Sale-leaseback arrangements can be interesting companies looking for a liquidity boost or a strategy to manage their debt ratio.
However, for accounting professionals, they can also be complex to evaluate and figure out whether a sale has happened.
So how precisely does sale-leaseback accounting work?
This post covers everything you require to understand about these transactions, including the meaning of sale-leaseback, advantages and disadvantages, and accounting examples.
What is a sale-leaseback?
A sale-leaseback (a.k.a. sale and leaseback) transaction happens when the owner of a property sells it, then rents it back through a long-term lease. The initial owner ends up being the seller-lessee, and the buyer of the asset ends up being the buyer-lessor.
While this transaction does not impact the functional usage of the property by the seller-lessee, it does have different accounting outcomes for both celebrations. The seller-lessee can continue using the property, however legal ownership is transferred to the buyer-lessor.
Learn more about the obligations of lessors and lessees.
What is the purpose of a sale-leaseback?
The most common reasons to go into a sale-leaseback agreement are to raise capital, improve the balance sheet, or gain tax benefits. The seller-lessee is normally seeking to free the cash saved in the value of a residential or commercial property or property for other functions however does not wish to compromise their capability to use the asset.
Purchasers who participate in these contracts are usually institutional financiers, leasing business, or financing companies pursuing an offer that has a safe and secure return as the buyer-lessor.
Sale-leasebacks are typically seen in industries with high-cost fixed assets, such as building, transportation, property, and aerospace.
How does a sale-leaseback work?
In a sale-leaseback arrangement, ownership is transferred to the buyer-lessor, while the seller-lessee continues to use the possession. For instance:
- An energy business can sell the properties that comprise their solar-power system to a financing company, then instantly lease it back to work and fulfill the demand of clients.
- Construction companies can offer their realty residential or commercial properties and after that quickly rent them back from the purchaser to develop them.
- Aviation companies regularly sell their aircraft to an air travel financing organization and immediately rent them back without any pause in their regular routine.
- Real estate companies typically have sale-leaseback programs that give homeowners more flexibility than a traditional home sale. Equity in the home can quickly be transformed into cash by the seller-lessee, and mortgage brokers get to a broader customer base as the buyer-lessor. These deals are likewise known as "sell and remain" arrangements.
Advantages and disadvantages of sale-leasebacks
Sale-leaseback deals have the versatility to be structured in numerous ways that can benefit both celebrations. Naturally, there are likewise risks associated with this type of arrangement that both parties need to examine, in addition to organization and tax ramifications.
Mutual understanding of the benefits and drawbacks is an essential element when specifying the agreement. Let's take an appearance at the benefits and drawbacks for each celebration.
Pros for the seller-lessee:
- They get the alternative to broaden their business or buy new equipment with the influx of cash while keeping daily access to the possession.
- It's a more economical way to get funds compared to loan funding, hence enhancing the balance sheet.
- They can invest money in other places for a greater return, therefore enhancing the profit and loss statement (P&L).
- Sale-leaseback permits the complete deductibility of lease payments with the transfer of tax ownership to the buyer-lessor.
- There's restricted risk due to asset volatility.
Cons for the seller-lessee:
- The owned property is gotten rid of from the balance sheet.
- The right of usage (ROU) asset increases, depending upon the lease term and agreed-upon lease payments surpassing fair-market value.
- They should acknowledge capital gains.
Pros for the buyer-lessor:
- Rental income over the life of the lease reinforces their financial position.
- They can make sure that lease terms are crafted to fit their requirements.
- They have more control over return on financial investment (ROI) based on the conditions described in the contract.
- They can repossess the possession if the seller-lessee defaults on payments.
Cons to the buyer-lessor:
- They need to renegotiate contracts if the seller-lessee defaults on lease payments.
- They're the primary creditor/owner if the seller-lessee apply for personal bankruptcy.
- There's a risk that the property worth may decrease faster than the forecasted market and end up being impaired.
How to determine if a deal qualifies as a sale-leaseback
To qualify as a sale-leaseback, a transaction must fulfill a number of criteria. When assessing the contract under ASC 842, entities must apply ASC 606 (profits from agreements with consumers) to figure out whether the sale of an asset has actually happened. There is a substantial quantity of judgement that enters into this procedure, and it is good practice to have an auditor review the information and intricacies of the offer.
Let's go over the procedure action by step.
1. Determine if there's an agreement
First, you need to figure out if there is an agreement as discussed in ASC 606-12-25-1 through 8.
Essentially, any contract that produces lawfully enforceable rights and obligations normally fulfills the meaning of an agreement. Contracts can be oral, composed, or suggested by an entity's traditional service practices.
2. Asses if there's a sale
Assess from an accounting perspective if there is a sale or a financing contract.
The primary question is if control has transferred from the seller to the buyer, for that reason satisfying the efficiency commitment. If the answer is yes, then a sale has actually taken place. Otherwise, the unsuccessful sale is treated as a funding arrangement.
ASC 842 references ASC 606-10-25-30 for a list of indications indicating that control has actually been transferred to the buyer-lessor. The 5 control signs are:
1. The reporting entity has a present right to payment; the buyer-lessor has a present commitment to pay the seller-lessee.
1. The customer has a legal title.
1. The client has physical possession.
1. The customer has significant risks and benefits of ownership.
1. The client has actually accepted the property.
This is where judgment will be necessary to evaluate, mainly from the buyer-lessor's position, if control has been transferred. It is not required that all the indications be satisfied to draw this conclusion. However, it is needed that both the seller-lessee and buyer-lessor perform this evaluation separately.
