A recent comment concerning off balance sheet financing generated several additional questions and thoughts that I would like to share with you. The basic issue was why banks put leverage ration restrictions on companies that prevent them from entering into loans or capital leases for equipment, but then allow them to enter into operating leases.
It is common knowledge that banks and rating agencies, among others, restate the lessees' financial statements to take the operating leases into account. In this regard, they are monitoring the indebtedness associated with the operating lease. What never gets into this analysis is the residual portion of the lease, meaning that the residual portion of the equipment acquisition is always off balance sheet. Many internal compensation plans do not consider operating leases, which adds impetus to use operating leases as a financing technique.
But what about those residuals? It seems that banks are ignoring them, some of which can be material in amount, depending on the technology, term, and structure of the lease. Is this an example of the banking industry giving its customers room to acquire needed equipment or is it an oversight? I think there are several issues going on here.
The first is that the residual position in an operating lease is, at best, a contingent liability. There is absolutely no obligation on the part of the lessee to purchase the asset (if the auditor has done his job). Second, the accounting does not require recognition of this contingent at best obligation. You know banks - they go for the accounting perspective big time. Even so, lessees, as well as lessors selling off balance sheet leases, are seeing auditors taking a different approach than in the past. Some are, for example, attempting to attach return fees to the 90% test, as well as more carefully considering the likelihood of the lessee exercising exercise any purchase or renewal options.
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