How Sale-and-Leaseback Accounting Works with Examples

Leases come in all shapes and sizes. Sale-leaseback transactions provide a way to negotiate existing lease contracts to cater to specific business needs. A sale-leaseback is appealing to companies looking for a liquidity boost or strategy to manage their debt ratio. This article provides a high-level summary of the benefits and drawbacks of a sale-leaseback, the steps to define what qualifies an account for a sale-leaseback and common examples. This article is written assuming the audience has already adopted ASC 842 and ASC 606.  

What is a sale-leaseback?  

A sale-leaseback occurs when the owner of an asset sells it, then leases it back through a long-term lease. The original owner becomes the seller-lessee, and the purchaser of the asset becomes the buyer-lessor. While the result of this deal does not affect the operational use of the asset by the seller-lessee, it does have different accounting outcomes for both sides depending on the structure; the seller-lessee is able to continue to use the asset, but legal ownership is transferred to the buyer-lessor.

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What is the purpose of a sale-leaseback?  

The most popular motivations for a sale-leaseback agreement are to raise capital, improve the balance sheet or gain tax advantages. The seller-lessee is seeking a way to free the cash stored in the value of a property or asset for other purposes but does not want to compromise their ability to use the asset. Purchasers who enter into these agreements are typically institutional investors, leasing companies or finance companies pursuing a deal that has a secure return as the buyer-lessor. Sale leasebacks are commonly seen in industries with high-cost fixed assets such as construction, transportation, real estate and aerospace.

For example:

  • An energy company will sell the assets that comprise their solar-power system to a financing company, then immediately lease it back to function and meet the demand of customers.
  • Construction companies that sell their real estate properties and then instantly lease them back from the purchaser to develop is another example.
  • Aviation companies frequently enter these sale-leasebacks by selling their aircraft to an aviation financing organization and immediately leasing them back with no pause in their regular routine. 

    In the real estate market, these transactions are also known as "sell and stay" arrangements. Companies like EasyKnock and Rentback have created sale-leaseback programs that give homeowners more flexibility than a traditional home sale. Equity in the home can quickly be converted into cash by the seller-lessee and mortgage brokers gain access to a wider customer base as the buyer-lessor.

Pros and cons of sale-leasebacks 

Sale-leaseback transactions have the flexibility to be structured in a variety of ways that can benefit both the seller-lessee and buyer-lessor. Of course, there are also risks involved in this type of arrangement that both parties should evaluate, as well as business and tax implications. Mutual understanding of the advantages and disadvantages to both parties is a key element when defining the contract.  

Pros to the seller-lessee include: 

  • Option to expand business or buy new equipment with influx of cash, while maintaining day-to-day access to the asset. 
  • Less expensive way to obtain funds than through loan financing, thus improving the balance sheet.  
  • Cash can be invested in other venues for a higher return, thus improving the P&L.  
  • Allows for the full deductibility of lease payments with the transfer of tax ownership to the buyer-lessor. 
  • Limited risk due to asset volatility. 

Cons to the seller-lessee include: 

  • Elimination of the owned asset from the balance sheet. 
  • Increase right of use (ROU) asset, depending on the lease term and agreed-upon lease payments that exceed FMV. 
  • Recognition of capital gains. 

Pros to the buyer-lessor include:  

  • Rental income over the life of the lease strengthens their financial position. 
  • Ensure that lease terms are crafted to fit their needs. 
  • Control over return on investment (ROI) based on conditions outlined in the agreement. 
  • Repossesses the asset if the seller-lessee defaults on payments and other benefits of ownership. 

Cons to the buyer-lessor include:  

  • Renegotiation of contracts if the seller-lessee defaults on lease payments. 
  • Primary creditor/owner if the seller-lessee files for bankruptcy. 
  • Risk that the asset value might decrease faster than the projected market and become impaired.

