Types Of Equipment Leases

There are basically two types of equipment Leases in Canada with different variations within each type.

Operating Lease.

An equipment operating lease is sometimes referred to as off balance sheet financing due to the fact that the outstanding balance does not have to be recorded on the business balance sheet as an outstanding liability, although it is still frequently referred to in the notes to the financial statements if the amount outstanding is viewed to be material to the users of the financial statements.

Operating leases tend to be utilized on shorter term financing requirements where there is a higher need for equipment replacement due to wear and tear or technology obsolesence. To be considered an operating lease, the financing facility offered must meet all of the following criteria:

  • Equipment ownership does not get transferred automatically to the lessee at the end of the lease.
  • The written lease terms do not include a bargain purchase option at the end of the lease.
  • The actual term of the lease must be less than 75% of the estimated useful life of the asset.
  • The net present value calculation on all lease payments is no greater than 90% of the actual cost of the equipment.

The payments made under a properly qualified operating lease are an expense to the business and the debt outstanding does not appear in on the balance sheet as was previously mentioned.

While these are the basic guidelines, we strongly encourage you to review their application with your accountant to make sure they are applied properly. Also, tax regulations can change from time to time, so its best to get the most up to date information from your accountant or tax adviser.

Capital Lease.

If an equipment lease does not meet all of the four criteria listed above, it is then classified as a capital lease. For accounting purposes, a capital lease is treated much in the same manner as an equipment loan whereby the implicit cost of borrowing can be deducted as an operating expense as well as equipment depreciation and the outstanding liability will be recorded on the balance sheet.

At the end of the lease term, the lessee will be provided with a pre-established buyout price for the equipment, typically set at a nominal amount between $1 and $20. There can be other calculations of the buyout amount to benefit the cash flow of the lessee during the lease term.

Capital leases also tend to provide the lowest available cost of borrowing due to the fact that they do not have to allow for equipment disposal risk at the end of the lease term.

Sale and Leaseback.

While not an actual type of lease per say, a sale and lease back is more of a process that lease companies utilize to provide more value to their customers.

There are two types of situations in which a sale and lease back can apply.

The first and most common situation is when a business owner buys an asset for cash and, within 6 months of purchase, decides to finance the asset to make the cash available once again to the operations of the business. To accomplish this, the business owner sells the asset to the leasing company can gets a lease back in return.

The second situation is where a business owner is trying to generate cash for business operations and would like to sell assets back to a leasing company that have potentially been owned by the business for several years. These assets may have even been previously financed and now do not have any claims against them.

The underlying lease to a sale and lease back transaction could potentially be an operating lease or a capital lease, although most of these transactions fall into the capital lease category.

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