Sale-leaseback agreements can be attracting business looking for a liquidity increase or a method to manage their debt ratio.
However, for accountants, they can also be complex to evaluate and determine whether a sale has actually happened.
So how exactly does sale-leaseback accounting work?
This post covers everything you need to understand about these deals, consisting of the meaning of sale-leaseback, benefits and drawbacks, and accounting examples.
What is a sale-leaseback?
A sale-leaseback (a.k.a. sale and leaseback) deal takes place when the owner of a possession sells it, then rents it back through a long-lasting lease. The original owner ends up being the seller-lessee, and the purchaser of the possession becomes the buyer-lessor.
While this transaction doesn't impact the operational use of the property by the seller-lessee, it does have various accounting results for both celebrations. The seller-lessee can continue using the property, however legal ownership is moved to the buyer-lessor.
Discover more about the duties of lessors and lessees.
What is the function of a sale-leaseback?
The most typical reasons to enter a sale-leaseback contract are to raise capital, enhance the balance sheet, or acquire tax benefits. The seller-lessee is generally looking for to release the cash kept in the value of a residential or commercial property or possession for other purposes however does not want to compromise their ability to use the asset.
Purchasers who enter into these agreements are usually institutional investors, renting business, or financing companies pursuing an offer that has a safe return as the buyer-lessor.
Sale-leasebacks are typically seen in industries with high-cost set assets, such as building, transportation, genuine estate, and aerospace.
How does a sale-leaseback work?
In a sale-leaseback contract, ownership is moved to the buyer-lessor, while the seller-lessee continues to use the asset. For instance:
- An energy business can sell the possessions that comprise their solar-power system to a funding business, then immediately lease it back to operate and fulfill the demand of clients.
- Construction business can sell their property residential or commercial properties and after that immediately rent them back from the buyer to establish them.
- Aviation companies regularly sell their airplane to an air travel financing organization and instantly rent them back with no time out in their regular regimen.
- Real estate companies typically have sale-leaseback programs that provide homeowners more versatility than a standard home sale. Equity in the home can quickly be transformed into cash by the seller-lessee, and mortgage brokers access to a broader consumer base as the buyer-lessor. These deals are also referred to as "sell and remain" arrangements.
Advantages and disadvantages of sale-leasebacks
Sale-leaseback deals have the flexibility to be structured in different manner ins which can benefit both celebrations. Obviously, there are also threats involved in this kind of arrangement that both celebrations should assess, along with company and tax implications.
Good understanding of the benefits and drawbacks is an essential element when defining the contract. Let's have a look at the pros and cons for each party.
Pros for the seller-lessee:
- They get the alternative to broaden their service or buy new devices with the influx of cash while maintaining everyday access to the asset.
- It's a more economical way to obtain funds compared to loan financing, thus enhancing the balance sheet.
- They can invest cash in other venues for a greater return, therefore enhancing the earnings and loss statement (P&L).
- Sale-leaseback enables for the full deductibility of lease payments with the transfer of tax ownership to the buyer-lessor.
- There's limited danger due to property volatility.
Cons for the seller-lessee:
- The owned asset is removed from the balance sheet.
- The right of use (ROU) asset increases, depending upon the lease term and agreed-upon lease payments surpassing fair-market worth.
- They need to acknowledge capital gains.
Pros for the buyer-lessor:
- Rental earnings over the life of the lease reinforces their monetary position.
- They can ensure that lease terms are crafted to fit their needs.
- They have more control over roi (ROI) based on the conditions described in the arrangement.
- They can reclaim the property if the seller-lessee defaults on payments.
Cons to the buyer-lessor:
- They must renegotiate contracts if the seller-lessee defaults on lease payments.
- They're the primary creditor/owner if the seller-lessee apply for insolvency.
- There's a threat that the property value might reduce faster than the forecasted market and become impaired.
How to determine if a deal qualifies as a sale-leaseback
To qualify as a sale-leaseback, a transaction must satisfy a number of criteria. When examining the contract under ASC 842, entities must apply ASC 606 (profits from agreements with customers) to determine whether the sale of an asset has actually occurred. There is a considerable quantity of judgement that enters into this process, and it is great practice to have an auditor evaluation the information and intricacies of the offer.
Let's review the process action by action.
1. Determine if there's an agreement
First, you must figure out if there is a contract as discussed in ASC 606-12-25-1 through 8.
Essentially, any arrangement that develops legally enforceable rights and obligations typically fulfills the definition of a contract. Contracts can be oral, composed, or suggested by an entity's traditional business practices.
2. Asses if there's a sale
Assess from an accounting point of view if there is a sale or a funding agreement.
The main question is if control has actually moved from the seller to the purchaser, for that reason fulfilling the efficiency commitment. If the answer is yes, then a sale has taken place. Otherwise, the failed sale is dealt with as a funding plan.
ASC 842 referrals ASC 606-10-25-30 for a list of signs showing that control has been transferred to the buyer-lessor. The five control signs are:
1. The reporting entity has a present right to payment; the buyer-lessor has a present responsibility to pay the seller-lessee.
1. The consumer has a legal title.
1. The client has physical ownership.
1. The customer has substantial threats and rewards of ownership.
1. The client has actually accepted the possession.
This is where judgment will be required to examine, generally from the buyer-lessor's position, if control has actually been transferred. It is not needed that all the indications be met to draw this conclusion. However, it is required that both the seller-lessee and buyer-lessor perform this evaluation independently.
