Balance Sheet Management for Corporate Lessees

From the perspective of the lessee, there are only two ways to classify a lease ' either as an operating lease or as a capital lease. Generally, if the lease meets one or more of the following criteria, at the inception of the lease, the lessee must classify it as a capital lease:

a) The lease transfers ownership of the property to the lessee by the end of the lease term. This is met in situations in which the lease agreement provides for the transfer of title at or shortly after the end of the lease term, automatically or in exchange for the payment of a nominal fee.

b) The lease contains a bargain purchase option. A 'bargain purchase option' is an option that allows the lessee to purchase the leased property for a price that is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable.

c) The lease term is equal to 75% of the estimated economic life of the leased property. The 'estimated economic life' is the estimated remaining period during which the property is expected to be economically usable by one or more users, with normal repairs and maintenance, for the purpose for which it was intended at the inception of the lease. If the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased property, this criterion is not applicable. Note that later changes in estimates of the economic life do not give rise to a new classification of a lease for accounting purposes.

d) The present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90% of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him or her. If the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased property, this criterion is not applicable. A few definitions are important to remember when evaluating this criterion:

• The 'minimum lease payments' are the payments that the lessee is obligated to make or can be required to make in connection with the leased property. Generally, this simply includes the minimum rental payments called for by the lease over the lease term; however, any residual value guarantees made by the lessee and any penalty payments that the lessee must make upon failure to renew or extend the lease must also be included.
• The 'fair value of the leased property' is the price for which the property could be sold in an arm's length transaction between unrelated parties. Sales of property similar to the leased property are generally accepted as evidence of the fair value of the leased property. However, if there are no sales comparisons available, other evidence may be utilized in determining the leased property's fair value. For example, an independent appraisal of the leased property or replacement cost information may be used. There is no requirement to obtain an appraisal or similar valuation as a general matter, but FASB indicates that it is advisable to do so if: a) classification as a capital lease seems likely and b) the effects of capital lease classification would be significant to the financial statements of the lessee.
• The interest rate that the lessee is to use in the present value calculation is its incremental borrowing rate, unless: 1) it is practicable for the lessee to learn the implicit rate computed by the lessor, and 2) the implicit rate computed by the lessor is less than the lessee's incremental borrowing rate. The lessee's 'incremental borrowing rate' is the rate that, at the inception of the lease, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset. The 'implicit rate' in the lease is the rate implicit in the recovery of the fair value of the property at the inception of the lease through the minimum lease payments.

Sale-Leaseback Transactions

Sale-leasebacks are becoming increasingly popular with corporate lessees in an effort to free up cash and credit lines and enhance the balance sheet. Sale-leaseback accounting is a method of accounting for a sale-leaseback transaction in which the seller-lessee records the sale, removes all property and related liabilities from its balance sheet, recognizes gain or loss from the sale, and classifies the leaseback in accordance with the criteria set forth above. Sale-leaseback accounting only applies to sale-leaseback transactions involving real estate, property improvements, or integral equipment.

Sale-leaseback accounting shall be used by a seller-lessee only if a sale-leaseback transaction includes all of the following:

• A normal leaseback, which is defined as a lessee-lessor relationship that involves the active use of the property by the seller-lessee in consideration for payment of rent, including contingent rentals that are based on the future operations of the seller-lessee and excludes other continuing involvement provisions or conditions. The phrase 'active use of the property by the seller-lessee' refers to the use of the property during the lease term in the seller-lessee's trade or business, provided that subleasing of the leased back property is minor.
• Payment terms and provisions that adequately demonstrate the buyer-lessor's initial and continuing investment in the property.
• Payment terms and provisions that transfer all of the other risks and rewards of ownership as demonstrated by the absence of any other continuing involvement by the seller-lessee.

When evaluating whether the seller-lessee has 'continuing involvement,' the key question to ask is: Are the terms of the sale-leaseback transaction substantially different from terms that an independent third-party lessor or lessee would accept? The following are some examples of continuing involvement:

a) The seller-lessee has an obligation or an option to repurchase the property or the buyer-lessor can compel the seller-lessee to repurchase the property. A right of first refusal based on a bona fide offer by a third party ordinarily is not considered an obligation or an option to repurchase; however, an agreement that allows the seller-lessee to repurchase the asset in the event no third-party offer is made is an option to repurchase;

b) The seller-lessee guarantees the buyer-lessor's investment or a return on that investment for a limited or extended period of time;

c) The seller-lessee is required to pay the buyer-lessor, at the end of the lease term, for a decline in the fair value of the property below the estimated residual value on some basis other than excess wear and tear of the property levied on inspection of the property at termination of the lease;

d) The seller-lessee provides non-recourse financing to the buyer-lessor for any portion of the sales proceeds or provides recourse financing in which the only recourse is the leased asset;

e) The seller-lessee is not relieved of the obligation under any existing debt related to the property.

f) The seller-lessee provides collateral on behalf of the buyer-lessor, other than the property directly involved in the sale-leaseback transaction; the seller-lessee or a related party to the seller-lessee guarantees the buyer-lessor's debt, or a related party to the seller-lessee guarantees a return of or on the buyer-lessor's investment;

g) The seller-lessee's rental payment is contingent on some predetermined or determinable level of future operations of the buyer-lessor;

h) The seller-lessee enters into a sale-leaseback transaction involving property improvements or integral equipment without leasing the underlying land to the buyer-lessor;

i) The buyer-lessor is obligated to share with the seller-lessee any portion of the appreciation of the property;

j) Any other provision or circumstance that allows the seller-lessee to participate in any future profits of the buyer-lessor or the appreciation of the leased property.

