OPEX, CAPEX, and Tax Breaks, Oh My!

In honor of tax season, let’s take a look at the differences between operating expenditures (OPEX) and capital expenditures (CAPEX), and how they can influence the way your company acquires hardware infrastructure.

Diving right in, operating expenditures are the expenses that a business incurs as a result of performing its normal business operations. These include wages, depreciation expenses, office expenses, lease payments, etc. Obviously, the fewer operating expenditures a company has, the more profitable it will be. This is great for a publicly traded company wanting to boast a higher net income on its income statement in order to increase its stock price; however, when the tax man comes a-knocking, most companies are looking for any expenses that they can deduct to lower their taxable income. For income tax purposes, the more OPEX a business has the better.

Meanwhile, capital expenditures are funds used by a business to acquire or improve physical assets, such as new equipment, a factory, or vehicles. Typically, these assets are included on the balance sheet. The depreciation and amortization of these assets and the interest expense associated with acquiring them are expensed as OPEX on the income statement. Tangible assets are usually depreciated, while intangible assets are amortized.

To make matters more confusing, the IRS uses its own method of depreciation for tax purpose called MACRS. To give you a better idea, most computer hardware is classified as a 5-year asset under MACRS and it is depreciated via the following schedule. Additionally, for certain assets, the IRS has historically allowed bonus depreciation to be taken on assets during the first year. Currently, the bonus depreciation rate for assets placed in service between Jan 1, 2012 and Dec 31, 2017 is 50%. This means that half of the cost of qualifying assets, can be expensed and deducted for tax purposes during the first year. Furthermore, certain business may also qualify for Section 179 Deduction for hardware purchases.

So what does all of this accounting mumbo-jumbo about CAPEX and OPEX have to do with how your company acquires hardware? Well, by thinking about how your company acquires equipment, you may be able to make better purchases in order to receive certain tax deductions sooner. For the most part, a company can either purchase hardware via cash or a capital lease, or lease the equipment via an operating lease.

Cash Purchase

When hardware is outright purchased with cash, the purchase is treated as a capital expenditure, which to reiterate, means that the asset is included on the balance sheet and that the related depreciation is expensed overtime on the income statement. However, keep in mind that assets and businesses that qualify for bonus depreciation and Section 179 Deductions, realize a majority of an asset’s depreciation during the first year. This allows expenses to be realized quicker than if the assets were acquired via an operating lease, which we will discuss shortly.

Of course the downside to purchasing equipment outright is that it eats up a company’s free cash flow that could be utilized elsewhere. This may negatively affect a company’s valuation and its financial ratios, such as free cash flow to equity. One way to improve cash flow is to lease assets. This can be either accomplished via a capital lease or an operating lease.

Capital Lease

A capital lease is in essence an installment purchase. According to GAAP, a lease must be capitalized as a capital lease if it meets one of the following requirements.

• The life of the lease is 75% or greater of the asset’s useful life.
• The lease contains a purchase agreement for less than market value.
• The lessee gains ownership at the end of the lease period.
• The present value of the lease payments is greater than 90% of the asset’s market value.

Like an outright purchase, capital leases are recorded on the company’s balance sheet, and the asset’s depreciation expense is recorded on the income statement. However, the remaining amount due on the lease is also recorded as a liability and the associated interest is recorded as an expense. One upside to the added interest expense is that it is tax deductible. In the end, hardware purchased via a capital lease is a capital expenditure and the rights of ownership of the asset are conveyed to the lessee.

Operating Lease

Meanwhile, an operating lease gives the lessee the right to use the asset, without the benefits of ownership. One major downside to this is that the lessee cannot realize any depreciation, and thus the tax benefits associated with it. Instead, an operating lease is accounted for as a rental expense and appears only as an expense on the income statement and a footnote in the disclosure statements. This form of “off-balance sheet” financing has been the root of a lot of controversy in recent years.

Since a company only has to record an operating lease as an expense, the liability of the remaining lease payments is not accounted for except in the seldom-read disclosure notes. As a result, the FASB has introduced a rule change that will change the way operating leases will be accounted for beginning in 2019. According to the FASB’s proposed accounting standards, operating leases will soon be treated more like capital leases and require a retroactive restatement of a company’s financial statements.

Until then, lessees get to enjoy simpler accounting and only have to record current lease payments as operational expenses, which are fully tax deductible. Furthermore, operational leases improve a company’s Return on Asset (ROA) and other asset based ratios since the equipment and related liability are not included on the balance sheet.

Depending on what a company wants to accomplish, whether it be improving its books or taking advantages of tax deductions, creative financing options can help improve cash flows and allow a company use its cash more efficiently.

Metric Loop and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Originally published at metricloop.com on April 22, 2016.