It is possible that while the actions to examine control equal for both celebrations, each can pertain to a different conclusion that would impact the occurrence of a certified sale.
For instance, parties might make differing assumptions concerning aspects such as the financial life, reasonable worth of the possession, or the discount rate that would affect the lease category determination.
If the seller-lessee classifies the lease as a finance lease or the buyer-lessor categorizes the lease as a sales-type lease, then the test for control has failed. The transaction ought to then follow accounting treatment for a funding deal. Even though the seller-lessee no longer lawfully owns the possession, they would keep it on their books. The earnings would be thought about a funding liability.
Compliance for sale-leaseback deals
Accounting for sale-leasebacks is reasonably the same by the transition from ASC 840 to ASC 842.
If a deal was previously accounted for as a sale-leaseback under ASC 840, it does not need to be reassessed to determine whether it would have likewise certified as a sale (or purchase) under ASC 842. The lease component of any transaction that certified as a sale-lease back needs to be represented by both the lessees and lessors in accordance with transition requirements.
See ASC 842-10-65-1 for assistance on deferred gain or loss balances after shift depending on the lease classification.
Any transactions that were represented as a failed sale-leaseback under ASC 840 need to be reassessed under the brand-new lease requirement. Seller-lessees require to identify if a sale would have taken place either:
1. At any point on or after the start period of the earliest duration presented in the monetary declaration under ASC 842 (if a reporting entity elects to adjust relative periods).
1. At the reliable date (if a reporting entity elected to not change comparative durations).
If a sale would have happened, the sale-leaseback should be accounted for according to the lease shift guidance in ASC 842-10-65-1 on a modified retrospective basis from the date a sale is figured out to have happened.
Buyer-lessors, nevertheless, do not need to review effective purchases previously tape-recorded given that the sale-leaseback model of ASC 840 did not use to lessors. In this circumstance, buyer-lessors ought to represent the leaseback in compliance with regular lessor transition guidance.
How to account for sale-leasebacks under ASC 842
If the deal satisfies the requirements under ASC 842 to certify as a sale-leaseback, then the seller-lessee will:
- Recognize the sale and any gain or loss-the difference between the cash received and the book worth of the asset when the buy-lessor takes control of the property.
- Derecognize the property, removing it from the balance sheet.
- Calculate and acknowledge the associated lease liability and ROU property for leaseback in accordance with ASC 842.
The buyer-lessor need to likewise choose whether the transaction led to a business combination according to ASC 805 or an asset acquisition. An asset acquisition can be recorded based on ASC 350: Residential Or Commercial Property, Plant & Equipment (PP&E). The assessment of the property need to amount to the fair-market worth separate from the leaseback agreement. The contract must then be acknowledged as any other lease agreement.
To sum up, ASC 842-40-25-4 provides the following guidance on how to represent the sale-leaseback.
The seller-lessee will: - Recognize the transaction cost when the buyer-lessor acquires control of the property
- Derecognize the underlying possession amount.
The buyer-lessor will: - Represent the possession purchase.
- Recognize the lease in accordance with ASC 842-30.
How to change for off-market terms
Accountants must take additional steps to change for off-market terms. Per ASC 842-40-30-1, the first step is to figure out whether the prices is at reasonable value using among the following methods, depending upon the details readily available:
- Comparison of the price of the asset vs. the fair worth of the asset.
- Comparison of today value of the lease payments vs. today value of market rental payment
If there is a difference, the sale-leaseback must be gotten used to show the fair-market worth of the asset according to ASC 842-40-30-2.
If the list price is below fair value, the difference is recorded as prepaid lease. If the list price of the property is above reasonable value, the excess is thought about extra financing, different from the lease liability, gotten from the buyer-lessor.
To sum up, if there is a balance between the list price and the reasonable worth, the seller-lessee requirements to adjust the impact of the deal:
List price is lower than fair worth: Make a modification to increase the sales price through an increase (debit) to pre-paid lease (reflected in the seller-lessee's preliminary measurement of the ROU property).
Sale rate is higher than reasonable worth: Make a change to reduce the list prices through a boost (credit) to extra financing liability.
Sale-leaseback accounting examples
Now that we understand the theory, let's go through a practical example of how sale-leaseback accounting works.
Suppose Blue Sky Airlines sells one of its Boeing planes to ABC Aviation. Blue Sky Airlines is the seller-lessee and ABC Aviation is the buyer-lessor. Let's see what it looks like if the list price is lower than reasonable worth and greater than reasonable worth.
List price or lease payments are lower than reasonable worth
Let's state the seller-lessee sold the asset at a discount or less than market price. Thus, they must acknowledge the distinction and adjust for it with the right-of-use possession amount for lease accounting.
- Asset sale quantity: $78.5 million.
- Fair-market value: $84 million.
- Lease duration: 18 years.
- Annual lease payment: $3 million.
- Interest rate: 6%.
The ROU present worth of $3 million for 18 years at 6% rate of interest is $32,482,810. The difference in the market worth and prices is $5.5 M.
Price or lease payments are higher than fair value
Now, let's say the seller-lessee sold the asset at a premium or more than market price.
- Asset sale quantity: $86 million.
- Fair market worth: $84 million.
- Lease period: 18 years.
- Annual lease payment = $3 million.
- Rate of interest: 6%.
The ROU present worth of $3 million for 18 years at 6% interest rate is $32,482,810. The distinction in the market value and prices is $2 million.
Blue Sky Airlines will record the following journal entries for this deal.
Note: PP&E is recorded at bring worth with the seller-lessee. Gain on the sale is the distinction in the price ($ 86M) and the bring value ($ 80M) of the property less the off-market modification ($ 2M).
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