All businesses will have major purchases of some sort.  These major investments and equipment/machinery can be a big decision.  You need to take into consideration how it will affect the bottom line of your company.  If you are very profitable (I hope everyone is), you may need to think about adding to your expense line instead of the asset line.

If you purchase an asset, you can’t necessarily expense the entire amount.  You will be able to expense an amortized amount, interest, insurance, etc.  A lease will allow you to expense the entire amount.  The usable life of equipment can also help make the choice (i.e. do you really want to lease a computer for five years when it will be obsolete in three or less?).  Your overall financial history, cash position and projections can help make this decision.

There is a big difference between a Fair Market Value (FMV) lease and a $1 Buyout lease contract:

• A FMV lease generally means that you will have a substantial payment due at the end of the lease if you want to own the equipment.  For example, you lease a truck over a four year period and if you want to buy it at the end of the lease for $5,000.  This is a true lease.
• A $1 Buyout lease to purchase the same truck will have a higher monthly payment.  However, when the lease term ends in four years you have the option to purchase the truck for a small fee…like $1.00.  Of course you are going to buy a truck for a dollar.

While the second scenario is called a lease, it really isn’t for tax purposes…it is essentially a finance deal because of the relatively low final payment to own it.  Therefore it is classified as an asset, not an expense and you need to communicate this to your tax professional.

No matter how you acquire equipment or other major investments, the factors are numerous in making the decision.  There is no wrong answer, just the right one for you and your business.

I work with business owners of varied educational background.  Even if they have had a formal business class, it’s sometimes been a while. Discussions regarding the difference between profitability and cash flow are frequent.  Let me explain with a very simplified example.

In January, you purchase $1000 worth of paper to make and then sell origami swans.  You have to pay staff, rent, and utilities, too.  Let’s say that’s another $2000.  We have spent $3000 so far.  On January 31, we sell half the origami swans we made for $4000.

At this point, we show a profit of $1000.  We have $4000 in sales and $3000 in expenses for a net profit of $1000.  We don’t actually have that money yet.  The customer who bought the product will pay us in 15 days.  Cash flow is not positive until February 15th when the client pays us.  We have had to invest a bit before making money.

Another simple example is an asset purchase.  I buy a new paper folder for my origami swan business for $5000 cash.  This is a large purchase that has value that I could sell.  I can’t not expense the entire purchase price of the folding machine…it is going to be depreciated over 7 years.  My bank account will reflect that $5000 went out, but there is not a $5000 expense to match.  I will only be able to expense $1200 this year for the machine.  Net result is $5000 less is cash, $1200 more in expenses, and we have about $3800 in assets.

Surely, every business needs to review the Profit & Loss (Income Statement) frequently.  But you must also realize that this reflects only part of the financial status of your business.  The P&L Report must be used in tandem with your Balance Sheet report to get a more accurate picture.  Both of these reports can be run quickly in QuickBooks anytime.

Speak with your tax professional about what minimum limit you should track for major purchases (i.e. items over $500, $1000, etc.).   These are items that could be computers, machinery, office furniture, leasehold improvements and so on.  Usually, these items can’t be expensed all at once.  They are amortized over the course of 3 years, 5 years, 7 years, or longer.

Your tax preparer can help you classify these assets and let you know the schedule of depreciation.  A program like QuickBooks can help with tracking individual assets, too.  You can then setup the monthly depreciation expenses so your financial reports will be more accurate.  Also, speaking with your tax professional BEFORE the end of the year can help you plan whether you should make a major purchase now, or delay into the next cycle.

Also, don’t forget to keep good records about these purchases.  Keep original invoices to archive indefinitely.  You should also keep receipts for freight charges, delivery, installation services (i.e. electrician to wire power for a new piece of equipment).  Expenses directly related to the specific asset may also be part of the deprecation schedule.  Keep good notes and make sure your vendors detail their invoices to you accordingly.

Tax law changes each year, and the qualifications for assets also change.  You probably maintain a maintenance record for major equipment.  Don’t forget to keep thorough financial records as well.