Sale-leaseback agreements can be interesting business looking for a liquidity increase or a strategy to manage their debt ratio.
However, for accounting professionals, they can also be complicated to examine and determine whether a sale has actually happened.
So how exactly does sale-leaseback accounting work?
This post covers whatever you require to understand about these deals, including 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 becomes the seller-lessee, and the purchaser of the possession ends up being the buyer-lessor.
While this transaction doesn't impact the operational usage of the property by the seller-lessee, it does have different accounting results for both celebrations. The seller-lessee can continue utilizing the asset, but legal ownership is moved to the buyer-lessor.
Find out 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 arrangement are to raise capital, improve the balance sheet, or get tax advantages. The seller-lessee is usually looking for to release the money kept in the worth of a residential or commercial property or asset for other purposes however does not wish to compromise their ability to use the asset.
Purchasers who get in into these arrangements are typically institutional investors, leasing companies, or finance companies pursuing a deal that has a secure return as the buyer-lessor.
Sale-leasebacks are frequently seen in markets with high-cost fixed assets, such as building, transport, realty, and aerospace.
How does a sale-leaseback work?
In a sale-leaseback agreement, ownership is moved to the buyer-lessor, while the seller-lessee continues to use the possession. For example:
- An energy business can offer the possessions that comprise their solar-power system to a financing business, then immediately lease it back to work and meet the need of clients.
- Construction business can sell their realty residential or commercial properties and then instantly rent them back from the buyer to develop them.
- Aviation companies often sell their aircraft to an air travel financing organization and right away rent them back with no pause in their regular regimen.
- Real estate business frequently have sale-leaseback programs that provide house owners more flexibility than a traditional home sale. Equity in the home can quickly be converted into money by the seller-lessee, and mortgage brokers gain access to a wider consumer base as the buyer-lessor. These transactions are also referred to as "sell and stay" arrangements.
Advantages and disadvantages of sale-leasebacks
Sale-leaseback deals have the flexibility to be structured in different manner ins which can benefit both parties. Naturally, there are likewise dangers included in this type of arrangement that both parties need to evaluate, in addition to service and tax ramifications.
Mutual understanding of the benefits and disadvantages is a key aspect when specifying the contract. Let's have a look at the advantages and disadvantages for each party.
Pros for the seller-lessee:
- They get the alternative to expand their company or purchase brand-new equipment with the increase of money while maintaining day-to-day access to the possession.
- It's a more economical method to get funds compared to loan financing, thus improving the balance sheet.
- They can invest money in other venues for a greater return, thus enhancing the earnings and loss declaration (P&L).
- Sale-leaseback allows for the complete deductibility of lease payments with the transfer of tax ownership to the buyer-lessor.
- There's restricted threat due to possession volatility.
Cons for the seller-lessee:
- The owned asset is removed from the balance sheet.
- The right of usage (ROU) property increases, depending on the lease term and agreed-upon lease payments going beyond fair-market worth.
- They need to acknowledge capital gains.
Pros for the buyer-lessor:
- Rental earnings over the life of the lease strengthens their financial position.
- They can guarantee that lease terms are crafted to fit their needs.
- They have more control over roi (ROI) based on the conditions detailed in the arrangement.
- They can reclaim the possession if the seller-lessee defaults on payments.
Cons to the buyer-lessor:
- They should renegotiate agreements if the seller-lessee defaults on lease payments.
- They're the primary creditor/owner if the seller-lessee files for insolvency.
- There's a danger that the possession worth might reduce faster than the predicted market and end up being impaired.
How to figure out if a deal qualifies as a sale-leaseback
To qualify as a sale-leaseback, a transaction needs to meet several criteria. When assessing the contract under ASC 842, entities must use ASC 606 (profits from agreements with customers) to identify whether the sale of a property has actually taken place. There is a considerable amount of judgement that enters into this procedure, and it is good practice to have an auditor review the information and complexities of the deal.
Let's review the procedure action by step.
1. Determine if there's an agreement
First, you should identify if there is an agreement as described in ASC 606-12-25-1 through 8.
Essentially, any agreement that develops legally enforceable rights and obligations typically meets the meaning of an agreement. Contracts can be oral, composed, or suggested by an entity's traditional company practices.
2. Asses if there's a sale
Assess from an accounting point of view if there is a sale or a financing contract.
The primary concern is if control has transferred from the seller to the purchaser, therefore satisfying the performance obligation. If the response is yes, then a sale has actually happened. Otherwise, the unsuccessful sale is dealt with as a financing plan.
ASC 842 referrals ASC 606-10-25-30 for a list of signs suggesting that control has been moved to the buyer-lessor. The five control indications 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 client has a legal title.
1. The consumer has physical ownership.
1. The consumer has substantial risks and benefits of ownership.
1. The customer has accepted the possession.
This is where judgment will be needed to examine, mainly from the buyer-lessor's position, if control has been moved. It is not required that all the signs be satisfied to draw this conclusion. However, it is necessary that both the seller-lessee and buyer-lessor perform this evaluation independently.
