What it means
In a synthetic lease the company, called the lessee, chooses an asset it wants to use. A special purpose entity, which is a company created only for this deal, buys the asset using money from lenders and a small amount of equity.
The entity then leases the asset to the company. The structure was designed to give two different treatments.
For accounting, the lease was classified as an operating lease, so the asset and the borrowing stayed off the company's balance sheet. For tax, the company was treated as the owner, so it could claim depreciation and deduct the interest portion of the rent.
The attraction was financial reporting. Debt that sits off the balance sheet makes leverage ratios, which compare debt with equity or earnings, look healthier.
Companies could therefore borrow for property and equipment while appearing less indebted to lenders and investors. Concerns grew after the accounting scandals of the early 2000s, when off-balance-sheet structures were associated with hidden risk.
Rules on consolidating special purpose entities were tightened, and lease accounting standards were later overhauled so that most leases now appear on the balance sheet. The accounting advantage that drove synthetic leases has therefore largely gone.
The structure still appears in forms that suit the tax outcome, and analysts routinely adjust reported debt to include lease obligations. For managers, the main lessons are to look beyond the reported balance sheet when judging a company's real borrowing, and to read the notes where lease commitments are disclosed.
Related structures show up under different names, so it helps to recognise the family resemblance. A sale and leaseback, in which a company sells an asset and rents it back, is the simplest version and is fully visible on the balance sheet under modern lease accounting.
A build-to-suit lease, where a developer constructs a facility for a tenant, can create similar questions about who really owns the asset and bears the risk.
In practice
Real-world examples.
Example
A retailer needs a new $25,000,000 distribution centre. It uses a synthetic lease so that the building does not appear as debt, and its credit adviser later adds the commitment back when analysing the company.
Example
An analyst reviewing a manufacturer's accounts notices a note describing a synthetic lease on its main plant. She adds the lease payments to debt and finds that interest cover, which is profit divided by interest, is lower than the company reports.
Example
A bank considers a loan to a technology firm and asks for details of all off-balance-sheet lease structures. The credit team wants to understand the full set of fixed payments before approving a facility.
Formula
Calculation
Debt-to-equity ratio = Total debt / Total equity
Suppose a company has reported debt of $50,000,000, equity of $100,000,000, and a $40,000,000 synthetic lease that sits off the balance sheet.
Reported debt-to-equity = $50,000,000 / $100,000,000 = 0.50
Economic debt-to-equity = ($50,000,000 + $40,000,000) / $100,000,000 = 0.90
The off-balance-sheet lease makes the company look much less indebted than its economic position suggests. Lenders and analysts normally add such commitments back, so the true gearing is 0.90, which is 0.40 higher than reported.Case study
Seen in the real world.
Ashgrove Retail is an illustrative, fictional chain that wanted to expand without breaching a loan covenant limiting debt to 0.6 times equity. Its reported debt was $60,000,000 against equity of $120,000,000, a ratio of 0.50.
The finance team arranged a synthetic lease for a $30,000,000 distribution centre. The reported ratio stayed at 0.50, while the economic ratio would have been ($60,000,000 + $30,000,000) / $120,000,000 = 0.75, which is above the covenant limit.
In the illustrative sequel, the lenders learned of the structure during a review and required that it be counted in the covenant test, and the company had to renegotiate its loans on less favourable terms. The episode showed how an arrangement that looks clever on paper can damage trust.
Watch out
Common mistakes.
- Reading reported debt as the full picture, when off-balance-sheet commitments can add significantly.
- Assuming the accounting and tax treatments are identical, when a synthetic lease was built to get different results for each.
- Thinking that a synthetic lease removes the obligation to pay, when the rent is a binding commitment.
Questions
People also ask.
Why was it called synthetic?
Because it combined features of a lease and a loan to create a hybrid result that did not exist in either alone.
Are synthetic leases still allowed?
Structures of this kind still exist, but accounting changes mean they no longer give the same balance sheet benefit.
How do analysts treat them?
They usually add the lease obligations back to debt and adjust ratios to reflect the true level of borrowing.
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