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Leasing vs. buying machinery

Lance Fenton for Progressive Dairyman Published on 28 September 2018

The current operating environment for the dairy industry could be classified as “challenging.” Every day, dairy owners are asked to produce more with fewer resources. Labor shortages, stagnant milk prices, increasing operating costs and the current political environment create several issues dairy operators must be educated about and be able to address.

Technology has the potential to improve operational efficiency, solve labor shortage issues and lead to greater profitability. The cost to put this technology in place is a large investment for any dairy operation.

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Once the decision is made to implement this technology, the economics of leasing versus buying are not always as clear as they should be. Following are some tips to assist with the decision of whether to buy or lease your next piece of equipment.

New accounting rules for leases

In the past, leasing equipment allowed companies to keep debt obligations off their balance sheet. This approach would assist with loan covenants and potentially increase borrowing capacity. Beginning in December 2019, ASC 842 requires all operating leases be included on an entity’s balance sheet.

Furthermore, this new standard requires lessees and lessors to include additional financial statement disclosures. While this should not be the main criteria when considering whether to buy or lease, it is imperative an organization consider their debt-to-equity ratio before entering into a lease to ensure doing so will not violate loan covenants.

Conditional sales contract

It is not uncommon to see leases that do not conform with IRS guidelines. Nonconforming leases are at risk of being classified as a conditional sales contract, which can negate some benefits of the lease. To ensure your lease is not at risk of being reclassified, please ensure it does not contain any of the following:

  1. Allows equity to be built in the asset
  2. Has an equal payment as the buyout
  3. Has a stated interest rate

Advantages and disadvantages of each option

Advantages of leasing equipment

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  • Less initial expense – Down payments are generally not required, allowing you to purchase equipment with minimal up-front costs.

  • Payments are tax-deductible – Lease payments are business expenses on your tax return, reducing the overall net cost of the lease.

  • Easier to upgrade equipment – There is generally no requirement to purchase the asset at the end of the lease. If the equipment may become obsolete, this will allow you to upgrade equipment easily.

  • Terms tend to be more flexible – Leases are generally easier to obtain and may have more flexible terms.

Disadvantages of leasing equipment

  • Higher overall cost – Leasing an asset is generally more expensive than purchasing it.

  • Terms may not be clearly laid out – Most leases do not state what the implied interest rate is.

  • You do not own the asset.

  • Obligated for the entire lease term – Even if you stop using the equipment, you are still obligated for the entire lease term. If you are able to terminate the lease, there is normally an early termination fee that must be paid.

Advantages of purchasing equipment

  • Ownership of the asset – Allows you to build equity in the asset and sell it, if necessary.

  • Depreciation deduction and ability to control timing – The cost of acquiring equipment is depreciated over its life, reducing your tax liability. Under Section 179 of the Internal Revenue Code, there are options to expense equipment purchases in the year of purchase. This may provide additional tax planning benefits.

Disadvantages of purchasing equipment

  •  Higher initial investment, generally in the form of a down payment

  • You own assets that can become obsolete

Consider your cash flow

Apart from the considerations above, the decision whether to lease or buy should be based on a cash-flow analysis. In order to determine the most advantageous option, owners must determine the after-tax cash-flow requirements for each option.

Once the cash-flow requirements are calculated, they will need to be converted to a present value. The option with the lowest present value will be the most advantageous.

The calculation of after-tax cash flows related to a lease are relatively simple. The cash flows consist of the periodic fixed payments and any maintenance costs you may be responsible for. If there is an option to purchase the asset at the end of the contract, this should also be included.

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The calculation of after-tax cash flows related to purchasing an asset consist of a few items:

  1. Purchasing the asset – If the company purchases the asset outright, the calculation is very simple. If financing is used, the associated interest must be included.

  2. Maintenance costs – Lease agreements typically obligate the lessor to cover all maintenance costs for the equipment.

  3. Tax savings – Depreciation, interest and maintenance costs are tax-deductible. The tax savings must be included in the analysis.

Once these costs have been calculated, they should be grouped by year, and the appropriate present value factor should be applied to each year’s cash flows. Each of the year’s cash-flow estimates should be added together for a total cost. The lower-cost option will be the most advantageous from a cash-flow perspective.

Determining the effect on cash flow can be complex. Consulting a tax adviser is a good way to determine whether an operation has the cash flow to buy versus lease. If cash flow is determined to be fairly tight, leasing may be the better way to go, as it avoids costly repairs and some maintenance.

Conclusion

Generally, the decision to lease or buy equipment is a situation-specific decision which should not be primarily motivated by tax considerations. This decision should be based on the financial position and growth outlook of the organization as well as intangible factors such as your attitude toward equipment repair costs, downtime management, building equity and overall equipment expense parameters, and fit within a broader strategy for your organization.

Please consider meeting with your tax adviser to discuss the implications of leasing versus buying specific to your situation and to establish a strategy you can work within for many years. Doing so will likely avoid any unwanted or unintended consequences.  end mark

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