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In: Accounting

You are planning to acquire an asset for use in your business. Should you lease or...

You are planning to acquire an asset for use in your business. Should you lease or purchase the asset? What do you feel the differences are between the two options. You may find it helpful to look outside the textbook for information on this. Try to keep it simple but try to describe some advantages and disadvantages to both options.

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Expert Solution

Lease defination:

​​​​​the accountingpolicies applicable for all types of leases except certain listed below. Alease is a transaction whereby anagreement is entered into by the lessor with the lessee for the right to use an asset by the lessee in return for a payment or series of payments for an agreed period of time.

There are two types of leases:

1. Finance Lease

2. Operating Lease

Finance Lease: A lease in which all risks and rewards are transferred to the owner of assets. The title may or may not eventually be transferred.

Examples of Finance Lease are:

1. Lease in which Assets is transferred to lessee at the end of lease term

2. Lease term in which lessee has the option to purchase the assets form lessor at the price which is lower than fair price on the date when option become exercisable

3. Lease term Covers complete economic life of the asset even if title is not transferred

4. Lease term in which present value of the minimum lease payments is equal to or substantially covers the fair value of the leased asset

5. Leased asset is of a specialized nature. Ex Ambulance (the lessee can use it without major modifications being made)

OPERATING LEASE: Any other lease other than finance lease is considered as an Operating Lease.

Advantages and disadvantages:

Advantages:

Leasing offers the following advantages:

1. Liquidity:

The lessee can use the asset to earn without investing money in the asset. He can employ his funds for working capital needs.

2. Convenience:

Leasing is the easiest method of financing fixed assets. No mortgage or hypothecation is required. Restrictions involved in long-term borrowing from financial institutions are avoided. Formalities involved in leasing are much less than in case of borrowing from financial institutions.

3. Hidden Liability:

Lease obligations are not reported as a liability in the company’s balance sheet. On the other hand, loans raised to buy assets are reported as liability. Thus, leasing helps the lessee to report a better debt-equity ratio.

4. Time Saving:

The asset is available for use immediately without loss of time in applying for the loan, wanting for approval and sanction, etc. Lease rentals can be matched with cash flows of the lessee.

5. No Risk of Obsolescence:

The risk of the asset becoming obsolete due to technological advancements is borne by the lessor.

6. Cost Saving:

Lease rentals are deductible from taxable income. The lessee has lower obligation in bankruptcy than under debt financing.

7. Flexibility:

Leasing arrangement is more flexible. The rental schedule can be adjusted to accommodate genuine needs and problems of the lessee.

Disadvantages:

1. The lessee gets only the right to use the asset. In case the leasing company is wound up the asset may be taken back from the lessee thereby disrupting his operations.

2. The lessee cannot make alterations or improvements in the asset without the prior approval of the lessor. The lessor may also put some restrictions on the lessee.

3. The lessee has to pay lease rentals on a regular basis to the lessor.

Leasing was introduced in the United States of America during 1940s and 1950s. It is estimated that leasing industry in the USA finances about 25 per cent of capital goods acquisition. The concept of leasing was pioneered in India by the SPIC group which established “First Leasing Company of India Limited” in 1973 at Chennai.

Later on 20th Century Leasing Company Limited was set up in Mumbai. Now, IFCI, IDBI, ICICI, State Bank of India, SIDCs, Sundaram Finance and other entities are running leasing companies in our country.

Purchase Definition: A purchase means to take possession of a given asset, property, item or right by paying a predetermined amount of money for the transaction to be completed successfully.

Each business is unique, however, and the decision to buy or lease business equipment must be made on a case-by-case basis. Here's a look at both options.

Leasing Equipment

Leasing business equipment and tools preserves capital and provides flexibility but may cost you more in the long run.

Advantages of Leasing Equipment

Less initial expense. The primary advantage of leasing business equipment is that it allows you to acquire assets with minimal initial expenditures. Because equipment leases rarely require a down payment, you can obtain the goods you need without significantly affecting your cash flow.

Tax deductible. Lease payments can usually be deducted as business expenses on your tax return, reducing the net cost of your lease.

Flexible terms. Leases are usually easier to obtain and have more flexible terms than loans for buying equipment. This can be a significant advantage if you have bad credit or need to negotiate a longer payment plan to lower your costs.

Easier to upgrade equipment. Leasing allows businesses to address the problem of obsolescence. If you use your lease to obtain items that may be outdated in a short period of time, such as computers or other high-tech equipment, a lease passes the burden of obsolescence onto the lessor. You are free to lease new, higher-end equipment after your lease expires.

Disadvantages of Leasing Equipment

Higher overall cost. Leasing an item is almost always more expensive than purchasing it. For example, a 3-year lease on a computer worth $4,000, at a standard rate of $40/month per $1,000, will cost you a total of $5,760. If you had bought it outright, you would have paid only $4,000.

You don't own it. You don't build equity in the equipment. Unless the equipment has become obsolete by the end of the lease, this lack of ownership is a significant disadvantage.

Obligation to pay for entire lease term. You are obligated to make payments for the entire lease period even if you stop using the equipment. Some leases give you the option to cancel the lease if your business changes direction and the equipment you leased is no longer necessary, but large early termination fees always apply.

Buying Equipment

Ownership and tax breaks make buying business equipment appealing, but high initial costs mean this option isn't for everyone.

Advantages of Buying Equipment

Ownership. The most obvious advantage of buying business equipment is that you gain ownership of it. This is especially true when the property has a long useful life and is not likely to become technologically outdated in the near future, such as office furniture or farm machinery.

Tax incentives. Section 179 of the Internal Revenue Code allows you to fully deduct the cost of some newly purchased assets in the first year. In 2012 and 2013, you can deduct up to $500,000 of equipment (subject to a phase-out if you placed more than $2,000,000 of equipment in service in any one year). For example, if you are in the 25% tax bracket and you purchase $100,000 in business equipment this year, the net cost to you is only $75,000.

Possibility of depreciation deduction.Although not all equipment purchases are eligible for Section 179 treatment, you can still receive tax savings for almost any business equipment through depreciation deductions. (Some assets that don't qualify for the Section 179 deduction are real estate, inventory bought for resale, and property bought from a close relative.)

Disadvantages of Buying Equipment

Higher initial expense. For some people, purchasing business equipment may not be an option because the initial cash outlay is too high. Even if you plan to borrow the money and make monthly payments, most banks require a down payment of around 20%. Borrowing money may also tie up lines of credit, and lenders may place restrictions on your future financial operations to ensure that you are able to repay your loan.

Getting stuck with old equipment.Although ownership is perhaps the biggest advantage to buying business equipment, it can also be a disadvantage. If you purchase high-tech equipment, you run the risk that the equipment may become technologically obsolete, and you may be forced to reinvest in new equipment long before you had planned to. Certain business equipment has very little resale value. A computer system that costs $5,000 today, for instance, may be worth only $1,000 or less three years from now.

Should You Buy or Lease?

When deciding whether to buy or lease a particular piece of business equipment, try to figure out the approximate net cost of that asset. Be sure to factor in tax breaks and resale value when making this calculation. After determining which option is more cost-effective, consider other intangibles such as the possibility that the product will become obsolete (if you are considering purchasing) or that your need for the product will expire before the lease does (if you are considering leasing).

If you are considering a car lease, see Leasing a Car to learn about the advantages and disadvantages of car leasing.


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