Sale-leasebacks are common in the industry, but these transactions can cause accounting issues under ASC 842. Shawn Halladay outlines the key issues and accounting requirements surrounding this product as well as strategies to overcome potential obstacles.
Customers enter sale-leasebacks for multiple reasons. Various tax, accounting and economic benefits can be obtained through this form of financing. The nature of sale-leasebacks, however, creates accounting issues under ASC 842, particularly for lessees. This article will address the lessee accounting ramifications of sale-leasebacks with a view towards more effectively selling this product.
From a financial reporting perspective, a sale-leaseback contains two transactions, as the name implies. Consequently, the seller-lessee accounts for a sale contract and recognizes the leaseback. The leaseback also is classified by the lessor and recognized accordingly.
The primary accounting challenge for sale-leasebacks relates to the lessee’s recognition of any gain on the sale portion of the transaction. The transaction is accounted as an asset sale and a leaseback of that asset only if the initial transaction qualifies as a sale under the revenue recognition requirements of ASC 606. Whether a sale of the asset has occurred is based on which party controls the asset after the transaction is completed.
It is not enough, however, for the seller-lessee to relinquish control of the asset. ASC 606 requires that the seller-lessee must relinquish control of the asset and the buyer-lessor must obtain control of the asset. This symmetry is a new concept introduced by ASC 842.
Despite this symmetry, the seller-lessee and the buyer-lessor are not required to reach similar conclusions (i.e., both the lessor and lessee do not have to recognize a sale, or vice versa). It is not unreasonable for the parties to the sale-leaseback to reach different conclusions regarding whether the transaction has transferred of control of the asset.
The existence of the leaseback, by itself, does not prevent the seller-lessee from transferring control of the underlying asset to the buyer-lessor. Circumstances related to the leaseback can prevent a transfer of control from the seller-lessee to the buyer-lessor under ASC 842, however. Two of these occur if the leaseback is classified as a sales-type lease by the lessor or as a finance leaseback by the lessee.
The nature of ASC 842’s lease classification rules indicates that the lessee effectively can direct the asset’s use and obtain substantially all the asset’s remaining benefits in a leaseback classified as a sales-type (lessor) or finance lease (lessee). The buyer-lessor, therefore, has not obtained control of the asset from an accounting perspective. Without buyer-lessor control of the asset, a sale cannot be recognized.
If the leaseback is an operating lease, however, the buyer-lessor is considered to be in control of the asset, just as in an operating lease that is not a leaseback. The lessor, in a normal operating lease, effectively can direct the asset’s use and obtain substantially all the asset’s remaining benefits.
Another situation in which control of the asset may not be passed to the buyer-lessor occurs when the lessee has the option to repurchase the asset. A seller-lessee option to reacquire the asset may preclude the buyer-lessor from obtaining control of the asset because the seller-lessee has not given up control of the asset.
A purchase option in the leaseback, therefore, precludes sale recognition unless that option is at fair value at the time the option is exercised and readily available (i.e., easily obtained by the seller-lessee) alternative assets exist in the marketplace. Furthermore, those assets must be substantially the same as the asset in the sale-leaseback. Sale recognition also is precluded if the seller-lessee has an obligation to repurchase the asset (a put) under the contract.
The requirement that there must be alternative, readily available assets in the marketplace, which are substantially the same as the asset in the sale-leaseback precludes sale recognition on assets for which exercise of the option essentially is assured. For example, if the lessee cannot find equivalent equipment in the market, exercise of the option virtually is assured. In circumstances such as this, the lessee never surrenders control of the asset.
These additional requirements are particularly relevant for real estate sale leasebacks. The FASB has taken the position that, for real estate, no alternative assets are substantially the same as the asset being transferred. Real estate assets are unique since “no two pieces of land occupy the same space on this planet.” Consequently, any purchase option in a real estate sale-leaseback precludes recognizing the sale-leaseback gain.
