What Is a Synthetic Lease?
A synthetic lease is an off-the-balance sheet operating lease whereby a special purpose entity, established by the operating or parent company, purchases an asset and then leases it back to the operating company. The synthetic lease is popular among publicly traded companies that seek to improve debt to equity ratios as the asset is shown on the balance sheet of the special purpose entity and expensed on the parent/operating company's income statement.
How a Synthetic Lease Works
With a synthetic lease, the special purpose entity treats the lease as a capital lease for tax purposes and charges depreciation expense against its earnings. Essentially, the synthetic lease allows a company to lease an asset to itself. However, the asset does not show up on the balance sheet of the parent company. Instead, the parent company treats it as an operating lease for accounting purposes, recording it as an expense on the income statement.
- A synthetic lease is an operating lease in which a special purpose entity, owned by a parent company, purchases an asset and leases it to the operating company.
- The asset is owned by the lessor for accounting purposes but is owned by the lessee for tax purposes.
- For the parent company/lessee, the depreciation of the asset does not affect net income, as shown in the income statement.
- The lessee can, however, claim depreciation deductions for tax purposes.
The structure of the synthetic lease allows a company to control real estate without being required to show the real estate as an asset on the financial statements. After the Enron crisis, laws tightened and the prevalence of synthetic leases waned. However, they are making a comeback for entities that have the resources to navigate the new regulatory landscape.
Benefits of Synthetic Leases
Synthetic leases provide sophisticated financing options, as well as other benefits. The real property is not recorded on the balance sheet of the operating company, yet depreciation benefits are recognized. For tax purposes, the lessee is recognized as the owner, which enables it to claim deductions for interest (interest portion of lease payments) and depreciation. However, because the property is not an asset of the lessee/operating company, its depreciation will not reduce net income on their income statement, creating a more favorable position with shareholders and potential investors. Under a synthetic lease, the lessee has the freedom to select the asset and make executive decisions regarding its construction and improvements; also, lease payments are relatively low compared to those of a conventional lease. Overall, the lessee benefits from improved financial ratios, tax benefits, and full control over how the asset is used: a best of both worlds scenario.
Traditional Lease vs. Synthetic Lease
Under a traditional lease, the lessor retains full control over how the property is used and is usually responsible for improvements; however, some lease provisions permit lessees to make alterations to the property to suit business needs. All benefits, expenses, and responsibilities (e.g., taxes) associated with asset ownership are assumed by the lessor. Simply, the lessor is the owner for tax and accounting purposes. The lessee has no interest in the property other than what is given by the operating lease.