This article was co-authored by Razmig Bolkorjian, CPA, Practice Leader at CNM LLP. “Raz” leads the financial service institution practice at CNM and is responsible for leading technical accounting engagement teams, including analysis and implementation of current new accounting standards, such as ASC 326, ASC 480, ASC 815, ASC 840 and ASC 842.
Sale leaseback transactions have been a popular technique for monetizing long term appreciated assets. In essence the owner sells the asset and then leases it back on a long term lease, generating cash flow and retaining use of the asset. However, the new lease accounting standards in conjunction with the new revenue recognition standard modifies the accounting considerations regarding whether the sale leaseback transaction is a bona-fide sale or a financing, and in certain cases, will affect the pattern of recognizing the gain or loss on a qualified sale leaseback.
The new accounting rules introduce a shift in the consideration of which transactions qualify as sale leaseback transactions from a transfer of risk and rewards of ownership assessment, to an assessment of control over the underlying assets.
Impact of the new lease accounting standards on sale leaseback
Here is an explanation of the impact of the two standards on sale leaseback from EisnerAmper, Blog 0816, August 4, 2016:
“In order to recognize the sale transaction, the transaction must qualify as a sale under the revenue recognition standards. Under the new revenue standards, the 5 core principles are as follows:
- Identify the contract with the customer.
- Identify the separate performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to separate performance obligations.
- Recognize revenue when performance obligations are satisfied.
A bona-fide contract would possess all of the following criteria:
- The parties to the contract have approved and are committed to perform their respective obligations.
- The entity can identify each party’s rights regarding the goods or services to be transferred.
- The entity can identify the payment terms for the goods or services to be transferred.
- The contract has commercial substance (risk, timing, or amount of future cash flows are expected to change as a result).
- It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. An entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due.
The key provision of the revenue recognition standard for sales treatment is that there must be commercial substance. The sale must result in a complete change of control from the seller to the buyer and there must not be substantive repurchase options tied to the agreement. The buyer must have paid the transaction price or have the ability and intention of paying the transaction price.
Also worth noting is that the new accounting standards specifically exclude from sale leaseback accounting those transactions where the lessee obtains legal title of an asset, but does not obtain control of the underlying asset before the asset is transferred to the lessor.
The transfer of control to the buyer/lessor must also be clear in the lease agreement to not include provisions that revert control back to the seller/lessee. Indicators that a customer has obtained control of as asset include:
- The seller/lessee has a present right to payment
- The buyer/lessor has legal title
- The buyer/lessor has physical possession
- The buyer/lessor has the significant risks and rewards of
- The buyer/lessor has accepted the asset
It is not required to meet all of the above indicators in order for control to be deemed transferred, and companies should apply judgment to assess all the facts, together and from the perspective of the buyer/lessor, to make the determination.
Under the new leasing standards for lessees, leases are classified as either financing or operating. Only an operating leaseback would qualify the sale for immediate profit recognition in a sale leaseback transaction. Finance leases would not qualify as a sale lease back transaction because a finance lease effectively represents a repurchase of the asset sold.
A qualified sale leaseback would be accounted for as two transactions:
a) one transaction to account for the sale of the assets and immediate profit/loss recognition (if the subsequent leaseback is deemed an operating lease), and
b) the second transaction to account for the lease.
This is a significant change from prior accounting rules, which in most cases required profit on qualifying sale leaseback transactions to be recognized ratable over the lease term (provided the subsequent leaseback was classified as an operating lease).
Below are the criteria for determining if a lease is a financing lease. If the lease does not have any of the stated criteria, it is considered an operating lease.
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease.
- The lease grants the lessee an option to purchase the underlying asset and the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset.
- The present value of the sum of the lease payments and residual value guaranteed by the lessee equals or exceeds the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use at the end of the lease term without significant modifications.
In essence, the lease must not be for such a long length of time and of such significant payment terms that it is in substance a sale of the property back to the lessee. The first 4 criteria are similar to the current standards, albeit without the bright-line objective tests. A new criterion has been added in the new standards where the underlying asset must have alternative uses with only reasonable alterations required to release to another lessee. That would preclude certain industrial equipment or certain improved real estate from sale recognition.
The standard also states that the buyer/lessor would need to classify the lease as an operating lease for their purposes as well for the sale leaseback to be recognized. A lessor would apply the same five criteria as a lessee to determine lease classification, plus the below two criteria (if either criteria is not met, the lessor treats the lease as an
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments and any third-party guarantees by third parties equals or exceeds the fair value of the underlying asset.
- It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy the residual value guarantee.
Under the new standards, both the sale transaction and the lease transaction will need to be recorded at fair value. Since both transactions are typically consummated as a package, the parties could (at least in theory) negotiate off-market terms on the sale and make up for it with off-market terms on the lease. The guidance requires adjustment of these terms to fair value so that the accounting reflects the commercial substance of the transaction; otherwise the seller/lessee ends up with deferred income or prepaid rent and not the intended result.
Once fully adopted, the new revenue and leasing standards could, if structured correctly, provide opportunistic seller/lessees to “more or less” have their cake and eat it too. Care needs to be taken to ensure that the “more or less” part of the strategy works. A sale leaseback transaction that does not qualify for sales recognition would be considered a financing arrangement. No profit would be recognized, and the seller would retain the asset on its books as property, plant and equipment (as opposed to a right of use lease asset had the transaction qualified for sale leaseback accounting), even though it no longer legally owns the asset. The cash proceeds would be considered a financing obligation(as opposed to a lease liability had the transaction qualified for sale lease-back accounting).”
We’ll cover other associated topics relating to sale leaseback and the new leasing standards in future blog posts such as build-to-suit topics and more.
Learn about software implementation best practices for preparing to adopt the new lease accounting standards: How to Implement Lease Accounting Technology
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