If the transfer of the asset meets the sale requirements of ASC 606, the seller-lessee recognizes a gain on the sale. The seller-lessee then measures its liability to make lease payments and the associated ROU asset as it would in any lease. As an example, assume that Santana Services is selling equipment it owns to Frumious Bandersnatch Financial and then leasing it back.
Under the terms of the leaseback, at the end of the lease, Santana can purchase the asset at its then fair value and return the equipment or renew the lease at fair value. The sale price is $50,000 and the book value of the equipment is $40,000. Although Santana has an option to repurchase the equipment, the option is at the end-of-term fair value, so the repurchase right does not preclude gain recognition. Assuming the other transfer of control criteria of ASC 606 have been met, Santana can recognize the $10,000 ($50,000 to $40,000) gain on the transaction.
Transactions that do not meet the transfer of control criteria of ASC 606 are considered failed leasebacks. These transactions are treated as financing arrangements and, instead of derecognizing the transferred asset, the seller-lessee keeps them on its books and the proceeds are booked as debt. The debt then is amortized to interest and principal over the term of the leaseback.
Prior Seller-Lessee Control
Another aspect of the sale-leaseback rules, control of the asset, has a direct operational impact that may affect how customers lease. Many lessees acquire multiple pieces of equipment over a period of time, typically a quarter, and then sell those assets to a lessor in a sale-leaseback transaction. Doing so creates efficiencies in the acquisition process while still allowing the lessee to take advantage of the benefits of leasing.
The problem with this practice, from an accounting perspective, is that the ASC 842 rules are much stricter than those of ASC 840, so if the lessee takes control of the asset, which it does in these circumstances, the new sale-leaseback rules apply. Under these rules, a lease with a purchase option may result in the assets remaining on the lessee’s balance sheet, forcing the lessee into the unpleasant situation of giving up efficiencies in order to gain advantages or vice versa.
The key consideration in this regard is prior lessee control of the asset, as this condition makes the transaction subject to the sale-leaseback rules. As in the rest of the sale-leaseback discussion, control of the asset is determinative. A lessee, for instance, may have temporary title to an asset before transferring it to a lessor. Unless the lessee has the ability to exercise control over that asset, however, legal ownership prior to the sale of the asset to the lessor will not trigger the sale-leaseback rules.
The lessor can provide a solution to the lessee in these circumstances, however. If the transactions can be documented in such a manner that the lessee acts as an agent of the lessor when it acquires the equipment, it will not be deemed to have taken control of the equipment. Such an arrangement allows the lessor to incorporate FMV options into the leases, thereby creating additional benefit to the lessee.
Control over an asset in sale-leasebacks also may occur when a lessee is involved with construction of an asset it intends to lease, oftentimes referred to as a build-to-suit arrangement. This latter category raises the most questions as to whether a transaction is subject to the sale-leaseback rules.
In a typical build-to-suit arrangement, the lessee is involved in the design and construction of the asset and may make payments related to these activities. These costs are not necessarily indicative of control over the asset. If the lessee does not have control over the asset being constructed, these payments are accounted for under other guidance, not ASC 842. An example of when a lessee may make payments toward construction of an asset is when it is hired by the lessor to be the general contractor during the construction project.
The accounting requirements of ASC 842 can be problematic when structuring sale-leasebacks. An appreciation of the key issues, when combined with a solid understanding of the accounting requirements surrounding this product, however, allows the sales team to successfully overcome these potential obstacles.
This and other relevant lease accounting topics are addressed in a new textbook by the author, Accounting for Leases: Embracing the New Paradigm, which provides guidance to both U.S. and international lessors and lessees by covering the many commonalities between ASC 842, the new U.S. lease accounting standard, and IFRS 16, the new lease accounting standard for countries outside the U.S. Although IFRS 16 recognizes one lease model for lessees and ASC 842 recognizes two (both finance and operating leases), there is significant overlap between the two standards.
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