Leasing, buying and financing machinery

When deciding to purchase sheet metal machinery, you must investigate the methods and costs of financing. This is a crucial step. Depending upon the type of rates you receive, it can make or break your decision.

Checking financing rates with your bank is a good first step. Many banks will negotiate attractive rates to keep your business. It can also save you time and hassle from applying for financing with other institutions.

A second approach is to check with the makers of the equipment you are considering. Often manufacturers will offer attractive financing or leasing packages as part of the sale. Many times, the manufacturer will finance the transaction or they will work with a leasing company to provide a package. Either way, one of the first questions you will be asked is if the sale will be financed, known as a "capital" lease, or leased, called an "operating" lease.

To answer this question, you must understand the benefits and the related costs of each method. Lease terms and provisions can vary widely. Those provisions affect a lease's accounting and tax treatment, so it's wise to learn a few rules before you commit to a major lease transaction.

A coil-to-coil slitting line at Basic Metals in Germantown, Wis. Image courtesy of Red Bud Industries.

Capital lease

With a capital lease, which is like an installment purchase, you take on the incidents of ownership for tax-reporting purposes. A capital lease must meet at least one of four criteria:

1. You take ownership of the leased property by the time the lease terminates.

2. The lease contains a bargain-purchase option. This provision allows a purchase for a price that is significantly lower than the machine's expected fair-market value so your exercising of that option is reasonably assured. For example, an option to purchase the property for $1 at the end of a lease would qualify.

3. The lease term is equal to 75 percent or more of the estimated economic life of the leased property.

4. The present value of the lease payments is equal to or more than 90 percent of the fair-market value of the property.

If a lease meets none of these four criteria, it will be treated as an operating lease. As with a capital lease, for accounting purposes, the equipment is recorded as an asset and then depreciated, usually over a term of seven years. The lease obligation is recorded on the balance sheet as a liability. As the lease payment is made, the principal part of the payment reduces the liability. The interest portion of the payment is shown as an expense on the income statement.

With the first-year bonus depreciation allowance being increased to 50 percent for property acquired after May 5, 2003, and before January 1, 2005, a capital lease is a very attractive option if you are trying to maximize deductions.

A multiblanking coil line at Alliance Steel Corp. in Laval, Quebec. Image courtesy of Red Bud Industries.

Operating lease

An operating lease is simply a rental agreement. The benefits and risks of ownership stay with the company you're leasing the machinery from and not you or your company. At the end of the lease, the leasing company retains ownership of the equipment, but can offer it for sale at the fair-market value. However, you must be careful to examine all the details of this particular type of lease.

An operating lease must have all of the following characteristics:

1. The lease term is less than 75 percent of estimated economic life of the equipment.

2. The present value of lease payments is less than 90 percent of the equipment's fair-market value.

3. The lease cannot contain a bargain-purchase option (less than the fair-market value).

4. The leasing company retains ownership during and after the lease term.

When accounting for an operating lease, rental payments are recorded as operating expenses as they are made. No asset or liability entries are recorded on the balance sheet, which improves some of the key accounting ratios, such as return on capital. This is a reason many companies find operating leases very attractive.

Some other major benefits of an operating lease are:

· It can be terminated before the end of the lease term. If your business changes or if the equipment does not meet specifications, you may be able to walk away with limited liability exposure, except for some minor costs of removal and shipping, as stipulated in the agreement.

· Risk of obsolescence is assumed by the lease holder. With ever-changing technology, a lot of sheet metal equipment makers have made major advancements over the years. An operating lease may allow you to trade up to a newer piece of equipment.

For example, at the end of a 10-year lease, at the end of the lease term, you could remove the leased equipment and install a more advanced piece without any further liability except for some minor costs stated in the agreement. Operating leases may offer a practical way of staying ahead of your competition with the latest technology.

· Your cash investment is kept to a minimum. Since no large deposit or capital expenditure is required, except for a possible small security deposit, an operating lease preserves working capital reserves.

At the end of the lease, many lease contracts allow you to:

1. Continue to rent on a month-to-month basis

2. Upgrade to new equipment

3. Renew the lease at a lower rate

4. Offer to purchase equipment at fair-market value. In some cases, the manufacturer may be able to forecast what the fair-market value will be at the end of the lease term. This value is usually indicated as a percentage of the original equipment cost. In the lease agreement, the purchase price can be stated as "equal to fair-market value, not to exceed __ percent of the original equipment cost." This means you know the maximum purchase price in advance.

5. Return equipment to the supplier

Maintenance and insurance costs will most likely be paid by you. In some cases, the lease holder may provide a maintenance contract on the equipment to keep it in working order. This may be negotiated.

Leasing can be a cost-effective way to acquire assets, but only if it is done correctly. Some lease provisions can result in exceptions or variations to the accounting treatments described above. It is wise to review the overall economic benefits and the accounting and tax treatment of the lease with your tax advisor.

A 6-foot coil line at Reliance Steel in Los Angeles. Image courtesy of Red Bud Industries.
(This article was reprinted from January 2004 issue of The Cutting Edge, a newsletter published by Red Bud Industries, an Illinois-based manufacturer of steel-processing equipment.)