By: Bryan Porter
In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-02: the new lease accounting standard. By now, many private companies have considered the impact the new standard will have on financial reporting beginning in calendar year 2020. Those who have familiarized themselves with the changes realize the largest impact relates to recording operating leases on the balance sheet. Previously, an operating lease provided companies with the ability to obtain property or equipment without influencing the company’s balance sheet, debt covenants or other financial ratios. Given this option is no longer available, with the exception of short-term leases defined as 12 months or less, companies should revisit their business strategy on when to lease equipment and when to purchase equipment.
Factors important to Manufacturers in the Lease vs. Buy Decision
- Purpose of Capital Investment. Manufacturers must define the need for a specific piece of equipment. Questions to consider include:
- Does the company have short-term production needs?
- Is the equipment to be used in an ancillary division or new venture of the company?
- Is the investment more closely aligned with core manufacturing?
Lease arrangements may offer a better solution for temporary operating needs or new and exciting capabilities that could evolve as the company learns more about the competitive landscape. The flexibility of a lease arrangement would allow the business to be more nimble and competitive.
- Cash Considerations. The company’s current cash position combined with future cash flow projections may also play a significant role in determining the best option. Items to consider include:
- Purchasing an asset. This option will likely require fewer dollars over the long haul, however, it will require up-front cash or a significant down payment.
- Will approval for obtaining equipment hinge on the cash flow generated by the equipment?
Companies should consider whether it is prudent to deplete cash reserves to invest in new equipment. Those with healthier balance sheets are afforded the option of determining whether the upfront payment is worth the lower overall cost and diminished flexibility.
- Technology. We are all well aware of the impact that technology has on our daily lives. For manufacturing companies, the impact largely depends on your industry sector. Items to consider include:
- Is your particular industry sector experiencing rapid changes in technology to manufacture core products?
- Are technological advances providing those who invest in the new technology a competitive advantage? If so, estimate the financial impact that advantage would have on the bottom line.
- What could you sell high tech equipment for in three to five years?
Purchasing equipment in industry sectors where well-maintained equipment can foreseeably provide years of productive returns makes financial sense. Rapidly changing industry sectors or industry sectors that are considered to be in their infancy stages may be better suited to hedge against purchasing equipment that could be rendered obsolete in just a few years’ time. Equipment in developing industry sectors will likely be much more expensive until the competitive marketplace can catch up. Remember – the cost of the first mobile phone was nearly $4,000.
- Tax considerations. The new tax law (Tax Cuts and Jobs Act) passed in December of 2017 should be a topic of consideration for every major strategic corporate decision. Equipment procurement is no different. Although the new tax law is complex and requires a holistic view of the company, here are a few items that may affect the decision to lease or buy equipment.
- The new tax law allows for 100% expensing for purchased equipment and expands bonus depreciation to “new to you” assets. That’s right, used equipment now qualifies for 100% expensing.
- Like-kind exchanges previously allowed companies to defer gain on the sales of equipment, if new equipment with substantially the same capabilities was purchased within a specific time-frame. The new tax law removes this option.
- State and Local tax jurisdictions apportion a company’s taxable income in several ways. Changes to the new lease standard require a closer look at state apportionment rules for states in which you could have nexus, and thus may owe tax.
Companies may realize greater short-term tax treatment by purchasing new or used equipment. Although the like-kind rules reduce the benefit of owned equipment sold at a gain, the 100% expensing of replacement equipment largely offsets the negative impact. All tax strategies require a broad view of the company and its operating activities – Don’t forget to include your capital investment strategy.
The new lease standard will bring significant, but predictable changes to financial reporting. Manufacturers should take advantage of the spotlight placed on lease arrangements to determine if they have the best strategic equipment procurement approach from a financial reporting, tax, and most importantly business perspective.
BRYAN C. PORTER, CPA, MS, is a director in the Audit, Accounting and Consulting Department, where he advises privately-held businesses in various industries, including manufacturing, wholesale distribution, construction, technology and not-for-profit. Bryan is also a member of the firm’s Audit and Accounting Technical Standards Committee, which oversees programs designed to educate the firm and its clients on current accounting and business topics. He can be reached at: firstname.lastname@example.org.