Fixing Synthetic Leases
Richard A Graff
The accounting scandals of 2001-02 focused greater regulatory scrutiny on off-balance-sheet financings that convey inaccurate impressions of corporate investments and liabilities. The synthetic lease attracted great attention in this regard.
Under the off-balance-sheet accounting standard in effect at the time, the synthetic lease was allowed to pass for a true lease. Accordingly, the synthetic lease allowed corporate investors to (1) use an asset, (2) invest in the asset's upside potential, (3) leverage the asset at low cost, (4) keep both the asset and the leverage off the balance sheet, and (5) expense all cash outlays related to asset use.
The fly in the ointment for the FASB and the SEC is that leverage in the synthetic lease capital structure is mortgage debt and the lessee guarantees to make the lender whole under nearly all loss scenarios. In other words, the mortgage debt is actually a lessee debt obligation that does not appear on the lessee balance sheet. Such hidden debt contributed to the Enron, Global Crossing and WorldCom debacles and acquired greater significance in their aftermath.
In 2002, the FASB instituted a high-priority program to tighten accounting regulations relating to off-balance-sheet finance. This resulted in FASB Interpretations Nos. 45 and 46. The Interpretations curb synthetic lease accounting abuses by modifying three off-balance-sheet financing requirements: (1) the minimum equity capital from third-party investors is raised from 3% to at least 10%; (2) the definition of risk capital is changed to ensure that the equity investor bears the brunt of investment risk, (3) the synthetic lease guarantee becomes a lessee balance sheet liability.
No synthetic lease will remain totally off the lessee balance sheet beyond mid-2003. Although existing off-balance-sheet financial instruments are grandfathered by Interpretation No. 45, synergy between Interpretations Nos. 45 and 46 removes the protection for synthetic leases created under the previous accounting standard. Accordingly, the synthetic lease guarantee is the minimum that must appear on the lessee balance sheet. In the case of most older synthetic leases, including all older real estate synthetic leases, the entire asset capital structure must be consolidated on the lessee balance sheet unless there is a major restructuring prior to mid-2003.
Restructured synthetic leases that meet the reformed off-balance-sheet accounting standard are likely to cost the lessee significantly more in fees and rent, both because of the increase in the amount of equity capital and because the change in the financial guarantee necessitated by modification (2) turns equity investment uncertainty into a case of heads the lessee wins, tails the equity investor loses. The higher cost may prompt lessees to consider less costly off-balance-sheet alternatives.
Several alternative capital structures are available to keep older synthetically leased assets off lessee balance sheets beyond mid-2003. Of these, only the synthetic debt all-equity capital structure provides the lessee with the five economic benefits enumerated above that synthetic leases heretofore provided. This simplifies the comparison of the alternatives.