Leasing, Accounting & Taxes

• How does a business depreciate its equipment?
• Getting tax benefits from a lease.
• Lease accounting practices.
• What is the impact of mid-quarter and half-year conventions on leasing?
• Leasing and the balance sheet.

How does a business depreciate its equipment?

The owner of equipment can take a tax deduction for the reasonable exhaustion, wear and tear, and obsolescence for equipment used by the business. The deduction reduces taxable income and thereby reduces any tax liability. Under the applicable depreciation schedule, the cost of the equipment is allocated over time.

Using the commonly applied Modified Accelerated Cost Recovery System (MACRS), personal property is grouped into six different classes of recovery periods - 3, 5, 7, 10, 15 or 20 years. For most equipment MACRS deductions are determined using the double-declining balance method and then switch to the straight-line method to maximize the depreciation allowance. Depreciation deductions are determined based on the fair cost of the equipment and the applicable recovery period. Any actual residual value at the end of the recovery period is not considered.

In a capital lease the lessee is treated as the owner of the equipment for tax purposes. Therefore, it can claim depreciation deductions on its tax return.

Under an operating lease, the lessor is the owner of the equipment. While the lessee cannot claim depreciation deductions on its tax return, it can expense the lease payments as a deduction. In addition, because the lessor is entitled to take the depreciation, the lessee will benefit from lower rental payments.

A lease may be classified as a capital lease or an operating lease for accounting purposes. Under the Statement of Financial Accounting Standards No. 13 (FASB 13) promulgated by the Financial Accounting Standards Board, an operating lease cannot have any of the following characteristics:

• Automatic transfer of ownership to the lessee at the end of the term of the lease
• A bargain purchase option
• The term of the lease is greater than 75% of useful life of equipment
• The present value of the lease payments is greater than 90% of the equipment price (using the lessee’s incremental borrowing rate)

A lease having any of the above features is classified as a capital lease. Operating leases are accounted for by expensing the lease payment and the equipment is not added to the balance sheet (but the lease is set forth in the notes to financial statements).

A capital lease is treated as an asset and is included as such on the balance sheet with a corresponding liability entry for the capital lease obligation. The asset is treated as if it was purchased with debt financing.

Under the MACRS’ “half-year convention” only one-half of a full first year's depreciation can be claimed on the tax return, no matter when the equipment actually went into service. Yet, if the business places more than 40% of it new equipment in service during the last quarter of its tax year, the business must use the "mid-quarter convention". Under this convention, the depreciation deduction is more limited as it is determined as if the equipment was placed in service in the middle of the quarter in which it was acquired.

Leasing can help the lessee decide whether it wants a half-year or mid-quarter classification. As equipment acquired via operating leases is not used in calculating the 40% rule of the mid-quarter convention, a business can employ operating lease to circumvent the application the mid-quarter convention.

Many companies would like to reduce their balance sheet debt and improve their financial ratios. Still other businesses have existing loan covenants that bar direct capital equipment acquisition or additional debt. Operating leases reduce balance sheet debt because the lease obligation is only noted in the financial statements and not reported as a liability. Due to this balance sheet treatment, operating leases usually do not violate lender covenants.

 

CSK Leasing disclaims the accuracy of the information listed in this website as such information is based on generalized or hypothetical circumstances. The information in this website should not be applied to any specific situation nor considered financial, legal, accounting or tax advice. All users of this web site are strongly cautioned to consult their own financial, legal, accounting and tax professionals regarding the topics listed in this web site.