A sale-leaseback transaction that does not qualify for sale-leaseback accounting because of any form of continuing involvement is to be accounted for by the deposit method or as a financing, whichever is appropriate (such methods are not discussed in this article).

Conclusion

Unless your corporate client is flush with cash and is not trying to increase the size of the company or enhance its performance, you can bet that operating leases are (or should be) important to it. When commencing the negotiation of a lease transaction, you should ask your client the following questions:

1) Do you have an internal policy mandating operating leases?

2) Does your credit facility prohibit the creation of debt and/or capital leases?

3) Do you want to enhance the company's performance by managing the balance sheet and the debt-to-equity ratio?

4) Are you in an acquisition mode and interested in preserving existing lines of credit and/or cash?

If your client answers 'yes' to any of the above questions, it is important to have an understanding of the requirements set forth in this article and to be able to spot the obstacles to operating lease treatment or sale-leaseback accounting early in the negotiation of the transaction. A preliminary check of the criteria set forth above should be done as soon as a proposal or letter of intent is received or sent. A final check (in conjunction with the client's accountant or financial adviser) should be done prior to signing a commitment or a lease agreement. If your clients have not already thought about these issues, they will be thankful that you did.

Michelle L. Barnett is an associate in the Corporate Practice Group of Seyfarth Shaw LLP (Atlanta office). Her practice concentrates in counseling public and private corporations on a variety of corporate issues, including financing and incentives. She can be reached at 404-881-5456 or [email protected].

Operating leases are becoming increasingly important to many corporate lessees for a variety of reasons. The primary reason a corporate lessee prefers operating leases to capital leases is for balance sheet management reasons. Operating leases, or 'true leases' ' as opposed to capital leases ' reduce the lessee's outstanding debt recorded on the balance sheet, which results in a better debt-to-equity ratio. The other motivations behind the corporate lessee's preference for operating lease treatment vary. For example, many corporate credit facilities have covenants preventing corporations from creating debt, which usually includes capital leases. Also, many companies want to preserve current lines of credit and cash for other ventures, such as the acquisition of a new business line.

This article provides the general rules you must know to evaluate a lease from an accounting perspective. It begins by setting forth the general rules of classifying a lease from the lessee's perspective, as provided by the Financial Accounting Standards Board ('FASB'). The article then sets forth the general requirements to qualify for sale-leaseback accounting, from the seller-lessee's perspective, also as provided by FASB.

General Rules

From the perspective of the lessee, there are only two ways to classify a lease ' either as an operating lease or as a capital lease. Generally, if the lease meets one or more of the following criteria, at the inception of the lease, the lessee must classify it as a capital lease:

a) The lease transfers ownership of the property to the lessee by the end of the lease term. This is met in situations in which the lease agreement provides for the transfer of title at or shortly after the end of the lease term, automatically or in exchange for the payment of a nominal fee.

b) The lease contains a bargain purchase option. A 'bargain purchase option' is an option that allows the lessee to purchase the leased property for a price that is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable.

c) The lease term is equal to 75% of the estimated economic life of the leased property. The 'estimated economic life' is the estimated remaining period during which the property is expected to be economically usable by one or more users, with normal repairs and maintenance, for the purpose for which it was intended at the inception of the lease. If the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased property, this criterion is not applicable. Note that later changes in estimates of the economic life do not give rise to a new classification of a lease for accounting purposes.

d) The present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90% of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him or her. If the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased property, this criterion is not applicable. A few definitions are important to remember when evaluating this criterion:

• The 'minimum lease payments' are the payments that the lessee is obligated to make or can be required to make in connection with the leased property. Generally, this simply includes the minimum rental payments called for by the lease over the lease term; however, any residual value guarantees made by the lessee and any penalty payments that the lessee must make upon failure to renew or extend the lease must also be included.
• The 'fair value of the leased property' is the price for which the property could be sold in an arm's length transaction between unrelated parties. Sales of property similar to the leased property are generally accepted as evidence of the fair value of the leased property. However, if there are no sales comparisons available, other evidence may be utilized in determining the leased property's fair value. For example, an independent appraisal of the leased property or replacement cost information may be used. There is no requirement to obtain an appraisal or similar valuation as a general matter, but FASB indicates that it is advisable to do so if: a) classification as a capital lease seems likely and b) the effects of capital lease classification would be significant to the financial statements of the lessee.
• The interest rate that the lessee is to use in the present value calculation is its incremental borrowing rate, unless: 1) it is practicable for the lessee to learn the implicit rate computed by the lessor, and 2) the implicit rate computed by the lessor is less than the lessee's incremental borrowing rate. The lessee's 'incremental borrowing rate' is the rate that, at the inception of the lease, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset. The 'implicit rate' in the lease is the rate implicit in the recovery of the fair value of the property at the inception of the lease through the minimum lease payments.

