Petrobanc Finance Blog

RNCOS, a market research firm, has released a report that says the U.S. convenience stores industry should register impressive growth between 2009-2013. Entitled “U.S. Convenience Stores Market Outlook to 2013,” the report projects convenience stores sales will grow at a compound annual growth rate of approximately 5 percent due to strong demand for motor fuel and increasing in-store sales. An overview of the report is available here.

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Many business owners pursue lease financing for desired accounting and tax treatment.  With a true (or operating) lease the property user can expense its monthly lease payment — allowing for a typically larger monthly write-off) — as opposed to depreciating the asset.  Also, with a true lease, the property user does not show the asset and corresponding liability on its balance sheet.  For some entities these are very important factors in its loan vs. lease decision process, but there are defined conditions that have to be met in order to treat the asset as leased property.

The Financial Accounting Standards Board (FASB) issued FASB Statement No. 13 Accounting for Leases (SFAS No. 13) to address the differences between these two types of financing.  SFAS No. 13 creates standards for financial accounting and reporting for leases by lessees and lessors.

For lessees, a lease is a financing transaction that becomes a “capital lease” (purchase/sale agreement) if it meets any one of four specified criteria; if not, it is an operating lease (usage or rental agreement). Capital leases are deemed as the acquisition of assets and the incurrence of obligations by the lessee.  Operating leases are treated as current operating expenses.

There are situations that can affect these guidelines but generally, FASB 13 states that a lease will be considered a capital lease if one or more of the following four criteria are met. If none of the following applies, the lease is then treated as an operating lease:
- The lease automatically transfers ownership of the property to the lessee by the end of the lease.
- The lease contains a bargain purchase option (usually 10% or less is considered a bargain).
- The lease term equals 75% or more of the estimated economic life of the property (determined by the IRS depreciation tables).
- The present value of the minimum lease payments (excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon) equals or exceeds 90% of the excess of the fair value of the leased property to the lessor.  The leased property is recorded at the total cost net of interest expense (the present value at the inception of the lease).

The fourth point is often the most difficult to determine.  The lessee must know its incremental borrowing rate to calculate the 90% present value measurement.  One must understand that the rate (and term) that the lessee typically borrows from its bank for most assets may not be the same as the bank would provide for this particular leased asset.  The Lessee’s Incremental Borrowing Rate is defined as:  The “rate that, at the inception of the lease, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset.”
The property user should calculate the present value of the guaranteed payment stream using its true incremental borrowing rate (not the rate of the lease).  If the borrower is obligated to make 48 payments of $1,000 (factoring in if the payments are to be made in advance or arrears, usually with a lease, it is in advance) and had an 8.5% incremental borrowing rate, the present value of that payment stream is $40,858.12.  The property must cost $45,398 or more at the lease’s inception (and, of course, none of the other three conditions have been met) for this to be given operating lease treatment by FASB.

If it is important to have operating lease treatment, an experienced lessor should be able to help a lessee achieve this goal.  If the lessor cannot, then they are unwilling to take sufficient risk on the property’s residual value (meaning that they feel that the property will not be worth much at the end of the lease so, in essence, you might as well pursue a loan or “$1-out” lease with this lessor).  If the lessor specializes in this type of property and has been in the industry for some length of time you should respect their opinion, if they are not familiar with this type of property, the lender may fear overestimating the residual value at lease termination and being underwater on their investment.

A well structured operating lease may be in the best interest of many property users, but entities should understand how FASB will view their property acquisition before they enter into any lease.

Author: Ted Smith

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