What are sale and leaseback transactions under ASC 842?
A sale and leaseback transaction is one that involves two contracts. One contract in which a seller sells an asset to a buyer, and another contract in which the seller then leases the asset back from the buyer. There are benefits to both parties for this type of transaction. The seller-lessee is provided with an immediate inflow of cash that can be used by the business. Also, this type of transaction can be more attractive to the seller, rather than trying to obtain conventional financing, in that it may be cheaper and have the added flexibility in structuring the transaction (i.e., flexibility in collateral, loan covenants, possible balloon payments, and other restrictions). The buyer-lessor may have a reduced default risk and the ability to more easily terminate the contract than would be the case under conventional financing. There are a number of tax advantages to the buyer including depreciation and perhaps the option of a cost segregation study, further accelerating depreciation.
The importance of “control” in sale and leaseback transactions
To qualify as a sale, the seller-lessee needs to ensure the customer (in this case, the buyer-lessor) obtains control of the asset. The leases standard refers to the revenue standard, ASC 606, Revenue from Contracts with Customers, for making this determination.
The sale must meet the requirements of ASC 606 and specifically the provisions dealing with the existence of a contract (paragraphs 606-10-25-1 through 8) and the satisfaction of performance obligations (paragraph 606-10-25-30). However, in addition to meeting the requirements of ASC 606, repurchase options and lease classification also impact sale qualification.
The existence of a repurchase option will generally (but not always) preclude recognition of a sale in a sale and leaseback arrangement, but probably the most significant hurdle to a successful sale and leaseback is the lease classification. An operating lease qualifies for sale and leaseback accounting while a finance lease does not.
The lease classification criteria are as follows:
- There is a transfer of ownership of the asset to the lessee at the termination of the lease;
- The lessee has an option to purchase the asset that is reasonably certain to be exercised;
- The lease term constitutes a major part of the remaining economic life of the asset;
- The present value (PV) of the sum of the lease payments and guaranteed residual value by the lessee must equal or exceed substantially all of the fair value of the underlying asset;
- The underlying asset must be of a specialized nature precluding any alternative use to the lessor at the termination of the lease period.
If any of these criteria are met, then the lease is a finance lease. If none of the criteria are met, then the lease is an operating lease.
The accounting depends on the “success” of the sale and leaseback
In a successful sale and leaseback, the sale and the leaseback are accounted for as separate transactions. The sale is accounted for in accordance with the guidance in ASC 606 while the leaseback is accounted for under ASC 842. The seller-lessee first derecognizes the underlying asset and recognizes a gain or loss on sale as appropriate, similar to a sale without a leaseback. Separately, the seller-lessee recognizes a “right of use” asset and lease liability and reduces these assets and liabilities with offsets to lease expense and cash as lease payments are made.
A failed sale and leaseback is essentially a financing transaction with the seller-lessee as the borrower and the buyer-lessor as the lender. In a failed sale and leaseback, the seller-lessee does not derecognize the underlying asset and continues to depreciate the asset as if it was the legal owner. The seller-lessee recognizes the proceeds received from the buyer-lessor as a liability. As the seller-lessee makes rental payments, the payments are allocated between principal and interest using the seller-lessee’s incremental borrowing rate.
Watch out for these contract provisions
Contracts often contain residual value guarantees and renewal options, which can change an otherwise operating lease into a finance lease. The present value of any residual value guarantee, once added to the lease payments, may guarantee a lessor the recovery of substantially all of the fair value of its underlying asset, making the arrangement a finance lease. Therefore, if the residual value guarantee can be removed, there will be a greater likelihood of reaching an operating lease conclusion. Likewise, a renewal option within the control of the lessee can impact both the lease term and the fair value classification criteria, especially if the lessee is “reasonably certain” to exercise the option. The reasonably certain assessment is made based on factors that create an economic incentive for the lessee and not based on intentions or past practices. In other words, it would be difficult to conclude that a renewal option that benefits the lessee will not be exercised. Therefore, renewal options should be carefully considered, and removed if possible.
Lessons learned
- Know the accounting you are trying to achieve and make sure all parties involved understand the difference between a successful and failed sale and leaseback.
- Structure the agreement to ensure that it does not qualify as a finance lease, paying particular attention to residual value guarantees and renewal options.
- Get a qualified CPA involved to verify that the agreement does not meet the finance lease criteria.
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