Off-balance sheet financing of leases and residual values: different structures for different leases--legal and accounting requirements applied.

Author:Strauss, Ruth A.

Your company leases commercial equipment pursuant to five-year leases. There is an active market for used equipment of this type, and your company has a track record of successfully selling or re-leasing the equipment at lease termination. You desire to obtain off-balance sheet financing for the leases and the residual value of the equipment. If possible, you would also like to retain the depreciation benefits for tax purposes.

What are some basic determinations and concepts that will help you structure the leases and the financing to achieve these goals? How will implementation of FASB's proposed interpretation related to the consolidation of special purpose entities, if adopted in the summer of 2002 as currently contemplated, affect the relevant structures?


    1. Type of Lease for Accounting Purposes

      You need to determine whether the leases are (1) direct financing or sales-type leases (henceforth, "financing leases") or (2) operating leases, because significantly different accounting procedures apply to the different lease types. In plain English:

      * a financing lease is a lease that transfers to the lessee substantially all of the benefits and risks of ownership (it effectuates the sale of the equipment or a financing of the sale of the equipment), and

      * an operating lease is a lease that evidences a rental of property rather than a sale.

      More specifically, a financing lease is a lease for which any one of the four requirements described on Exhibit 1 is met. An operating lease is any other lease.

      Exhibit 1 DIRECT FINANCING OR SALES-TYPE LEASE VS. OPERATING LEASE In the hands of a lessor, a direct financing or sales-type lease is a lease as to which, at lease inception, collectibility of minimum lease payments is reasonably predictable and any unreimbursable costs yet to be incurred by the lessor are certain, and any one of the following requirements is met: 1. The lease transfers ownership of the property to the lessee by the end of the lease term (1); 2. The lease contains an option to purchase the leased property at a bargain price; 3. The lease term (2) equals or exceeds 75% of the estimated economic life of the leased property (3); or 4. At the beginning of the lease term (4), the present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property less any investment tax credit retained by the lessee. (5) In the hands of the lessor, an operating lease is any other lease. See FAS 13 (paragraphs 8 and 5(j)), FAS 98, and FAS 29. (1) The lease term includes the period through the date a bargain purchase option becomes exercisable, including (i) the fixed, noncancellable term, (ii) any periods covered by bargain renewal options, (iii) all periods for which failure to renew imposes a penalty such that as of lease inception, renewal appears reasonably assured, (iv) any periods covered by ordinary renewal options during which the lessee is expected to be a lender or guarantor of debt to the lessor related to the leased property, (v) all periods covered by ordinary renewal options preceding any bargain purchase option, and (vi) all periods representing renewals or extensions at the lessor's option. (2) Please refer to footnote 1. (3) Clauses (3) and (4) are not available when the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased property. (4) please refer to footnote 1. (5) Please refer to footnote 3. B. 90% Test

      Frequently, determining whether a particular lease is a financing lease or an operating lease boils down to determining whether or not the lease meets the fourth of these alternative requirements:

      * At the beginning of the lease term, was the present value of the minimum lease payments at least equal to 90% of the fair value of the leased property less any investment tax credit retained by the lessee?

      If the answer is yes, then for accounting purposes the lease will generally be a financing lease. For details, please see Exhibit 2.

      Exhibit 2 CALCULATION OF MINIMUM LEASE PAYMENTS FOR 90% TEST The minimum lease payments include: (i) the minimum rental payments over the lease term and the value of any bargain purchase option, and (ii) if there is no bargain purchase option: (a) any residual value guaranty by the lessee or a third party related to the lessee, or (b) any guaranty of the residual value or of rental payments beyond the lease term by a financially capable third party unrelated to the lessee or the lessor. The rental payments exclude contingent rentals and any obligation of the lessee to pay (apart from the rental payments) insurance, maintenance and taxes. See FAS 13 (paragraph 5(j) and FAS 29). C. How a Lease Appears on a Lessor's Balance Sheet/ Income Statement

      FAS 13 governs this for both lease categories. Basically,

      * For a financing lease:

      (i) the balance sheet reflects future rental payments as net investment in lease receivable, which equals gross investment in lease receivable less unearned income and unamortized initial direct costs; and

      (ii) gross investment in lease receivable consists of two components:

      (a) minimum lease payments, and

      (b) unguaranteed residual value accruing to the benefit of the lessor.

