Loans vs. Leases: What’s it all about?

One of the most frequent questions I get asked is “Shall I lease or buy?” Most likely the lease vs. buy choice for a business would arise when considering the acquisition of a company automobile or delivery truck, but it could be any expensive piece of equipment. This decision is usually predicated by the desire to obtain the highest deduction or tax savings. The first step in answering the “lease or buy” question is to clarify the difference between these two purchasing options.

Buy

When you buy an item you either pay cash for it all at once, or, you sign an agreement, called a promissory note, to pay for it over time. When you buy and make installment payments, you are considered to have entered into a “contract of sale”. From an accounting and tax standpoint, you have purchased an asset and incurred a liability. The asset cost is deducted over a period of time through an expense category called depreciation. Usually, a down payment of a certain amount is required to consummate the purchase. Note how this transaction is set up on the books using the following journal entry:

When payments are made on the note there are two components to consider, i.e., principal and interest. Principal is the original amount borrowed and interest is the cost of borrowing the money. Since interest is a cost, it is a deductible expense and has its own category. For instance:

Do you see that in a “contract of sale” the expense deduction comes from two sources, depreciation and interest?

Lease

A lease is an agreement under which the owner of property permits someone else to use it for a fee. The owner is the lessor and the user is the lessee. There are two types of leases from the standpoint of the lessee: a “dirty” lease and a “true” lease. The “dirty” lease is called a “capital lease” or a “lease obligation” in accounting circles, and, a “true” lease is called an “operating lease”.

A capital lease is one in which the rights and risks of ownership of the property will be transferred to the lessee. Therefore, the lessee must evaluate the provisions of a lease in order to determine if the lease should be classified as a capital lease or an operating lease.

How does the lessee do this? This is the tough part. There are four criteria to use and, if any one of them fit, the lease should be treated as a capital lease:

The lease transfers ownership of the property to the lessee by the end of the lease term.The lease contains a bargain purchase option (like a $1.00 buyout).The lease term is equal to 75% or more of the estimated economic life of the leased property.The present value of the minimum lease payments, at the beginning of the lease term, is at least equal to 90% of the fair value of the leased property.

I recognize that at this point I may have left many of you scratching your heads. But, don’t give up just yet. Look, most of the lease contracts you are going to enter into contain the first two criteria. If the lease contracts do, don’t worry about the last two criteria. If they don’t and the lease doesn’t appear to have the characteristics of an operating lease (see below), then you should check with your accountant to make sure you are giving the lease proper accounting treatment.

In the United States, the Internal Revenue Service (IRS) and the Financial Accounting Standards Board (FASB) feel that a capital lease type of contract is so similar to a “contract of sale” that it should be given the same accounting and tax treatment as a normal purchase.

The cost of leasing is built into the lease payment but is not stated separately (like interest on a note). However, the IRS considers it to be the same. Therefore, a Capital Lease is set up the same as a Notes Payable.

Note here that the cash down payment is less than the contract of sale above. This is one advantage of buying through a lease. Normally, the down payment includes only the first and last payment of the lease ($550 + $550 = $1,100).

Depreciation occurs just as in a contract of sale.

Often you will find that the leasing company does not give you the actual cost of the asset you are buying. What they will do is give you the total cost of the lease. For instance, if your lease payments are $550 per month for twenty months then the total lease contract will be stated as $11,000. You must remember to find out the actual value of the asset ($10,000) in order to record it accurately on your balance sheet and depreciation schedule.

The rule is that the cost of the asset can never exceed its fair market value. There may be other costs called “executory costs” included in the lease payments. These are items such as insurance, maintenance, and property tax. These items can be expensed in each payment as they are incurred.

The $550 lease payment is split up in the same manner as the principal and interest payment of the notes payable except that you may have to include the executory costs.

The only difference between a Capital Lease and a Contract of Sale purchase is that the down payment on the lease may be less. The deductible expense is the same.

An operating lease (or “true lease”) is one in which the lessor retains the rights and risks of ownership. The lessee is simply obtaining the right to use the property for the term of the lease and no more. If the four criteria above are not met then the lessee should treat the lease as an operating lease.

If, at the end of the term of an operating lease, you decide to keep the property, then, technically you should be required to pay the fair market value of the item at that time. However, many lessors offer the leased property at 10% of its original fair market value. This practice of using a 10% buyout at the end of the lease term does not constitute a “bargain purchase option”. In addition, the bookkeeping is simpler, because the full cost of the lease payments is treated as a rent expense each month. There is no asset recorded on the books, no Capital Lease Payable or Interest Expense. Here is how the journal entry looks each month:

Unless you can write off the equipment all in one year using the IRS 179 Election, you can probably expense this property faster than a “contract of sale” which uses depreciation and interest. In twelve months, using my example, you could deduct $6,600 ($550 x 12 mo = $6,600) assuming you bought the property on January 1.

What about automobile leasing vs. buying? This is a whole different ball game. The politicians have tinkered with the auto deduction over the years and made it very complicated. However, the bottom line in the U.S. is: There are statutory limitations as to how much you can depreciate an automobile in one year, depending on the cost of the auto and when you bought it. If you lease an auto, there may be an advantage; however, it depends on the lease terms. You can write off the payments (modified by the business use percentage) each month, which could very well exceed the allowable depreciation amounts.

In an effort to find parity between the lease payments and the allowable depreciation amounts, the IRS constructed Lease Inclusion Tables. The idea is to modify the amount of the deductible lease payments by the amount found in the Lease Inclusion Tables. However, the amount you have to include from these tables is astoundingly small. Understandably, no one is complaining about the higher write off.

Calculation

Now that you have a sense for the accounting theory of leases and loans, your next step will be to calculate the numbers associated with the equipment in mind. The Internet has many Lease or Buy calculators. For instance, http://www.lease-vs-buy.com will take you through the process step-by-step and provide explanations and definitions for unfamiliar terms. If you don’t like this one, just put “lease or buy calculator” in Google and pick one you do like. Once you are finished, it’s probably a good idea to check your results with an accounting professional.