When you require a new asset for your business, it is a good idea to consider whether you should lease or buy prior to the purchase. The asset could be motor vehicles, machinery, IT equipment or other items required for your business. There are cash flow, accounting and tax differences to the options.
A finance lease means that the lessee has the risks and rewards of ownership, with an operating lease the lessor retains the risks and rewards. For example, if the asset depreciates in value the lessee with a finance lease suffers, however, the operating lessee does not.
Cash Flow Considerations
If your business isn’t cash rich, either a finance lease or an operating lease may be an attractive option. I recommend comparing all available options when making the decision. Utilising a return on investment calculation, net present value and/or comparing costs of finance are all useful to the decision making process.
Cash flow Comparison Tips
- If you are cash rich, buying outright may be the right decision, compare your savings rate to cost of finance whether from borrowing money via a bank or through a finance lease company. However, also consider whether your business is going to require the cash for operating costs or possible business investments.
- Compare the financing costs for the different lease options versus how much it would cost for you to borrow from the bank. Interest rates can vary greatly, so it is always best to shop around before committing.
- Compare the taxation impact comparisons to cash flow. I will go into more detail regarding taxation differences shortly.
Accounting Considerations
If you own the asset, whether via a cash purchase or a finance lease, the asset should be reflected on your balance sheet. An asset for accounting purposes is typically over £250 and has a useful life of over 2 years. If purchasing via a finance lease, the outstanding lease value should also be shown on your balance sheet. If you are utilising the assets via an operating lease, this will be treated the same as a normal rental, and not shown as an asset on the balance sheet, but expensed via the profit and loss account.
Example
A £10,000 van is bought for the business, these are the different ways it may initially be shown depending on financing.
NOTE: VAT consequences are not shown below
[Option A] Cash Purchase
- Assets increase by £10,000 on the balance sheet
- Bank/cash decreases by £10,000 on the balance sheet
- The asset is then depreciated as per the business’s depreciation policy.
[Option B] Finance Lease
- Typically a deposit is required, I will assume 10% – £1,000
- Assets increase by £10,000 on the balance sheet
- Bank/cash decreases by £1,000 on the balance sheet for deposit payment
- Finance lease increases by £9,000 on the balance sheet
- The asset is then depreciated as per the business’s depreciation policy.
- The interest from the finance lease is expensed to the profit and loss account as it arises.
[Option C] Operating Lease
- The asset isn’t shown on the balance sheet.
- The cost of the lease is expensed to the profit & loss account as the costs are incurred.
Taxation Considerations
If an asset is purchased outright or via a finance lease, it will be subject to capital allowances. Capital allowances rules do sometimes change from year to year. Details can be found in the Tax Centre section of our website. However, in the tax year 2010/11 up to £100,000 is available for the 100% annual investment allowance, which decreases to £25,000 in 2011/12. Please ensure that you check current rules and whether your assets qualify before making any decisions based on tax impact.
This is a great advantage to finance leases over purchase leases, as the business may be able to claim 100% of the cost of the asset in their tax calculation before it has been fully purchased. This has been particularly popular for van purchases and environmentally friendly cars which also attract the 100% rate.
As per the above example, the finance lease would receive £10,000 capital allowances to reduce their tax bill; however, the operating lease would only be able to use the operating lease payments to reduce their tax bill.
If your business is looking to acquire assets it is a good idea to check the tax implications before year end. For example if your year end is June 2012, and you know that at some point in 2012 you would like to buy a new van, it may be worthwhile purchasing before 30th June 2012 to ensure you get the tax benefit in the year ending June 2012 if you have taxable profits.
The above is just a general guide and introduction; please do review large purchase decisions with your finance director and/or accountant to consider all options, including the VAT differences.
Tags: accounting bank interest rates borrowing money business investments cash flow accounting finance lease lease company lease options motor vehicles operating lease return on investment return on investment calculation tax taxation