      * For an operating lease:

      (i) leased property is included with or near property, plant, and equipment, leased property is depreciated following the lessor's normal depreciation policy, and accumulated depreciation is deducted from the investment in the leased property;

      (ii) rent is reported as income as it becomes receivable over the term of the lease; and

      (iii) initial direct costs are generally deferred and allocated over the lease term in proportion to recognition of rental income, but may be charged to expense as incurred under some circumstances.

    2. General Structuring Concepts for Off-Balance Sheet Accounting

      Two concepts are critical for achieving off=balance sheet accounting treatment for an asset.

      * First, the sponsor must transfer the asset to another entity in a transfer that meets accounting standards for removing the asset from the sponsor's balance sheet.

      * Second, the entity that ultimately holds the asset must not be an entity that will be consolidated in the financial statements of the sponsor. (Otherwise, the asset will reappear on the sponsor's balance sheet).

      The accounting statements and guidance that govern these two concepts differ substantially depending on which type of lease is used.


    1. FAS 140 Applies Components Approach to Financing Leases

      FAS 140 applies to transfers of recognized financial assets and allows a lease receivable that it governs to be divided into its component parts for appropriate accounting treatment. Transfer of the component that is a recognized financial asset is governed by FAS 140. Transfer of the component, if any, that is not a recognized financial asset is governed by FAS 13, as amended.

      * In general terms, a financial asset is an asset that provides one entity with a contractual right to payment by another entity.

      * The balance sheet entry for a financing lease is gross investment in lease receivable. This entry consists of two components: minimum lease payments and residual value. Residual value represents the lessor's estimate of the "salvage" value of the leased equipment at the end of the lease term.

      * With respect to a financing lease:

      (I) the following items are financial assets.

      (a) minimum lease payments, and

      (b) the residual value, or any portion thereof, guaranteed at lease inception.

      (ii) the following item is not a financial asset and is subject to FAS 13, as amended, rather than FAS 140:

      (a) the residual value, or any portion thereof, not guaranteed at lease inception.

      See FAS 140 (paragraph 89).

    2. FAS 140 Conditions for Transfer

      A transfer of all or part of a financial asset will be accounted for as a sale, rather than a financing, and the financial asset derecognized from the transferor's balance sheet, if the following requirements are met:

      * the transferor surrenders control over the transferred assets; and

      * the transferor receives cash or other consideration other than notes, bonds, certificates, stock, or other beneficial interests in exchange for the transferred assets, but only to the extent of such consideration.

      To establish the surrender of control, there must be evidence that the transferred assets have been legally isolated from the transferor-put beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. The evidence normally takes the form of a "true sale" opinion provided by counsel to the transferor, to the effect that the transferred assets would not be deemed to be property of the bankruptcy estate of the transferor or a consolidated affiliate of the transferor (other than a special purpose bankruptcy-remote entity or "SPE") if the transferor or such consolidated affiliate became a debtor in a bankruptcy proceeding.

      NOTE: Rating agencies and investors often require a "true sale" opinion for another purpose. To provide a rating on the securities that is better than the general credit rating of the transferor (and thus to allow the transferor to obtain a more favorable interest rate or yield than would otherwise be the case), the rating agencies and securityholders want reasonable assurance that the transferred assets are not likely to be tied up in a bankruptcy of the transferor. If there is sufficient liquidity in the transaction to permit payment of the securities during a delay (while the securityholders or their representative establish their right to foreclose), rating agencies and others are sometimes willing to accept a security interest opinion in lieu of a "true sale" opinion.

    3. Significant Advantage to FAS 140 Treatment: Ability to Use QSPE

      Perhaps the most significant benefit to categorization as a financing lease is the fact that FAS 140 permits the...

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