Fair Market Value
Fair Market Value is defined as, a subjective estimate of what a willing buyer would pay a willing seller for a given asset assuming both have a reasonable knowledge of the asset’s worth.
Of all of the unknowns in equipment leasing, this is by far the biggest, which means that it can hurt you the most. The reason for that is because the fair market value of the equipment may be different in 3 years than what it would be right now. So if you decide to purchase a piece of equipment with a fair market value buyout, you will not know for certain what that buyout will be until the lease term is up. One other important factor to consider about fair market value is that it can only be determined after both parties agree. So in a case where neither party will budge on what they believe the value to be, then a long and expensive negotiation will take place.
Keep in mind that choosing a fair market value buyout leaves the end of term as a question mark, and if the lease term is short enough, the FMV will never be a bargain purchase option. Using this end of term will strengthen your case that your lease qualifies as a true operating lease.
Fair Market Value with Restrictions
So you want to be certain that your lease will qualify as an operating lease, but you don’t want the question mark of how much you will be paying at the end of term to be so BIG. A common end of term option for this type of scenario is to have a fair market value with a floor or a ceiling. The way this would read on paper for a floor would be,
Fair Market Value with a Floor
“The lessee has an option to purchase the equipment at the end of the lease term for its’ fair market value, not to be less than 20%”
In this scenario, the agreement is stating that the equipment’s fair market value will be greater than 20% of the equipment cost, but no less. This is generally going to favor the lessor because they are guaranteeing a minimum amount of money they will get back at the end of term. When the lessor is calculating their profitability in this scenario, they are assuming the worst-case scenario of being paid 20% for the equipment. So anything they negotiate above the 20% is pure gravy for them. Let’s look at the opposite, a ceiling,
Fair Market Value with a Ceiling
“The lessee has an option to purchase the equipment at the end of the lease term for its’ fair market value, not to be more than 20%”
Any time a ceiling is in place, the odds are in the favor of the lessee to negotiate a better deal. The reason for this is that the worst-case scenario for the lessee is that they will have to pay the high-end. But when it comes to negotiating the end of term, the lessee is in the driver’s seat. The determined value can only go down. This type of end of term will be difficult to negotiate up front because the lessor understands the risks involved.
The downside to this type of end of term is that it may not qualify as an operating lease if it is in place. The reason for this is that even though the agreement states that this lease has a fair market value, it has a ceiling. There is a chance that the price can be negotiated lower than the ceiling and if it is determined that price is a “bargain purchase price” then you have yourself a capital lease. Some people want the best of both worlds, so they will have the lease written as:
“the lessee has an option to purchase the equipment at the end of the lease term for its’ fair market value, to be equal to 20%”
Well, what’s the issue here? A fair market value for the equipment is determined before the lease term even begins. From an accounting standpoint, this can go either way. While the words “fair market value” are placed in the end of term lingo, we all know what this really is, a fixed buyout. If the fixed buyout is large enough to still pass all of the tests of FASB 13 to qualify as an operating lease then you should be ok. If it is not, then you have nothing more than a capital lease. In this scenario, the words, “fair market value” really don’t need to be in the sentence. Some lessee’s and their accountants prefer to have them in there to strengthen their argument to the IRS (if need be) that they have an operating lease. But what’s the big deal anyway, why would a CPA want an operating lease so bad?
