Seek advice before year-end purchasing

Now that the end of 2022 is upon us, it feels like it’s the first time we have had a normal year in quite a while, and fortunately, there still is plenty of business to discuss. Manufacturers are working quickly to get finance approvals in place so they can have equipment on their floor before the end of the year.

The struggle is equipment availability because COVID-19 still is affecting the supply chain. However, year-end equipment purchases still are happening, so it’s a good idea to understand how they should be handled on your company’s financial statements.

Even in the pre-pandemic market, manufacturing companies tended to put off purchases until the fall because the investment in capital equipment was significant and they wanted to see how the year went before making a large financial commitment. Sometimes companies are too busy to allocate the necessary time to research and source the right piece of equipment.

Leftover Budget Dollars

As the year comes to a close, pressure exists to take care of this business because either budgeted money needs to be spent (or it will be lost going forward) or they were fortunate enough to find a machine that suits their shop perfectly. Either way, machinery sellers know that now is the time to move equipment because January and February traditionally are slower months.

If a piece of machinery is in stock anywhere in North America, it typically can be delivered and invoiced in a matter of days or a few weeks, so getting the purchase into the current year is easy. However, if the machine is coming from another part of the world, getting it on your shop floor by the end of the year could be challenging from a logistical standpoint. Even if a machine is in the Far East and is crated and ready to ship from the factory floor, it still takes more than 30 days to arrive in Canada. Make sure to consider this travel time when you are trying to get a piece of equipment delivered before year-end.

From an accounting perspective, the one question I often get is how a purchase should be handled from a purely business perspective. When a piece of equipment is purchased outright, either using cash, a bank loan, or a line of credit, the buyer takes immediate ownership, and the equipment becomes an asset on their balance sheet.

A standard balance sheet has three parts: assets, liabilities, and ownership equity. The difference between the assets and the liabilities is known as equity (or the net worth) of the business. From a taxation perspective, the benefit of ownership allows a manufacturer to use the depreciation of an asset to reduce earnings and, in turn, pay less taxes. This often is one motivation to get a machine purchase on the books before the end of the year.

However, if the purchase happens near the end of the financial year, the tax savings could be minimized because the Canada Revenue Agency may not allow the full year’s depreciation to be used. It is very important for business owners considering a year-end acquisition to have a conversation with their accountant before any purchase order is issued.

Know Your Leases

Based on my experience, a preferred method to handle this transaction is with an operating lease.

Accountants classify equipment leases into two main categories: capital leases and operating leases. Capital leases convey immediate ownership of equipment to a manufacturer. An operating lease, however, is a contract that allows for the use of a piece of equipment but does not convey rights of ownership. The funding institution maintains ownership.

This means that the equipment is not put on the books as an asset, and the corresponding lease payment is accounted for as a rental expense in what is known as off-balance sheet financing.

Operating leases have very appealing tax incentives because the payment is an expense like any other cost, such as tooling, material, and labour. Therefore, the operating income and profitability of a business is reduced by the full amount of the payments, which results in tax savings.

Also, manufacturers that have done significant borrowing from their bank, whether it is in the form of a loan or an operating line, typically have financial covenants that must be maintained, including debt-to-equity as well as minimum working capital requirements.

This becomes relevant because if equipment is added in the form of a capital lease, meaning both the asset and liability are noted on the balance sheet, it can easily throw off these ratios and could result in the business being noncompliant with its banking agreement.

These are some basic ideas for how transactions, year-end or otherwise, can be handled from a financial perspective, but once again, let me reiterate the importance of having a discussion with your accountant or financial adviser before any major spending is done. They are the experts who will be most familiar with your banking covenants and are best equipped to provide a short- and long-term strategy for handling both borrowing and investments from an accounting perspective.

Lastly, and on a personal note, I want to thank Joe Thompson and Canadian Metalworking for once again making this space available for finance talk. Whether you just came across my column this month or you’ve been following it for the past nine years, my hope is you have enjoyed reading it as much as I have enjoyed sharing my experiences within the manufacturing industry.

Ken Hurwitz is vice-president of Equilease Corp., 416-499-2449, ken@equilease.com, www.equilease.com.