It is possible that while the actions to evaluate control equal for both celebrations, each can pertain to a different conclusion that would affect the occurrence of a certified sale.
For instance, parties might make differing assumptions concerning factors such as the financial life, fair value of the possession, or the discount rate that would affect the lease classification decision.
If the seller-lessee classifies the lease as a financing lease or the buyer-lessor classifies the lease as a sales-type lease, then the test for control has actually stopped working. The transaction should then follow accounting treatment for a financing transaction. Even though the seller-lessee no longer lawfully owns the asset, they would keep it on their books. The proceeds would be considered a financing liability.
Compliance for sale-leaseback deals
Accounting for sale-leasebacks is relatively the same by the transition from ASC 840 to ASC 842.
If a transaction was previously accounted for as a sale-leaseback under ASC 840, it does not require to be reassessed to determine whether it would have likewise qualified as a sale (or purchase) under ASC 842. The lease element of any deal that certified as a sale-lease back must be accounted for by both the lessees and lessors in accordance with shift requirements.
See ASC 842-10-65-1 for assistance on postponed gain or loss balances after transition depending upon the lease category.
Any transactions that were represented as a stopped working sale-leaseback under ASC 840 must be reassessed under the new lease requirement. Seller-lessees require to identify if a sale would have taken place either:
1. At any point on or after the beginning period of the earliest duration provided in the financial statement under ASC 842 (if a reporting entity elects to adjust comparative periods).
1. At the effective date (if a reporting entity chosen to not adjust relative durations).
If a sale would have occurred, the sale-leaseback ought to be accounted for according to the lease transition guidance in ASC 842-10-65-1 on a customized retrospective basis from the date a sale is determined to have actually happened.
Buyer-lessors, nevertheless, do not need to reevaluate successful purchases formerly recorded considering that the sale-leaseback design of ASC 840 did not use to lessors. In this scenario, buyer-lessors should represent the leaseback in compliance with regular lessor shift guidance.
How to represent sale-leasebacks under ASC 842
If the deal fulfills 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 money received and the book worth of the asset when the buy-lessor takes control of the possession.
- Derecognize the asset, removing it from the balance sheet.
- Calculate and recognize the associated lease liability and ROU possession for leaseback in accordance with ASC 842.
The buyer-lessor need to likewise decide whether the deal resulted in a business combination as per ASC 805 or a property acquisition. An asset acquisition can be taped based on ASC 350: Residential Or Commercial Property, Plant & Equipment (PP&E). The evaluation of the possession must amount to the fair-market value different from the leaseback agreement. The contract must then be recognized as any other lease agreement.
To sum up, ASC 842-40-25-4 gives the following guidance on how to account for the sale-leaseback.
The seller-lessee will: - Recognize the transaction rate when the buyer-lessor acquires control of the possession
- Derecognize the underlying possession amount.
The buyer-lessor shall: - Represent the property purchase.
- Recognize the lease in accordance with ASC 842-30.
How to adjust for off-market terms
Accountants should take additional steps to adjust for off-market terms. Per ASC 842-40-30-1, the primary step is to determine whether the sales cost is at reasonable value utilizing one of the following approaches, depending upon the info offered:
- Comparison of the price of the possession vs. the fair worth of the possession.
- Comparison of today worth of the lease payments vs. today worth of market rental payment
If there is a difference, the sale-leaseback should be changed to reflect the fair-market worth of the asset according to ASC 842-40-30-2.
If the price is below reasonable value, the difference is taped as pre-paid lease. If the sale price of the property is above fair worth, the excess is considered extra financing, different from the lease liability, gotten from the buyer-lessor.
To summarize, if there is a balance in between the sale price and the reasonable value, the seller-lessee requirements to adjust the effect of the deal:
List price is lower than reasonable worth: Make a modification to increase the list prices through an increase (debit) to prepaid lease (shown in the seller-lessee's preliminary measurement of the ROU asset).
List price is greater than fair value: Make a modification to decrease the list prices through a boost (credit) to additional 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 offers among 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 sale price is lower than fair value and higher than fair worth.
List price or lease payments are lower than reasonable worth
Let's say the seller-lessee sold the possession at a discount rate or less than market value. Thus, they must acknowledge the difference and change for it with the right-of-use possession amount for lease accounting.
- Asset sale quantity: $78.5 million.
- Fair-market value: $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% rate of interest is $32,482,810. The difference in the market worth and sales price is $5.5 M.
Sale price or lease payments are higher than fair value
Now, let's state the seller-lessee sold the property at a premium or more than market value.
- Asset sale quantity: $86 million.
- Fair market value: $84 million.
- Lease duration: 18 years.
- Annual lease payment = $3 million.
- Rate of interest: 6%.
The ROU present value of $3 million for 18 years at 6% rates of interest is $32,482,810. The distinction in the market worth and list prices is $2 million.
Blue Sky Airlines will tape-record the following journal entries for this deal.
Note: PP&E is tape-recorded at bring value with the seller-lessee. Gain on the sale is the distinction in the sale price ($ 86M) and the bring worth ($ 80M) of the asset less the off-market adjustment ($ 2M).
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