Synthetic Lease

Unlocking the Mechanics of Synthetic Leases

Demystifying Synthetic Leases

Understanding Synthetic Leases: A synthetic lease is a financial arrangement wherein a special purpose entity, typically established by the operating or parent company, acquires an asset and then leases it back to the operating company. This innovative lease structure is favored by publicly traded companies aiming to enhance their debt to equity ratios, as it allows the asset to be reflected off the balance sheet of the parent company while still being utilized by the operating entity.

Delving into How Synthetic Leases Operate

Operational Mechanism: In a synthetic lease setup, the special purpose entity treats the lease as a capital lease for tax purposes and records depreciation expenses against its earnings. This arrangement essentially enables a company to lease an asset to itself. However, the asset is not included on the balance sheet of the parent company; instead, it is treated as an operating lease, with lease payments recognized as expenses on the income statement.

Key Insights into Synthetic Leases

Ownership Discrepancy: While the lessor technically owns the asset for accounting purposes, the lessee enjoys ownership benefits for tax purposes, allowing for depreciation deductions.
Financial Impact: Depreciation of the asset under the synthetic lease does not impact the net income of the lessee, creating a more favorable financial standing.
Regulatory Landscape: Synthetic leases experienced a decline post-Enron crisis due to regulatory tightening but are now witnessing a resurgence among entities equipped to navigate the revised regulatory environment.

Advantages Offered by Synthetic Leases

Sophisticated Financing: Synthetic leases present advanced financing options while affording benefits such as depreciation recognition without asset inclusion on the lessee's balance sheet.
Tax Efficiency: Lessees can claim interest and depreciation deductions for tax purposes, enhancing financial flexibility and shareholder appeal.
Operational Autonomy: Lessees retain full control over asset selection, construction, and improvements, alongside relatively lower lease payments compared to conventional leases.

Comparing Traditional and Synthetic Leases