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Use of “creative” accounting methods
has led to the recent downfall of some major corporations in the United
States. In response, Congress is holding hearings, the Security Exchange
Commission and the major securities exchanges have modified procedural
and disclosure requirements, and the boards of directors for many public
and private companies are taking a long, hard look in the mirror, and at
their books. What impact will all this have on synthetic leases?
A synthetic lease is simply a financing mechanism that qualifies as an
operating lease for financial reporting purposes, but is considered a
loan for tax purposes. This mechanism can improve financial metrics and
it preserves cash for other, perhaps more productive, business uses. As
an example, a few years ago, before the “tech bubble” burst, a
manufacturer/developer of microprocessors for personal computers might
have owned and operated a research and production facility that was
worth $100,000,000.00. The company may have needed access to some
or all of that $100,000,000.00, without losing operational control over
the facility. Working capital funds may have been needed to provide the
cash that would allow the company to develop and market the next
generation of microprocessors. In order for the company to be able to
access some or all of that $100,000,000.00, the company could have
elected, among other things, to (i) sell the facility and then lease it
back, (ii) procure traditional mortgage financing, using the facility as
collateral, (iii) procure an unsecured line of credit, based on the
company’s credit rating, or (iv) enter into a synthetic lease.
Assuming that the company decided to enter into a synthetic lease, it
would have found (i) that its effective cost of “borrowed” funds
were significantly less than if it had procured traditional mortgage
financing, (ii) that it was able to “borrow” 100% of the value of
the facility, (iii) that it would still be treated as the owner of the
facility, for tax purposes, avoiding recognition of any gain and
permitting the company to continue to take depreciation deductions, (iv)
that the obligations of the company did not constitute indebtedness, for
financial accounting purposes, allowing the company’s books to reflect
the company’s financial condition, without disclosing that the company
was, for practical purposes, carrying $100,000,000.00 in debt.
The typical synthetic lease utilizes a newly formed and un-affiliated
single purpose entity to hold legal title to the facility. Appropriately
utilized, synthetic leases typically serve some appropriate “arm’s
length” business purpose. Bookkeeping and accounting practices that
may have led to the recent collapse of some companies have been
creative, but they probably went well over and beyond what you might
expect to find in a typical synthetic lease transaction. One company in
particular used single purpose entities that were its own affiliates,
and (essentially speaking) made loans to those affiliates under
circumstances that would not have reasonably supported underwriting
loans to an unrelated party. This approach goes well beyond
conventional synthetic lease protocols.
Recent accounting scandals, have led corporate officers and boards of
directors to take a second look at existing synthetic leases in a
proactive way. Since the typical term of a synthetic lease lasts for no
more than seven years, companies need to have a workable “exit
strategy” anyway. While the original strategy may have been to let the
synthetic lease run its course and expire, then refinance, more
companies have started looking for ways to get out early, or
“un-wind” their synthetic leases. Given the current financial
climate, relatively low interest rates, and skepticism over anything
that has the appearance of impropriety, companies seem to be turning
away from “off balance sheet” synthetic lease financing.
Notwithstanding recent accounting abuses, synthetic leases still may
offer companies an appropriate financing tool, under the right
circumstances. The Financial Accounting Standards Board (FASB) may end
up re-examining its position on synthetic leases. If that happens, we
can expect, at a minimum, more rigorous financial disclosure
requirements for companies who decide to secure financing through a
synthetic lease. 
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