Are you going through a financial crunch? Small business owners often run out of cash due to limited capital investment. At times, they need funds to keep the company operational, whereas sometimes, they require money to finance non-current assets. They want to reinvest additional capital into the business, and there are two ways to go about it.
First, you can raise money through equity financing, meaning selling a small percentage of your company’s ownership in exchange for money. It might seem straightforward, but you will lose operational control. On the other hand, entrepreneurs can raise money through debt financing. It involves applying for a loan to fulfill capital requirements. However, loan types and interest rates can vary. Therefore, you must be careful when opting for external financing.
Opening a credit line or applying for merchant financing is suitable if you want to finance working capital. But leasing is the only viable choice when it comes to capital investment, such as purchasing a fixed asset. It enables an organization to finance an asset and repay the amount over its useful life. Thus, giving you sufficient repayment time with a low-interest rate.
If you want to familiarize yourself with leasing, look below. Here is an ultimate guide to leasing for all small businesses.
What is Leasing?
Accounting and finance experts define a lease as a contract where one party agrees to rent an asset. The lessee acts as a tenant who uses the asset and pays rent. By the end of the lease tenure, the tenant can purchase the asset. Simply put, these are binding contracts that set terms for rental agreements. Therefore, a small business must learn to record leases in its financial statements.
As leasing differs from loans, you can record it as a liability. And you must look into financial standards to understand their accounting treatment. The accredited standard committee has introduced a new lease principle – ASC 842. It explains the difference between operating and finance leases to make reporting more accurate. If you don’t know much, learn more about ASC 842 before making leasing entries in your financials. Correct accounting adjustments in the books will save you from audit checks and non-compliance problems.
How Does Leasing Work?
Even though not all leases work the same, they all have standard practices. First, every lease shall include a rental amount, due date, and lease term. Every lessor and the lessee will sign a non-binding contract, agreeing to all lease terms before occupying the asset.
At times, the lessee has the option to lease the asset over its useful life. For instance, you can lease the equipment for ten years if you believe it will work for that long. In such cases, the lessor will cover the equipment cost in rentals. After all, the asset will be useless once the lease term ends. In short, the rentals for such assets are higher. However, the lessor bears any damage or maintenance required for the asset since you don’t have asset ownership.
Further, the lessor can purchase the asset once the lease term is over. The right of use, ownership, and asset control can get transferred to the lessee at a low cost. As a result, you can increase your non-current assets.
Why is Leasing a Good Option?
Many entrepreneurs wonder why to lease when they can buy the asset. When you lease an asset, the rental amount becomes a part of the profit and loss statement. It means you record rentals as an expense, reducing your taxable income and increasing profitability. Hence, it could be the best way to maximize profits without breaking laws.
Moreover, a lease provides both parties with a structure and establishes costs associated with renting. It gives a clear understanding of how to adhere to the contract. In addition, it unfolds the consequences of breaking the lease or going against any terms laid out in the contract.
Types of Leases
Practically, there are two lease options – operating and finance lease. An operating lease allows businesses to use assets and pay rent. On the other hand, a finance lease enables companies to purchase the asset. Alongside rentals, they pay interest to acquire the asset. Therefore, the asset gets transferred to the lessee once the lease ends.
Besides these two categories, we have different sub-leases. You can acquire a single-net lease to pay property taxes or a double-net lease for paying taxes and insurance. Further, the gross lease could be another viable choice as it enables the lessor to pay for all costs, such as maintenance and repair.
Things to Consider Before Opting for a Lease
By now, leasing an asset might seem like the best possible choice. However, it is worthwhile to consider a few things before opting for a lease. Look below.
- Special Considerations: As you enter into a binding contract when signing a lease agreement, breaking this contract can have consequences. If a business owner breaks the lease without prior notice, they will face a lawsuit. Not only that, but it will also reflect badly on the credit report, making it impossible to lease an asset in the future. If at any point you want to break the contract, discuss it with the lease provider, or seek legal counsel. Sometimes, giving notice or forfeiting the security deposit can allow you to get out of the lease contract.
- Taxation: Even though you haven’t purchased the asset, understand the tax implications. You can depreciate it and pay tax if it is a capital lease. However, you must ensure that total payments are deductible; otherwise, interest payable is entirely tax deductible. Next up, check with your tax accountant whether you will record it under your assets or liabilities. Depending on the accounting treatment, you must fulfill all tax obligations.
- Option Lease: As a small business owner, you might come across lease providers selling a 10% option lease. It is a leasing condition where you can purchase the equipment for 10% of the asset’s initial value at the end of the lease term. Remember, the monthly payment will be lower on the 10% option lease than the buyout option. In addition, you can make a balloon payment too.
Truthfully, leasing is a broad domain. It covers different terms and conditions with plenty of leasing choices for entrepreneurs. You must identify your business needs and budget and pick an option that best suits your requirement. But most importantly, understand leasing accounting treatment to ensure all assets, liabilities, and income represent the company’s actual and fair value.