One of the major characteristics that sets a lease apart from a loan is the ability of the lessor to provide off balance sheet financing to the customer. Under the rules of FASB 13, if the economic substance of a transaction is a usage agreement, rather than a purchase, the lessee does not record a liability for the lease in its balance sheet. The effect of off balance sheet financing to the lessee is lower leverage and an improvement in most of its key ratios.
Off balance sheet financing also can improve a lessee’s earnings, relative to a purchase, during the early portion of the lease. This occurs because the sum of the interest and depreciation expenses for the purchase of the equipment exceeds the rent expense for the equipment lease. As a result, the lessee reports a higher ROA, which is not a bad result if you are compensated on ROA.
Off balance sheet leasing is a popular financing technique because of these advantages. Not every lease can be classified as off balance sheet, however. As I mentioned, FASB Statement No. 13 has rules that govern how leases are classified. There are four criteria in FASB 13 that indicate whether the lease is, in substance, a purchase. These criteria measure whether:
- The lessee has actual ownership (automatic transfer of title)
- The lessee has potential ownership (bargain purchase option)
- The lessee has effective ownership (75% test)
- The lessee has effective ownership (90% test)
If any one of these criteria is met, the lease is classified as a capital lease, which is accounted for as a purchase. If none of these criteria are met, the lease is classified as an operating, or off balance sheet, lease. The trick for the lessor is to assess all aspects of the transaction, and make certain that none of the criteria is met. As an examination of the criteria indicates, each one has its own challenge. Some, like the automatic transfer, are very simple to avoid. Others, like the 90% test, which incorporates present value concepts, take a lot more effort and creativity. I will examine each of these in more detail in subsequent posts and explain how various leases are structured to achieve this customer need.
Shawn, why do you think banks put leverage ratio restrictions on companies which would prevent them from entering into loans or capital leases for equipment,but, allow those same companies to enter into operating leases?
Posted by: Jay Zeinfeld | January 24, 2006 4:31 PM | Permalink to Comment