Business Advisor: June 2013

When it’s time to upgrade equipment, what’s the best plan of action?

When it’s time to upgrade equipment, what’s the best plan of action?

It’s a question all businesses face when they are looking to purchase new equipment – should we lease or buy? It is important to understand that there are pros and cons to either route. There are several key factors to consider before you make your decision.

Cash flow
Put simply, cash flow refers to the amount of money coming in and going out of a business. With that as the backdrop, leasing can be considered a source of financing if you do not have cash available for the purchase. Leasing allows you to make steady fixed payments over a set period of time. If you don’t have cash available to buy new equipment, it will be necessary to obtain other forms of financing, such as bank financing. It is often easier to arrange lease financing than it is to secure bank financing, since the leasing company owns the asset while you lease it.

Interest rate
Even though it may be easier to arrange lease financing, depending on the credit rating of the company, you may be able to obtain a better borrowing rate from your bank. However, bank borrowing often comes with certain requirements, for example, financial reporting requirements and financial covenants (which may represent additional costs as a result of monitoring the company’s compliance with these covenants).

Accounting implications
For accounting purposes, there are two types of leases: operating and capital. Under an operating lease, the company would expense the lease payments (along with the interest) with no impact on the balance sheet. Under a capital lease, the company would set up the leased asset as part of its tangible assets and recognize a liability based on the overall minimum lease payments using the implicit interest rate. The leased asset is amortized over its useful life as if the company owns it, and the interest portion of the lease payments is expensed as it arises. At first glance, it doesn’t appear either method would have an impact on someone looking at the company’s financial statements; however, a common covenant that creditors look at is the current ratio, calculated by dividing current assets by current liabilities. In the case of a capital lease, the asset is recorded as a long-term asset on the balance sheet and the liability has a current component, which represents the minimum lease payments due within one year. This will negatively impact the current ratio. This will be a concern if the company has a minimum current ratio as a financial covenant in its banking agreement and is close to breaching this covenant.

Tax implications
If you own the asset, you will deduct capital cost allowance (CCA) or depreciation for tax purposes. This is the percentage of the asset cost you deduct from taxable income each year. The maximum percentage of the asset cost that is allowed to be deducted through CCA is dependent on the type or class of asset that was purchased. If bank financing is used to finance the purchase, only the portion of the payments relating to interest is tax deductible. If you lease the asset, regardless of whether it is classified as an operating lease or capital lease for accounting purposes, the lease payments (principal and interest) are tax deductible, as Canada Revenue Agency does not differentiate between operating lease or capital lease.

If you own the asset, depending on the asset class for tax purposes, the first few years (other than the first year with the half-year rule), may provide a larger tax deduction than later years, as the cost base decreases over time while the lease payments remain consistent.

Repairs and maintenance
In many cases, the lease agreement will dictate how often equipment must be maintained. Purchasing the equipment allows you to set your own maintenance schedule.

Staying current
In many cases, lease terms are set to co-ordinate with the release of new models, which can allow for timely upgrades of your machinery. However, if this is not the case and your leased equipment becomes outdated before the end of the lease, you will have to pay an early termination fee, which can be costly. If you buy the equipment, you may have to donate, sell, trade-in or scrap it.

What the bank thinks
The bank considers leased equipment a liability, so you can’t use it as collateral for future loans. On the other hand, if you purchase equipment, it can serve as collateral should your operations require financing. From the bank’s perspective, the equipment is considered an unencumbered capital expenditure.

Perhaps the biggest disadvantage of leasing is that in the long run, it costs more than buying outright because of the ongoing interest payments and the fact that you are not building equity. That said, if you have limited access to capital, it might be a better option. It also affords you more flexibility because your money is not tied up in the equipment. If your business has excess cash, buying is likely your best option because you avoid the interest expense and you have an asset that helps build the value of the business – if the equipment has a long, useful life, even better.
Bottom line: the decision has to be based on your unique set of circumstances. Be informed and choose wisely. / BJ

Bonita Lin is an audit and assurance manager at Fuller Landau LLP. Her practice focuses on technical accounting research and provides owner-managed enterprises with technical advice in the areas of tax and accounting. She can be reached at blin@fullerlandau.com or by phone at 416-645-6589.