     

     

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How to determine if a transaction meets the definition of a sale-leaseback 

Identifying a transaction as a sale-leaseback involves meeting several criteria. When evaluating the contract under ASC 842, entities must apply ASC 606, Revenue from Contracts with Customers (ASC 606), to determine whether the sale of an asset has occurred. There is a significant amount of judgement that goes into this process, and it is good practice to have an auditor review the details and complexities of the deal.  

Step one: Determine if there is a contract as explained in ASC 606-12-25-1 through 8. Essentially, any agreement that creates legally enforceable rights and obligations usually meets the definition of a contract. Contracts can be oral, written or implied by an entity’s customary business practices. 

Step two:  Assess from an accounting perspective if there is a sale of a financing agreement. The primary question is if control has transferred from the seller to the buyer, therefore fulfilling the performance obligation. If the answer is yes, then a sale has occurred. Otherwise, the failed sale is treated as a financing arrangement. ASC 842 references ASC 606-10-25-30 for a list of signs indicating that control has been transferred to the buyer-lessor. The five control indicators are

  1. The reporting entity has a present right to payment; the buyer-lessor has a present obligation to pay the seller-lessee 
  2. The customer has a legal title 
  3. The customer has physical possession 
  4. The customer has significant risks and rewards of ownership 
  5. The customer has accepted the asset 

This is where judgment will be necessary to assess, mainly from the buyer-lessor's position, if control has been transferred. It is not required that all the indicators be met to draw this conclusion. It is necessary though that both the seller-lessee and buyer-lessor perform this assessment independently. It is possible that while the steps to assess control are identical for both parties, each can come to a different conclusion that would impact the occurrence of a qualified sale.

Parties could make differing assumptions regarding factors such as the economic life, fair value of the asset or the discount rate that would affect the lease classification determination. If the seller-lessee classifies the lease as a finance lease or the buyer-lessor classifies the lease as a sales-type lease, then the test for control has failed. The transaction should then follow accounting treatment for a financing transaction. Even though the seller-lessee no longer legally owns the asset, they would keep it on their books. The proceeds would be considered a financing liability.  

How to transition a sale-leaseback from ASC 840 to ASC 842 

Accounting for sale-leasebacks is one item that is relatively unchanged by the transition from ASC 840 to 842. If a transaction were previously accounted for under ASC 840 as a sale-leaseback, it does not need to be reassessed to determine whether it would have also qualified as a sale (or purchase) under ASC 606. The lease component of any transaction that qualified as a sale-lease back should be accounted for by both the lessees and lessors in accordance with transition requirements.

See ASC 842-10-65-1 for guidance on deferred gain or loss balances after transition depending on the lease classification.  

Any sale and leaseback transactions that were accounted for as a failed sale and leaseback under ASC 840 should be reassessed under the new lease standard. Seller-lessees need to determine if a sale would have occurred either (1) at any point on or after the beginning period of the earliest period presented in the financial statement under ASC 842 (if a reporting entity elects to adjust comparative periods) or (2) at the effective date (if a reporting entity elected to not adjust comparative periods). If a sale would have occurred, the sale-leaseback should be accounted for according to the lease transition guidance in ASC 842-10-65-1 on a modified retrospective basis from the date a sale is determined to have occurred. Buyer-lessors, however, do not need to re-evaluate successful purchases previously recorded since the sale-leaseback model of ASC 840 did not apply to lessors. In this scenario, buyer-lessors should account for the leaseback in compliance with normal lessor transition guidance.  

How to account for sale-leaseback and ASC 842 

If the transaction meets the requirements under ASC 842 to qualify as a sale-leaseback, then the seller-lessee will

  1. Recognize the sale and any gain or loss the difference between the cash received and the book value of the asset when the buy-lessor takes control of the asset.
  2. Derecognize the asset, removing it from the balance sheet.
  3. Calculate and recognize the associated lease liability and ROU asset for leaseback in accordance with ASC 842. 

Another decision that will need to be made by the buyer-lessor is whether the transaction resulted in a business combination as per ASC 805 or an asset acquisition. An asset acquisition can be recorded as per ASC 350: Property, Plant and Equipment. The valuation of the asset should be equal to the fair-market value separate from the leaseback contract. The contract should then be recognized as any other lease contract.  

