The general purpose of this clause is related to the residual value I mentioned last post. When a lease agreement is made, the Lessor (that’s us) has an expectation that the equipment will have a certain value at the end of the lease. The Lessee (you) are generally paying for the usable life of the equipment during the time you have it. 

In order to arrive at the predicted residual value, the equipment must be both used in the manner it was intended, and also be maintained in accordance with the manufacturer’s specifications. 

In general, the terms regarding maintenance and wear and tear will look similar to the following (note: these are simply big-picture examples, and not legal statements):

The Lessee will: 

• Keep the equipment in good condition and make non-warranty repairs at its own expense (depending on the equipment, there may be a further provision stating that repairs need to be performed by an authorized/licensed entity.) 
• Keep the equipment properly maintained and serviced as per the manufacturer’s specifications/recommendations (again, perhaps by an authorized service entity. Oh, and keep records too.) 
• Ensure the equipment is used properly, and only by competent, trained employees.
• If applicable, keep/store the equipment at the agreed-upon location.
• Not change or add to the Equipment unless agreed upon.
• At lease end, return the equipment in good condition and working order, with ordinary wear and tear resulting from proper use.
• Make the Lessor aware of any accidents, damage, or similar. 

In most lease agreements, assuming proper and intended use, the residual value is typically spot on. But if it is not at the predicted amount due to abnormal use – if there’s damage, excessive wear, or similar – the Lessee will certainly find themselves responsible for making up the difference between the actual value of the equipment and the residual value. 

*Note that there can be a gray area between what’s considered normal wear vs. excessive wear. The Lessor is the one who determines this, typically by referencing industry guides and manufacturer’s specifications.

It is always best to look at a lease agreement and leased equipment like you would if you were borrowing a tool from a friend, or better still, a beloved family member. You want to give it back in the expected condition, and while it’s with you, care for it as if it were your own. 

The first point I want to make is the one overriding factor that any business needs to determine is their goals for a lease first, then they should choose a lease that best meets their needs.

There are really two “main-yet-different” goals for any lease: either you are leasing equipment to take advantage of the benefits of “ownership” (like Section 179), or you are leasing to “not own” the equipment, thus keeping the equipment off the balance sheet as an asset and instead listing the lease payments as an expense. 

First let’s take a look at how Tax Accounting (e.g., the IRS) views leasing. They will look at any lease one of two ways: a True Tax Lease (also called a True Lease), and a Non-Tax Lease. A True Lease means the lessee (the company using the equipment) is NOT the owner of the equipment. In a Non-Tax Lease, the lessee is considered the owner. 

So if you want to not own the equipment and keep it off the balance sheet as an asset and instead expense the lease payments, choose a True Lease. If you want to be considered the owner and take a Section 179 deduction, choose a Non-Tax Lease.

Now since this post is about leasing and taxes, I ought to stop right there, because that’s all you really need to know. But I’m a little OCD and want to finish, so let’s take a look at how Book Accounting views leasing.

Book Accounting leases are classified as either an Operating Lease or a Capital Lease. In an Operating Lease, the equipment is viewed as a rental – it’s neither an asset or a liability on the balance sheet. A Capital Lease is generally viewed as ownership.

These all seem similar, right? But “book accounting” and “tax accounting” don’t always see eye to eye on lease types. For example, a True Lease doesn’t always qualify as an Operating Lease, but an Operating Lease always qualifies as a True Lease.

I won’t go any further than that, because it’ll get into things that we all need to discuss with our CPA’s, not an equipment finance guru’s blog! And this is why I said earlier “pick your goal first, then pick a lease”, and we’ll get more into that next time. 

[As always, this is not intended to be tax advice – always consult your tax adviser for details specific to your situation.]

The two accounting methods are: 

Book Accounting (which could simply be called “accounting”) utilizes Generally Accepted Accounting Principles (GAAP), whose rules are set by the Financial Accounting Standards Board (FASB). 

Tax Accounting relies on the Internal Revenue Code (IRC), and, as you may have guessed, is used  by the Internal Revenue Service (IRS).

So what’s the difference between book accounting and tax accounting? 

Book Accounting provides business owners and other interested parties (such as lenders) with accurate and detailed financial data, giving them a clear picture as to how the business is actually doing.  

Tax Accounting provides the IRS and other taxing authorities (such as States and municipalities) with taxable income and deductible expenses, which of course determines how much tax the business owes.

To be honest, the differences between the two are fairly small. But one key difference has a LOT to do with equipment and equipment financing (and leasing, which is what prompted this series in the first place). 

This difference is in how equipment and assets are viewed and depreciated.    

