipment and essentially rents it to you for a specified period of time.
As a result, you don't report the equipment you are leasing on your books as an asset. From a tax viewpoint, you can immediately expense all of your costs.
In contrast, a capital lease is very similar to a loan. The equipment goes on your books as an asset and you can only directly expenses the interest costs. As with all assets, at the end of each fiscal year you can claim a depreciation amount using the government's capital cost allowance (CCA) formulas.
Cashflow friendly financing
Powell explains that there is no question that in overall terms a lease is more expensive than a loan, because with a loan you own the asset at the end of the term whereas with a lease you don't.
The main advantage of leasing lies in cashflow.
- With an operating lease you make payments plus interest on the portion of the asset you will use, which will be lower than the total value of the equipment. For example, if you plan to lease a $60,000 machine that was expected to have a value of $15,000 at the end of the lease term, your payments would be based on a cost of $45,000.
- You can still put money down with an operating lease to reduce the long term financing cost. Wayne McDougall, a chartered accountant with Brudner, Herblum & McDougall notes that the initial payment is not expensed immediately, but is usually capitalized and written off over the term of the lease.
- With an operating lease you pay taxes on your payments, not on the full purchase price of the equipment. In contrast, with a capital lease or loan you would pay the taxes in full when the asset was purchased.
- If you demonstrate that you are a good credit risk, leasing companies may offer you more flexible payment terms. For example, for a three year lease you may be able to negotiate lower payments in the initial year, with payments increasing after each year you use the equipment. Seasonal businesses may be able to negotiate higher payments during their busy season, with no payments during the off-season.
- With an operating lease the interest rate on a lease is usually fixed and the value of the equipment is leased to you is usually financed on a declining balance basis. A declining balance, according to Wikipedia, means that there is a higher depreciation value assigned to the asset in the first year of the asset's life, which then gradually decreases in subsequent years.
Leasing companies often specialize in a particular kind of equipment, which gives them the ability to maximize the residual value of the asset as they can dispose of the asset at its optimal value, thus reducing your costs.
Sample lease calculation
Powell explains lease financing using this simple example.
Asset purchase price: $30,000Estimated value at the end of the lease term: $7,500Initial payment: $5,000
Amount to be financed = purchase price - end value - initial payment$30,000 - $7,500 - $5,000 = $17,500
The amount you are financing in this scenario is $17,500.
The leasing company will calculate your payments on a declining balance basis. In this sense, the cost of your financing is linked to the depreciation of the asset, even though you will not be claiming that depreciation amount.
Evaluating your financing application
When looking for financing, banks and leasing companies will look at different criteria.
For the banks, their main concern is your ability to service the debt, so they will look at your income and all of your other debt obligations.
A leasing company, on the otherhand, has the advantage of actually owning the asset you plan to use. Your ability to make your monthly payments will still be important to them, but they also have the ability to get most if not all of their costs out of the transaction should you not pay. As a result they may be able to offer you financing when a bank cannot.
The lease agreement
Your agreement will depend on the nature of the equipment being leased, but generally it will set out conditions for reasonable use with penalties for use or wear and tear beyond what they have established as normal use.
For example, if you lease a car the biggest single determinant of its used value is mileage, so that is usually put into the lease agreement along with penalties designed to off-set the lost value that was estimated at the outset should you go over the agreed mileage cap.
You can also expect to be required to properly maintain the equipment and to be able to prove that you have met your maintenance obligations. For specialized equipment such as photocopiers, the company who sold the equipment may also service it, so they will know how the equipment was maintained.
An operating lease does not prevent you from purchasing the equipment outright at the end of the lease term. You simply have to pay fair market value for it, as opposed to the nominal amount you would expect to pay with a capital lease.
"The leasing company may still offer to sell the equipment to you at the end of the lease," says Powell. "As long as it's offered for sale at fair market value, you're basically buying a used piece of equipment. It just happens to be a piece of equipment you are very familiar with."
What if you have already bought equipment?
If you purchase equipment and then decide that it would have been better to have leased it, you can still look for a leasing company to buy the equipment from you and then lease it back to your business. This is known as a sales and leaseback agreement.
Trends towards intangible assets
At the current time operating leases to purchase software-based technology are not really being considered, says Powell, because the leasing companies want a hard asset.
Software may have tangible value, but it is often customized to meet the needs of a specific client, making it hard to transfer to a new owner. Software programs are also often governed by licensing agreements that either limit or prohibit the transfer of a license to a new owner.
Powell notes that it may be possible that a website that develops a valuable brand name could be the kinds of thing that could be leased one day, but right now it is too soon for that.