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SHOULD YOU LEASE OR BUY EQUIPMENT?
Small businesses have difficulty raising capital -- that's no secret.
This difficulty (among other reasons) has caused many to look at leasing
as an alternative financing arrangement for acquiring assets. All types
of equipment leasing - from motor vehicles to computers, from
manufacturing machinery to office furniture - have become more and more
attractive.
This page describes various aspects of the lease vs. buy decision. It
lists advantages and disadvantages of leasing and provides a format for
comparing the costs of each options. We also have a sample
analysis for download
Purchase vs.
Lease Analysis
Call us for a telephone review of the various aspects
WHAT IS A LEASE?
A lease is a term agreement to rent equipment, land, buildings, or any
other asset. In return for most - but not all - of the benefits of
ownership, the user (lessee) makes periodic payments to the owner of the
asset (lessor). The lease payment covers the original cost of the
equipment or other asset and provides the lessor a profit.
TYPES OF LEASES
There are three major kinds of leases: the financial lease, the
operating lease, and the sale and leaseback.
Financial leases are the most common by far. A financial
lease is usually written for a term not to exceed the economic life of
the equipment. You will find that a financial lease usually provides
that:
1) Periodic payments be made
2) Ownership of the equipment reverts to the lessor at the end of the
lease term,
3) The lease is noncancellable and the lessee has a legal obligation to
continue payments to the end of the term, and
The lessee agrees to maintain the equipment.
The Operating Lease, or "maintenance lease," can usually
be canceled under conditions spelled out in the lease agreement.
Maintenance of the asset is usually the responsibility of the owner (lessor).
Computer equipment is often leased under this kind of lease.
The Sale and Leaseback is similar to the
financial lease. The owner of an asset sells it to another party and
simultaneously leases it back to use it for a specified term. This
arrangement lets you free the money tied up in an asset for use
elsewhere. You'll find that buildings are often leased this way.
You may also hear leases described as net leases or gross leases. Under
a net lease the lessee is responsible for expenses such as those for
maintenance, taxes, and insurance. The lessor pays these expenses under
a gross lease. Financial leases are usually net leases.
Finally, you might run across the term Full Payout
Lease. Under a full payout lease the lessor recovers the
original cost of the asset during the term of the lease.
KINDS OF LESSORS
As the use of leasing has increased as a method for businesses to
acquire equipment and other assets, the number of companies in the
leasing business has increased dramatically. Leasing is now a billion
dollar industry.
Commercial banks, insurance companies and finance companies do most of
the leasing. Many of these organizations have formed subsidiaries
primarily concerned with equipment leasing. These subsidiaries are
usually capable of making lease arrangements for almost anything.
In addition to financial organizations, there are companies which
specialize in leasing. Some are engaged in general leasing, while others
specialize in particular equipment, such as trucks or computers, for
example.
Equipment manufacturers are also occasionally in the leasing business.
Of course, they usually lease only the equipment they manufacture.
ADVANTAGES OF LEASING
The obvious advantage to leasing is acquiring the use of an asset
without making a large initial cash outlay. Compared to a loan
arrangement to purchase the same equipment, a lease usually:
_ Requires no down payment, while a loan often requires 25 percent down;
_ Requires no restriction on a company's financial operations, while
loans often do;
_ Spreads payments over a longer period (which means they'll be lower)
than loans permit; and
_ Provides protection against the risk of equipment obsolescence since
the lessee can get rid of the equipment at the end of the lease.
There may also be tax benefits in leasing. Lease payments are deductible
as operating expenses if the arrangement is a true lease (and the
Internal Revenue Service agrees it is). Ownership, however, usually has
greater tax advantages through the investment tax credit and
depreciation. Naturally, you need to have enough income and resulting
tax liability to take advantage of those two benefits.
The investment tax credit may work to the benefit of the lessee as well
as the lessor. The credit is a dollar for dollar reduction in federal
income taxes, equal to 10 percent of the cost of the equipment in the
year the equipment is put into use. While the lessor usually takes the
tax credit, it may pass part of the benefit on to the lessee in the form
of a reduced lease payment.
Leasing has the further advantage that the leasing firm has acquired
considerable knowledge about the kinds of equipment it leases. Thus, it
can provide expert technical advice based on experience with the leased
equipment.
Finally, there is one further advantage of leasing that you probably
hope won't ever be of use to you. In the event of bankruptcy, claims of
the lessor to the assets of a firm are more restricted than those of
general creditors.
DISADVANTAGES OF LEASING
In the first place, leasing may cost more because you lose certain tax
advantages that go with ownership of an asset. Leasing may not, however,
cost more if you couldn't take advantage of those benefits because you
don't have enough tax liability for them to come into play.
Purchase vs.
Lease Analysis
Obviously, you also lose the economic value of the asset at the end of
the lease term, since you don't own the asset. Lessees have been known
to grossly underestimate the salvage value of an asset. If they had
known this value from the outset, they might have decided to buy instead
of lease.
Further, you must never forget that a lease is a long term legal
obligation. Usually you can't cancel a lease agreement. So, if you were
to end an operation that used leased equipment, you might find you'd
still have to pay as much as if you had used the equipment for the full
term of the lease.
FEDERAL TAX TREATMENT OF LEASES
Full lease payments are deductible as operating costs. You can make
these deductions only if the Internal Revenue service finds that you
have a true lease. You can't take a full deduction for a "lease" that's
really an installment purchase.
Although each lease arrangement may be different, there are some general
guidelines to meet:
In no way should any portion of the payment be construed as interest.
Lease payments must not be large compared to those that would be
required to achieve ownership.
Any renewal option at lease end must be on terms equivalent to what a
third party would offer.
Purchase options must be at amounts comparable with fair market value.
ACCOUNTING TREATMENT OF LEASES
Historically, financial leases were "off the balance sheet" financing.
That is, lease obligations often were not recorded directly on the
balance sheet, but listed in footnotes, instead. Not explicitly
accounting for leases frequently resulted in a failure to state
operational assets and liabilities fairly.
In 1977 the Financial Accounting Standards Board (FASB), the rule-making
body of the accounting profession, required that capital leases be
recorded on the balance sheet as both an asset and a liability. This was
in recognition of the long-term nature of a lease obligation.
LOOK BEFORE YOU LEASE
A lease agreement is a legal document. It carries long term obligations.
You must be thoroughly informed of just what you're committing yourself
to. Be reasonably sure that the equipment is what you need and the term
is what you want.
The lease document will spell out the precise provisions of the
agreement. Agreements may differ, but the major items will include:
The specific nature of the financing agreement
Payment amount
Term of agreement
Disposition of the asset at the end of the term
Schedule of the value of the equipment for insurance and settlement
purposes in case of damage or destruction
Who is responsible for maintenance and taxes
Renewal options
Cancellation penalties, and
Special provisions.
And finally, but perhaps most importantly, make sure that you analyze
the cost of a
Purchase vs. Lease
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