When considering the demand for equipment and tools to operate your business, an important question to consider is how to finance the purchase. Two common options are a capital lease agreement or financing your purchase with a conventional debt agreement. Both options have benefits depending on the needs of your business. The first step is to understand the differences between the two.
A capital lease is an agreement in which certain rights and risk of loss of the equipment are transferred to the lessee in exchange for scheduled payments. The lessee accounts for the transaction as a purchase and consequently recognizes both an asset and a liability on the balance sheet. Ownership of the asset is typically retained with the lessor.
To be accounted for as a capital lease one of the following must be present:
a) The lessor transfers ownership to the lessee at the end of the lease term
b) The lease contains an option to purchase the asset at a bargain price
c) The lease term is equal to 75% or more of the estimated useful life of the asset
d) The present value of the minimum lease payment is equal to 90% or more of the fair value of the asset.
A financing agreement is established when the transaction is made through a debt agreement that is collateralized by the purchased asset. Similar to a capital lease, this transaction is reported as assuming a liability and purchase of an asset. The title and risk of loss related to the asset pass to the purchaser at the time of the transaction. The terms of the transaction, equipment purchase price, interest rate and loan amortization are clearly stated in the agreement.
One of the considerations in comparing a capital lease and financing through a debt agreement is the overall cost. Capital leases are often for shorter terms than debt agreements and generally do not require a down payment. The lessor retains certain risks with ownership of the assets which require a greater return for the lessor and expense for the lessee. In addition, some leases can have additional costs in the payments associated with taxes or maintenance. When the value of the purchased asset is amortized against the monthly payments and compared to a debt agreement, the financing cost of a capital lease is often higher.
Another consideration is flexibility. Capital leases often provide for more flexibility related to the assets. The lease terms are often shorter, and the lessor retains ownership. The lessee will have more options, such as upgrading the equipment at the end of the lease term. With a conventional debt purchase, if an upgrade is needed, the property would need to be sold and debt retired.
The tax treatment of the two options is essentially the same. In both cases there is an asset that can be depreciated, often accelerated by section 179 deductions, and a liability with an interest component that can be deducted. The advantage of debt is that the value of the asset and terms of the arrangement are more evident. With a capital lease, there is often a list of assets under lease and payment terms but no clear purchase price for the asset or interest rate. The lessee often will be required to determine the fair market value of the purchased assets and amortize the related payments using the determined equipment value.
A third option is a straight operating lease. While these agreements provide the most flexibility and least amount of risk, they are also typically the most expensive. Accounting for an operating lease does not require recognizing an asset and liability on the balance sheet, only rent expense on the income statement. If EBITDA is a metric considered important to your business, an operating lease can have a detrimental effect on the calculation. Capital leases have a depreciation and interest component; however, operating leases contain only rent expense. Another advantage to an operating lease is that they are often allowed under loan covenants, where capital leases and other debt may be considered a violation.
Exploring these options are important considerations in equipment financing, and the decisions should be made specific to your business requirements. Before signing, any lease agreement should be thoroughly reviewed to determine whether it is considered a capital lease or operating lease and whether the terms meet your unique business requirements.