Under Book Accounting, the cost of any Equipment is depreciated/expensed over a period of time matching the Equipment’s useful life. This ‘Straight-Line’ method is the most common method used to calculate depreciation expense under GAAP. 

So basically, you buy equipment, and depreciate it a little each year depending on how long the equipment is supposed to reasonably last. 

Under Tax Accounting, the cost of Equipment is depreciated/expensed much quicker, which minimizes the immediate tax liability. Tax Accounting uses what’s called the Modified Accelerated Cost Recovery System (MACRS) method, which allows larger amounts expensed in the initial years.

In recent years, Section 179 and bonus depreciation are subtracted before computing MACRS deductions, allowing businesses to fully write-off the cost of equipment in the year it is obtained. Currently, the bonus depreciation is 100% thanks to 2017’s Tax Cut and Jobs Act, with no upper limit, so almost all equipment will fall under this. 

Real Quick: WHY?

People have asked “why are there two accounting methods”? The answer can be very intricate, but it can also be simple. Imagine you wanted to loan a business money. You want to make sure they are stable, with solid income. 

The following is general, but illustrate why both exist:

If you look at the business through a tax accounting lens, the business may seem to have low income, because of all the short-term high depreciation to save on taxes. Based on only that, you may not loan them money. 

But a look at them through book accounting shows the company’s true worth… you may have a fine loan candidate there. 

The finance guy in me knows it’s useful to understand the fundamental differences between the two accounting methods, which I hope I’ve accomplished for you in this post. 

Even though I’m quite schooled on the advantages of leasing equipment and I’ve spoken about it in this blog previously, I never really expressed just how flexible it is, and how it could help companies of any size, no matter their goals.

I also never really got into the accounting principles of leasing, and how the different types of accounting look at leasing. This is actually an important part of the leasing equation, and we should discuss it.

So let’s start a new series on leasing. In the weeks that follow, we’ll discuss:

• The Two Different Accounting Principles – Book Accounting and Tax Accounting.

• How the Two Accounting Principles View Leasing.

• The Advantages of Leasing – Taxes and Balance Sheets.

• Types of Leases and How They Help Companies.

We’ll dive deeper into these topics, but for now, I’m going to give a very big-picture overview: There are generally two main ways a lease can be viewed in an accounting sense – depending on the type of lease, either the leased equipment is seen as “owned” by the company in a tax and balance sheet sense, or it isn’t. 

There are advantages to both ways, depending on a company’s size and goals. Some companies (usually smaller businesses) want the tax advantages of ownership, including claiming a Section 179 deduction. So they will choose a lease structure that offers that.

A larger company may prefer to keep the leased equipment off the balance sheet, and have it viewed almost akin to a “rental”. They cannot claim a tax deduction or depreciation of course, but they can also treat the equipment as an expense, which has its own set of advantages (for example, expenses may not need board approval, where capital expenditures may). 

The bottom line is, leasing is incredibly versatile for businesses, and can be an excellent tool in aiding a company’s growth. Stay tuned for more on this interesting topic. 

Today I’ll talk about a trend that plays out month after month, quarter after quarter, year after year. And it’s the fact that we always experience a surge of equipment financing / equipment leasing requests at the “end” of certain time periods.

It happens at the end of every month; it happens at the end of every quarter; and it really happens at the end of every year. And they all want to close the transaction by the end of whatever period we’re in (e.g., “I need to close this by tomorrow”).

Over the last year, I made it a point to talk about this with the people doing the financing (more or less for my own curiosity.) But the range of answers I got was interesting.

One of the biggest reasons was budgetary. Many companies (especially larger entities) have budgets that, depending on the company, may be broken up into months / quarters / years. And it’s a “use it or lose it” scenario.

Another driving factor is profits – particularly quarterly profits. Let’s say a company is already having a bad quarter. They decide at the end of the quarter to lease new equipment. This does two things – it puts the transaction on the “bad side” of the break between quarters, but it puts the new (profit enhancing) equipment into the new quarter. In one fell swoop, next quarter is looking better already.

Lastly, I found out equipment salespeople are a driving force in this too. They often have monthly quotas, and don’t realize until the end they are going to fall short. So they get to it and start really selling. Or maybe their company is having a sales contest (a trip to Hawaii), and Joe realizes he can win if he just closes two more deals by tomorrow. Thus, Joe hits the bricks, makes a few calls, and gets three new sales (one more just for good measure.)

And the recipient of all this “end of month / quarter / year” business? Me. They all call me. But despite my great month-end numbers, nobody is offering me a trip to Hawaii (hey, wait a minute!)

Oh, I haven’t even mentioned how this plays out with Section 179. But you know that’ll be coming…