Sale-Leaseback Transactions

Sale-leasebacks are becoming increasingly popular with corporate lessees in an effort to free up cash and credit lines and enhance the balance sheet. Sale-leaseback accounting is a method of accounting for a sale-leaseback transaction in which the seller-lessee records the sale, removes all property and related liabilities from its balance sheet, recognizes gain or loss from the sale, and classifies the leaseback in accordance with the criteria set forth above. Sale-leaseback accounting only applies to sale-leaseback transactions involving real estate, property improvements, or integral equipment.

Sale-leaseback accounting shall be used by a seller-lessee only if a sale-leaseback transaction includes all of the following:

• A normal leaseback, which is defined as a lessee-lessor relationship that involves the active use of the property by the seller-lessee in consideration for payment of rent, including contingent rentals that are based on the future operations of the seller-lessee and excludes other continuing involvement provisions or conditions. The phrase 'active use of the property by the seller-lessee' refers to the use of the property during the lease term in the seller-lessee's trade or business, provided that subleasing of the leased back property is minor.
• Payment terms and provisions that adequately demonstrate the buyer-lessor's initial and continuing investment in the property.
• Payment terms and provisions that transfer all of the other risks and rewards of ownership as demonstrated by the absence of any other continuing involvement by the seller-lessee.

When evaluating whether the seller-lessee has 'continuing involvement,' the key question to ask is: Are the terms of the sale-leaseback transaction substantially different from terms that an independent third-party lessor or lessee would accept? The following are some examples of continuing involvement:

a) The seller-lessee has an obligation or an option to repurchase the property or the buyer-lessor can compel the seller-lessee to repurchase the property. A right of first refusal based on a bona fide offer by a third party ordinarily is not considered an obligation or an option to repurchase; however, an agreement that allows the seller-lessee to repurchase the asset in the event no third-party offer is made is an option to repurchase;

b) The seller-lessee guarantees the buyer-lessor's investment or a return on that investment for a limited or extended period of time;

c) The seller-lessee is required to pay the buyer-lessor, at the end of the lease term, for a decline in the fair value of the property below the estimated residual value on some basis other than excess wear and tear of the property levied on inspection of the property at termination of the lease;

d) The seller-lessee provides non-recourse financing to the buyer-lessor for any portion of the sales proceeds or provides recourse financing in which the only recourse is the leased asset;

e) The seller-lessee is not relieved of the obligation under any existing debt related to the property.

f) The seller-lessee provides collateral on behalf of the buyer-lessor, other than the property directly involved in the sale-leaseback transaction; the seller-lessee or a related party to the seller-lessee guarantees the buyer-lessor's debt, or a related party to the seller-lessee guarantees a return of or on the buyer-lessor's investment;

g) The seller-lessee's rental payment is contingent on some predetermined or determinable level of future operations of the buyer-lessor;

h) The seller-lessee enters into a sale-leaseback transaction involving property improvements or integral equipment without leasing the underlying land to the buyer-lessor;

i) The buyer-lessor is obligated to share with the seller-lessee any portion of the appreciation of the property;

j) Any other provision or circumstance that allows the seller-lessee to participate in any future profits of the buyer-lessor or the appreciation of the leased property.

A sale-leaseback transaction that does not qualify for sale-leaseback accounting because of any form of continuing involvement is to be accounted for by the deposit method or as a financing, whichever is appropriate (such methods are not discussed in this article).

Conclusion

Unless your corporate client is flush with cash and is not trying to increase the size of the company or enhance its performance, you can bet that operating leases are (or should be) important to it. When commencing the negotiation of a lease transaction, you should ask your client the following questions:

1) Do you have an internal policy mandating operating leases?

2) Does your credit facility prohibit the creation of debt and/or capital leases?

3) Do you want to enhance the company's performance by managing the balance sheet and the debt-to-equity ratio?

4) Are you in an acquisition mode and interested in preserving existing lines of credit and/or cash?

If your client answers 'yes' to any of the above questions, it is important to have an understanding of the requirements set forth in this article and to be able to spot the obstacles to operating lease treatment or sale-leaseback accounting early in the negotiation of the transaction. A preliminary check of the criteria set forth above should be done as soon as a proposal or letter of intent is received or sent. A final check (in conjunction with the client's accountant or financial adviser) should be done prior to signing a commitment or a lease agreement. If your clients have not already thought about these issues, they will be thankful that you did.

Michelle L. Barnett is an associate in the Corporate Practice Group of Seyfarth Shaw LLP (Atlanta office). Her practice concentrates in counseling public and private corporations on a variety of corporate issues, including financing and incentives. She can be reached at 404-881-5456 or [email protected].