During the normal course of my business, when gathering the data to prepare a professional appraisal of a dental practice, I frequently review the client’s equipment leases. In most instances, I perform a courtesy audit of these leases so that my client is certain to understand the facts and figures of the leases in the event the practice is sold. While performing such courtesy audits I have, on occasion, uncovered a discrepancy between the figures contained within the lease contract and those which my client says they were given to understand.
Why is this article necessary? To quote Henry David Thoreau, “The only obligation which I have a right to assume is to do at any time what I think right.” With this in mind, I have chosen to air my opinions of leasing because my company has been required, from time to time, to spend a considerable amount of time explaining leasing to its clients. This column may prevent this unnecessary, and unprofitable, use of my time from occurring in the future. As well, I hope to be viewed as an advocate for the dentists who supply my company with a means to earn a living. I encourage anyone who may have other information about leasing to write Ontario Dentist and express their views. I know the journal is interested in opposing views and a good debate.
Some of my clients – and even some accountants – readily admit that they do not completely understand the complex set of rules affecting their leases, as dictated by the Canada Customs and Revenue Agency (CCRA). With respect to the equipment leasing companies that serve the Canadian dental industry, it is my opinion that they have failed to fully educate dental professionals about the manner in which leases are calculated.
The greatest source of frustration reported by my clients when equipment leases are the topic, is that they do not know the true effective annual interest rate they are paying. I think this is due, in part, to a unique method of calculating leases, typically called rate factors, or the cost per thousand multiple, which was developed by the equipment leasing industry.
Rate factors were designed to assist dentists and equipment dealers to easily calculate monthly payments. These rate factors simplify the mathematics of leasing, yet they have an unfortunate side effect: a rate factor does not precisely identify the effective annual interest rate upon which an equipment lease is based. Rate factors “accidentally” began to allow for the figures of a lease to be presented, while inadvertently disguising the effective annual interest rate being paid. The use of these factors then prevents a traditional “apples to apples” comparison that most consumers perform when comparing varying financing options.
What information is required to audit a lease? Let’s start with the basics. There are five essential components of any lease:
1. the number of payments to be made, or the term of the lease;
2. the principal amount upon which the payments are based;
3. the final payment required at the end of the term;
4. the regular payment amount; and
5. the interest rate.
If provided with any four of these components, we can easily solve for the fifth. You will notice that the rate factor is not one of the five essential components of a lease. That’s because the rate factor is only a convenient mathematical tool designed by the leasing industry, yet it’s almost a totally meaningless number to the lease auditor or accountant. However, knowing the rate factor can assist in the search for the effective interest rate of a lease. In short, rate factors are an industry tool that is rarely used by the equipment lease auditor.
Some of the five components have been given other names that are unique to leasing. For example, the final payment can also be called the lease residual, the buy-out, the payout or the early purchase option amount due at the end of the lease. These terms, and many others that you may have encountered, are interchangeable and essentially mean that you must make a final payment, typically a percentage of the original principal amount, at the end of the lease term. Dentists often misunderstand the purpose of this final payment and they sometimes confuse it with other lease terminology, such as the “fair market value” option, that can also be found in leases.
The use of these various terms sometimes adds to the confusion surrounding leases. My advice with respect to final payment, or end of lease options, is this: Always exercise the final payment or early purchase option; i.e., 20 per cent of the original equipment cost after 36 monthly payments, and avoid things such as stretch leases, automatic annual renewals and fair market value purchase options.
Leasing companies sometimes ask you to pay them the “fair market value” of your equipment, even after you have paid back the entire principal amount – and the interest charges – during the term of the lease. Paying the fair market value of the equipment, after the term has expired, can be as costly as the total interest you’ve already paid. Another item that increases the yield, or earned interest, for the leasing company is to request the first and last payment in advance, versus the first payment only in advance, which I believe is best for the customer. I have also seen leases with various fees added into the total amount to be borrowed, such as Personal Property Search Act (PPSA) fees, and interim interest charges, among others. These are often agreed upon, and are fair fees, provided you are aware of them and how they are calculated.
Why do many dentists continue to lease most of their new dental equipment acquisitions, rather than purchasing it outright or using a line of credit or bank loan? Equipment dealers promote leasing because there are compelling economic reasons for doing so. Firstly, any equipment supplier, in any industry, will admit that the presentation of a low monthly lease payment, versus the much higher figure of the total purchase price, will reduce the likelihood that the customer will successfully negotiate a lower purchase price. In other words, by asking us to focus on the payment, not the price, profit margins typically become higher for the supplier. The most obvious example of this is the automotive industry. I’m certain you have noticed how most ads promote the monthly payment more so than the price.
Secondly, it has been a long-standing and customary practice for a leasing company to pay the equipment supplier a referral fee for introducing the customer to them. Many equipment dealers carry leases with their equipment order forms, which provides for a quick method of processing payment to the supplier. Some of my clients tell me that this is a simple and convenient process that eliminates the need to contact the bank, arrange an appointment, take time off work and go hat in hand to the banker.
What should you do?
Negotiate the lowest possible purchase price for the equipment with your supplier as though you were going to pay in cash. At that time – and only after you are certain that you know the lowest possible price – ask them to provide you with a written lease quote that contains the five components mentioned above. Quotes that only mention the number of monthly payments, or simply the rate factor, do not provide enough information to ascertain the effective annual interest rate.
Secondly, obtain one or two more quotations from other leasing companies. Now you can compare apples to apples. I suggest that you contact a Canadian chartered bank, trust company or credit union, as they are regulated by the Trust and Loan Companies Act. In some instances, you may find an interest rate, and therefore a monthly payment that is lower than those provided by your equipment supplier. Essentially, you are following the exact same process as when you buy a home. Namely, we negotiate the lowest possible purchase price, and then we go to another source (usually a bank) for the mortgage. Have you ever bought a home solely based upon the low monthly payments or do you negotiate the total price first? Negotiating the lowest purchase price first is prudent consumer behaviour. I encourage you to do the same with your next equipment purchase.
Another suggestion is to ask your accountant if he or she leases office equipment. If so, did they lease through the supplier, or did they negotiate the lowest purchase price first, then arrange the lease? I know some accountants who tell me they will never lease anything for their practice.
I wish to be clear that I’m not suggesting that dentists should never lease their equipment, as leasing is a useful and viable alternative form of financing, and it will be for many years to come. Just be sure you know exactly what you’re getting into before you sign.
It is my opinion that both the dental and accounting professions do not understand leases completely. This is witnessed by the reactions I receive when the results of my audits are measured. I also worked a short period with a leasing company, over 10 years ago, which helps me to understand the leasing business better than most dentists. It should also be mentioned that there is not a governing body that expressly regulates privately held leasing companies.
Send a copy of this column to your accountant, along with copies of your leases, so that a lease audit can be performed to verify the actual effective interest rate upon which your leases have been based. Leasing can be a little confusing, and it should not be this way. I hope this column will help.
Ontario Dentist – September 2002