To summarize, ASC 842-40-25-4 gives the following guidance on how to account for the sale-leaseback.  

The seller-lessee shall:  

  • Recognize the transaction price when the buyer-lessor obtains control of the asset. 
  • Derecognize the underlying asset amount. 

The buyer-lessor shall:  

  • Account for the asset purchase. 
  • Recognize the lease in accordance with ASC 842-30. 

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Off-market terms 

Additional steps must be taken to adjust for off-market terms. Per ASC 842-40-30-1, the first step is to determine whether the sales price is at fair value. Either of the two following methods is an acceptable approach: 

  • Comparison of the sale price of the asset vs. the fair value of the asset. 
  • Comparison of the present value of the lease payments vs. the present value of market rental payment. 

Entities can use either method based on the information they have easier access to. If there is a variance, the sale-leaseback should be adjusted to reflect the fair-market value of the asset according to ASC 842-40-30-2. If the sale price is below fair value, the difference is recorded as prepaid rent. If the sale price of the asset is above fair value, the excess is considered additional financing, separate from the lease liability, received from the buyer-lessor.  

To summarize, if there is a balance between the sale price and the fair value, the seller-lessee needs to adjust the impact of the transaction:  

  • Sale price < fair value = adjustment to increase the sales price through an increase (debit) to prepaid rent (reflected in the seller-lessee's initial measurement of the ROU asset). 
  • Sale price > fair value = adjustment to decrease the sales price through an increase (credit) to additional financing liability. 

Examples of sale-leaseback transactions

Suppose Blue Sky Airlines sells one of its Boeing airplanes to ABC Aviation. Blue Sky Airlines is the seller-lessee and ABC Aviation is the seller-lessor. 

Example—Sale price or lease payments are less than fair value 

Asset sale amount = $78.5M 

Fair-market value = $84 M 

Lease period = 18 years 

Annual lease payment = $3M 

Interest rate = 6% 

The seller-lessee sold the asset at a discount or less than market value. Thus, it should recognize the difference and adjust for it with the right-of-use asset amount for lease accounting.  

The ROU present value of $3M for 18 years at 6% interest rate is $32,482,810. The difference in the market value and sales price is $5.5M.  

Blue Sky Airlines will record the following journal entries for this transaction.  

Account 

Debit 

Credit 

Cash 

$78,500,500  

  

Right-of-Use Asset 

$26,983,310 

  

PP&E 

  

$84,000,000 

Lease Liability 

  

$32,482,810 

 

Example—Sale price or lease payments are greater than fair value 

Asset sale amount = $86M 

Fair market value = $84M 

Lease period = 18 years 

Annual lease payment = $3M 

Interest rate = 6% 

The seller-lessee sold the asset at a discount or less than market value. Thus, it should recognize the difference and adjust for it with the right-of-use asset amount for lease accounting.  

The ROU present value of $3M for 18 years at 6% interest rate is $32,482,810. The difference in the market value and sales price is $5.5M.  

Blue Sky Airlines will record the following journal entries for this transaction.  

Account 

Debit 

Credit 

Cash 

$86,000,000

  

Right-of-Use Asset 

$22,983,310 

  

PP&E 

  

$80,000,000 

Lease Liability 

  

$22,983,310 

Finance Liability 

 

$2,000,000 

Gain on Sale 

 

$4,000,000 

 

Note: PP&E is recorded at carrying value with the seller-lessee. Gain on the sale is the difference in the sale price ($86M) and the carrying value ($80M) of the asset less the off-market adjustment ($2M).

Bottom line

Sale-leaseback transactions can be complex to evaluate because significant judgment calls are necessary to determine whether a sale has taken place and whether control has been transferred. This article is a helpful guide to walk through these steps, but there are other factors, such as right to first refusal, renewal options, the seller-lessee residual value guarantee, etc., that have not been discussed that should be considered.

Luckily, we have tools to assist you and make accounting for leases and assets easier. 

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