synthetic lease

What Is a Synthetic Lease?

A synthetic lease is a financial instrument that companies use to finance assets without having to report them as capital expenses on the balance sheet. This special form of leasing is a blend of the features of both operating and capital leases. It allows businesses to keep certain assets and liabilities off their books, creating a more favorable financial appearance.

Understanding the Mechanics

In a synthetic lease, a special-purpose entity (SPE) is formed to hold the title of the asset. The company then leases the asset from the SPE. The main advantage of this arrangement is the tax benefit. The company can claim tax deductions for the lease payments as an operating expense while benefiting from the asset's use.

Relation to Financial Factoring

While synthetic leases and financial factoring are different financial tools, they share a common goal—to improve a company's cash flow and balance sheet. Financial factoring involves selling accounts receivable to a third party at a discount to quickly raise cash, whereas synthetic leasing provides a way to finance an asset without purchasing it outright.

Benefits of a Synthetic Lease

The benefits of a synthetic lease include improved cash flow management, retained capital, potential tax savings, and keeping large liabilities off the company's balance sheet. Additionally, it can provide more flexibility compared to traditional financing methods.

Considerations and Risks

Companies must consider the risks involved with synthetic leases. These can include complex set-up processes, the potential for increased costs over time, and scrutiny from tax authorities. It's critical to understand that while off-balance sheet financing like synthetic leases can make a company's financials look better short-term, they do not eliminate the obligation to pay for the asset.

Example of Synthetic Lease in Practice

Imagine a logistics company that needs a new warehouse but wants to avoid traditional financing. It sets up an SPE that purchases the warehouse. The company then enters into a synthetic lease with the SPE, gaining access to the warehouse while keeping the associated debt off its balance sheet. This way, the company enjoys the benefits of the asset without reporting significant capital expenses.