It is possible that while the actions to examine control equal for both parties, each can concern a different conclusion that would affect the incident of a qualified sale.
For example, parties could make varying presumptions regarding factors such as the financial life, reasonable value of the asset, or the discount rate that would impact 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 failed. The transaction needs to then follow accounting treatment for a financing deal. Despite the fact that the seller-lessee no longer legally owns the possession, they would keep it on their books. The earnings would be considered a financing liability.
Compliance for sale-leaseback transactions
Accounting for sale-leasebacks is reasonably unchanged by the shift from ASC 840 to ASC 842.
If a deal was formerly accounted for as a sale-leaseback under ASC 840, it does not need to be reassessed to figure out whether it would have also qualified as a sale (or purchase) under ASC 842. The lease element of any transaction that qualified as a sale-lease back ought to be represented 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 on the lease classification.
Any deals that were accounted for as a failed sale-leaseback under ASC 840 need to be reassessed under the new lease standard. Seller-lessees require to figure out if a sale would have happened either:
1. At any point on or after the start period of the earliest duration provided in the monetary statement under ASC 842 (if a reporting entity elects to adjust relative durations).
1. At the reliable date (if a reporting entity elected to not adjust comparative durations).
If a sale would have happened, the sale-leaseback must be accounted for according to the lease shift assistance in ASC 842-10-65-1 on a modified retrospective basis from the date a sale is identified to have actually occurred.
Buyer-lessors, however, do not need to reassess successful purchases formerly recorded given that the sale-leaseback design of ASC 840 did not apply to lessors. In this situation, buyer-lessors need to represent the leaseback in compliance with normal lessor shift guidance.
How to account for sale-leasebacks under ASC 842
If the transaction meets 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 distinction between the cash got and the book worth of the asset when the buy-lessor takes control of the possession.
- Derecognize the property, eliminating 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 should likewise decide whether the deal led to a service combination as per ASC 805 or a possession acquisition. A property acquisition can be recorded according to ASC 350: Residential Or Commercial Property, Plant & Equipment (PP&E). The assessment of the asset must be equal to the fair-market worth separate from the leaseback agreement. The agreement ought to then be acknowledged as any other lease agreement.
To sum up, ASC 842-40-25-4 provides the following assistance on how to account for the sale-leaseback.
The seller-lessee shall: - Recognize the transaction cost when the buyer-lessor gets control of the possession
- Derecognize the underlying asset amount.
The buyer-lessor shall: - Represent the asset purchase.
- Recognize the lease in accordance with ASC 842-30.
How to adjust for off-market terms
Accountants need to take additional actions to adjust for off-market terms. Per ASC 842-40-30-1, the primary step is to identify whether the prices is at fair worth utilizing among the following techniques, depending on the information available:
- Comparison of the sale price of the possession vs. the reasonable value of the possession.
- Comparison of the present value of the lease payments vs. today worth of market rental payment
If there is a variation, the sale-leaseback should be gotten used to reflect the fair-market worth of the asset according to ASC 842-40-30-2.
If the sale cost is listed below reasonable worth, the difference is taped as prepaid lease. If the price of the asset is above reasonable value, the excess is thought about additional 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 value, the seller-lessee needs to change the effect of the transaction:
List price is lower than fair worth: Make a modification to increase the prices through an increase (debit) to prepaid lease (shown in the seller-lessee's initial measurement of the ROU possession).
Price is higher than fair worth: Make an adjustment to reduce the prices through an increase (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 offers among its Boeing aircrafts 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 value and greater than reasonable value.
Sale price or lease payments are lower than fair value
Let's say the seller-lessee sold the property at a discount or less than market worth. Thus, they need to acknowledge the distinction and adjust for it with the right-of-use property quantity for lease accounting.
- Asset sale quantity: $78.5 million.
- Fair-market worth: $84 million.
- Lease period: 18 years.
- Annual lease payment: $3 million.
- Interest rate: 6%.
The ROU present worth of $3 million for 18 years at 6% rates of interest is $32,482,810. The difference in the market worth and list prices is $5.5 M.
List price or lease payments are greater than reasonable value
Now, let's say the seller-lessee offered the property at a premium or more than market value.
- Asset sale amount: $86 million.
- Fair market price: $84 million.
- Lease duration: 18 years.
- Annual lease payment = $3 million.
- Rates of interest: 6%.
The ROU present worth of $3 million for 18 years at 6% rates of interest is $32,482,810. The difference in the market worth and list prices is $2 million.
Blue Sky Airlines will tape-record the following journal entries for this deal.
Note: PP&E is taped at bring worth with the seller-lessee. Gain on the sale is the difference in the list price ($ 86M) and the bring value ($ 80M) of the asset less the off-market adjustment ($ 2M).
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