When it comes to machinery lease rates, capital leases have higher rates than operating leases.
Many business owners looking to lease machinery often wonder which type of equipment lease is suitable for them. The most common types of equipment leases offered are operational and capital leases. While capital leases have higher machinery lease rates, they do not have end of lease risks but operating leases have considerable end-of-lease risks despite their low rates.
Comparison Between Operating Lease And Capital Lease
The operating lease is popular among many business owners because it does not include the cost of the equipment in the balance sheets. The benefits of an operating lease can only be realized if you pay careful attention to provisions in your lease that might transform your lease agreement into one costly transaction. While it is tempting, you should be careful not to fore-go reasonable financial decisions and opt for short-term accounting benefits.
The terms used in both the operating and capital lease may not be as straightforward as many people would like them to be. In most instances, capital leases are often as risky as operating leases. In fact, they are operating leases masked as capital leases.
The complexity and confusion brought about by the two types of leases is further fueled by the U.S Financial Accounting Standards Board’s Bright Line Test, which recommends that a capital be categorized as so if any of these conditions are met:
- If the present value of the minimum lease payments are more than 90% of the fair market value of the machinery
- If more than 75% of the estimated economic life of the equipment is covered by the lease term
- If the lease contains a bargain buyout option
- The lease automatically transfers ownership of the equipment at the end of the lease term to the lessee
These conditions were put in place to prevent lessees from inappropriately keeping leases off their balance sheets. The good thing about these conditions is that the Bright Line Test will make it easy for you to structure lease agreements that qualify as capital leases even if they carry a great amount of risk.
In light of the current FASB accounting changes, all leases will be put on the balance sheet and there will be no more operating and capital lease categorizations. As a result, many companies have chosen to use only capital leases. Their assumption is that the capital lease offers low risk, which is no longer true. Remember that a capital lease is a lease that meets any of the four requirements mentioned.
Assess All The Risks
Regardless of whether you have a capital or an operating lease, all risks must be assessed, which is why you should have a leasing professional thoroughly examine your lease agreement.
For example, does your end of lease option include a $1 buyout or a Fair Market Value purchase option? If it includes a $1 buyout option, it might be the only end of lease option so you may need to meet a few requirements such as giving adequate notice in the manner indicated in the lease agreement, among other things. If you do not meet these requirements, you might end up paying for lease extensions and other unnecessary additional costs.
So How Does The Type Of Lease Affect Machinery Lease Rates?
The type of lease that you choose will determine the machinery lease rates that you get. Capital leases as mentioned earlier have higher rates as compared to operating leases.
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However, you shouldn’t rely solely on lease rates to choose the type of lease that will work for your business. Poorly structured leases contain bigger risks. If the terms and conditions of your lease are not properly negotiated, then machine lease rates will be the least of your worries once you sign the contract.
Many capital leases today are not structured the traditional way and pose considerable risk that only a person who is familiar with lease agreements can pinpoint.
There are many ways that your lease can become costly even if the rates are very low. Some of them are:
- Poorly defined fair market value
- All-but-not-less-than-all clauses that can lead to lease extensions
- Burdensome notice requirements that make compliance almost impossible.
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