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

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

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?

I. GENERAL CONCEPTS

A. 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...

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