If your company needs to expand its facilities or update equipment, you may be weighing the pros and cons of financing versus leasing. Here is some guidance to help you make an informed decision.
Traditional Financing
Few companies have enough liquidity on hand to outright make large fixed asset purchases. Instead, the buyer might utilize financing to acquire the asset. The term of the loan is typically connected to the item's useful life, for example, five years for an equipment loan. The loan's interest rate may be fixed or vary based on a market index. Additionally, loans might require a down payment based on the asset's price and personal guarantees from the company's owners. At the end of the loan term, the company owns the asset.
Borrowers can deduct interest expense and depreciation on their income tax returns. You can also elect to accelerate depreciation deductions under Section 179 and bonus depreciation. For 2017, the maximum section 179 deduction for qualifying equipment is $510,000. The 179 deduction is phased out dollar-for-dollar for purchases exceeding $2,030,000 and eliminated at $2.5 million. Bonus depreciation continues to be 50% for qualifying assets in 2017, but will be reduced over the following two years (2018-40% and 2019-30%). Bonus deprecation is generally available through 2019, unless revised legislation is enacted.
Leasing
Alternatively, a lease is a contract between a company (the lessee) and a landlord or financing company (the lessor). The approval process for leases is generally quicker and easier than for bank loans. A lease typically commits the lessee to make monthly payments over a period of time for the use of the equipment. Lease payments include imputed interest charges, which are typically higher than the interest rates for traditional bank loans. A lease also may include an option for the company to buy the equipment, for some stated price, at the end of the lease.
Lease terms can be flexible. Some leases require an initial down payment on the lease to help reduce monthly costs. Sometimes, the lessor covers all maintenance and insurance costs; other leases call for the lessee to pay these expenses over the lease term. It is important to understand and review the lease contract as the terms of each lease could vary.
Although lessees do not benefit from interest and depreciation deductions, lease payments are deductible for tax purposes. Leasing could be a good option if you need equipment that requires an upgrade every few years due to technological obsolescence. Additionally, if unexpected changes in the business occur, the lessee may be able to cancel the lease or downgrade to a smaller piece of equipment.
New Reporting Requirements
Current accounting rules require lessees to report capital leases on their balance sheets. Capital leases transfer ownership of the underlying asset to the lessee by the end of the lease term. Leases that do not meet the criteria established for capital leases are classified as operating leases. Operating leases are not currently presented on the balance sheet.
Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), requires companies to report all leases with terms of at least 12 months on their balance sheets. The new guidance takes effect in fiscal years starting after December 15, 2018, for public companies, and for fiscal years beginning after December 15, 2019, for private companies. The update focuses to increase transparency and comparability among organizations through the disclosure of key information about lease arrangements.
The expectation is that the standard will make lessees appear more leveraged than in previous years, which could cause loan covenant violations and hamper access to capital. So, it is important to consider how the financial reporting changes will be perceived by stakeholders.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
