Question

One way to structure a lease to qualify it as an operating lease for the lessee, but as a capital lease for the lessor is to use different discount rates for the lessees and the lessors. State the other method to achieve the same goal.

I was thinking of Direct Financing lease but wouldn't that be a capital lease for lessee as well? I'm lost. Thankful for your help!

Answer 1

The key objective to be achieved here is to ensure that the lease is classified as an operating lease for the lesee but a capital lease for the lessor.

Apart from the approach mentioned in the question, other way to achieve the same objective is to estimate different useful lives for the same asset by both the entities. As per US GAAP, asset leased for more than 75% of its useful life is considered to be an asset under capital lease. Lessor and lessees, depending on their respective businesses and business models, may consider different useful lives for the same asset, for eg. in case of a car lease, the lessee may have a policy of not using car for more than 3 or 5 years for its top executives and therefore, the useful life of the car typically will be 3 or 5 years. However, the agency leasing such cars may use the car even after a period of 5 years for different purpose or different set of customer. Therefore, 2 entities, can have different useful lives for the same asset, which can be used as a structuring mechanism to achieve the objective stated in the question.

Direct finance lease:

Direct finance lease is a structure wherein an intermediary, typically a bank or a financing institution leases/purchases the asset from the primary manufacturer and sub leases it to the lessee. The intermediary earns differential rent and finance charges as income, as the rentals recovered from the lessee would be more than the rentals paid to the manufacturer, on account of finance charges. Considering that these assets are specifically leased for the lessee, and that the intermediary will have no use of these assets, such transactions typically have a transfer clause at the end of the contract and therefore, in essence, will become finance lease for the lessees.