Understanding EOY financing

I think it is safe to say 2020 has been a year like no other, and even though many of us except the health experts did not see it unfolding quite like it did, I am pleased to report there is still some business to discuss.

Despite the chaos, numerous manufacturers did not shut down and were busy throughout the pandemic and are now working quickly to get approvals in place so they can have equipment on their floor before the end of the year.

It is nice to have at least one normal year-end occurrence, so I thought it would be relevant to talk about year-end purchases and how they are handled on a company’s financial statements.

End-of-year Purchasing

Even during a normal market, manufacturers tend to put off capital equipment purchases until the fall because the investment is quite significant and they want to see how the year goes before making a commitment. Or they have been too busy to allocate the time necessary to research and source the right piece of equipment.

But now, as the year begins to close, they are under pressure to buy because budgeted money needs to be spent or will be lost going forward.

If there is one (and really only one) ancillary benefit from COVID-19, it is the availability of inventory, which I assure that sellers will be more than happy to deliver before the end of the year. It is also a good time to get a great deal on a stock or demonstration machine because sellers are acutely aware of the normal buying cycle in which January and February traditionally are slower months for sales.

If machinery is in stock anywhere in North America, it can be delivered and invoiced in a matter of days or a few weeks, so getting the purchase into the current year is easy. But there are times when a machine needs to come from another part of the world, and getting it on the floor by the year-end could be challenging from a logistical standpoint.

The Role of Accounting

A question I get quite often, from both current and potential customers, is about how a purchase is actually handled from an accounting perspective.

When a piece of equipment is purchased outright, either in cash, using a bank loan, or using a line of credit, the buyer takes immediate ownership, meaning the equipment immediately becomes an asset on the 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 company.

From a taxation perspective, the benefit of ownership allows the company to depreciate the asset, which is a fancy way of reducing earnings and paying less tax, hence the motivation to get the purchase on the books by 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 taken. In reality, it is very important for any business owner who is contemplating a year-end acquisition to have a conversation with their accountant before any purchase order is issued.

The Lease Option

One method of handling year-end transactions is an operating lease.

Accountants classify equipment leases into two main categories, capital leases and operating leases.

Capital leases are treated in a fashion similar to an outright purchase or bank loan. Operating leases, on the other hand, are a contract that allows for the use of an asset but does not convey any right of ownership. The funding institution maintains ownership. The equipment is not put on the books as an asset, but instead 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 expensed like any other business cost and, therefore, reduces the company’s taxable income, which results in tax savings. Another benefit of the operating lease is that no additional assets or liabilities are recorded on the balance sheet.

Last, and most important, manufacturers that are doing significant borrowing from their bank, whether it is in the form of a loan or an operating line, have financial covenants that must be maintained. These typically are debt-to-equity ratios that must be maintained or restrictions on total debt level.

This becomes relevant if equipment is added in the form of a capital lease, when both an asset and a liability are added to the balance sheet. This can easily change these debt ratios, which could result in the company no longer being in compliance with its banking agreement.

As always, it’s vital to have a discussion with your accountant or financial adviser before proceeding with any major spending decision. They are the experts who are best equipped to provide both a short- and long-term strategy for handling investments from an accounting perspective.

Ken Hurwitz is senior account manager, Blue Chip Leasing Corp., 416-614-5878, www.bluechipleasing.com.