Sale-leaseback agreements can be appealing to companies looking for a liquidity boost or a strategy to manage their debt ratio.
However, for accountants, they can also be complex to evaluate and determine whether a sale has taken place.
So how exactly does sale-leaseback accounting work?
This post covers everything you need to know about these transactions, including the meaning of sale-leaseback, pros and cons, and accounting examples.
What is a sale-leaseback?
A sale-leaseback (a.k.a. sale and leaseback) transaction 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 this transaction doesn’t affect the operational use of the asset by the seller-lessee, it does have different accounting outcomes for both parties. The seller-lessee can continue using the asset, but legal ownership is transferred to the buyer-lessor.
Learn more about the responsibilities of lessors and lessees.
What is the purpose of a sale-leaseback?
The most common reasons to enter a sale-leaseback agreement are to raise capital, improve the balance sheet, or gain tax advantages. The seller-lessee is typically seeking 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.
How does a sale-leaseback work?
In a sale-leaseback agreement, ownership is transferred to the buyer-lessor, while the seller-lessee continues to use the asset. For example:
- An energy company can 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 can sell their real estate properties and then instantly lease them back from the purchaser to develop them.
- Aviation companies frequently sell their aircraft to an aviation financing organization and immediately lease them back with no pause in their regular routine.
- Real estate companies often have 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. These transactions are also known as "sell and stay" arrangements.
Pros and cons of sale-leasebacks
Sale-leaseback transactions have the flexibility to be structured in various ways that can benefit both parties. 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 is a key element when defining the contract. Let’s take a look at the pros and cons for each party.
Pros for the seller-lessee:
- They get the option to expand their business or buy new equipment with the influx of cash while maintaining day-to-day access to the asset.
- It’s a less expensive way to obtain funds compared to loan financing, thus improving the balance sheet.
- They can invest cash in other venues for a higher return, thus improving the profit and loss statement (P&L).
- Sale-leaseback allows for the full deductibility of lease payments with the transfer of tax ownership to the buyer-lessor.
- There’s limited risk due to asset volatility.
Cons for the seller-lessee:
- The owned asset is eliminated from the balance sheet.
- The right of use (ROU) asset increases, depending on the lease term and agreed-upon lease payments exceeding fair-market value.
- They must recognize capital gains.
Pros for the buyer-lessor:
- Rental income over the life of the lease strengthens their financial position.
- They can ensure that lease terms are crafted to fit their needs.
- They have more control over return on investment (ROI) based on the conditions outlined in the agreement.
- They can repossess the asset if the seller-lessee defaults on payments.
Cons to the buyer-lessor:
- They must renegotiate contracts if the seller-lessee defaults on lease payments.
- They’re the primary creditor/owner if the seller-lessee files for bankruptcy.
- There’s a risk that the asset value might decrease faster than the projected market and become impaired.
How to determine if a transaction qualifies as a sale-leaseback
To qualify as a sale-leaseback, a transaction must meet several criteria. When evaluating the contract under ASC 842, entities must apply ASC 606 (revenue from contracts with customers) 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.
Let’s go over the process step by step.
1. Determine if there’s a contract
First, you must 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.
2. Asses if there’s a sale
Assess from an accounting perspective if there is a sale or 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:
- The reporting entity has a present right to payment; the buyer-lessor has a present obligation to pay the seller-lessee.
- The customer has a legal title.
- The customer has physical possession.
- The customer has significant risks and rewards of ownership.
- 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. However, it is necessary 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.
For example, 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.
Compliance for sale-leaseback transactions
Accounting for sale-leasebacks is relatively unchanged by the transition from ASC 840 to ASC 842.
If a transaction was previously accounted for as a sale-leaseback under ASC 840, it does not need to be reassessed to determine whether it would have also qualified as a sale (or purchase) under ASC 842. 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 transactions that were accounted for as a failed sale-leaseback under ASC 840 should be reassessed under the new lease standard. Seller-lessees need to determine if a sale would have occurred either:
- 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)
- 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 reevaluate 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-leasebacks under ASC 842
If the transaction meets the requirements under ASC 842 to qualify as a sale-leaseback, then the seller-lessee will:
- 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.
- Derecognize the asset, removing it from the balance sheet.
- Calculate and recognize the associated lease liability and ROU asset for leaseback in accordance with ASC 842.
The buyer-lessor must also decide 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 & Equipment (PP&E). 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.
How to adjust for off-market terms
Accountants must take additional steps 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 using one of the following methods, depending on the information available:
- 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
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 is lower than fair value: Make an 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 is higher than fair value: Make an adjustment to decrease the sales price through an increase (credit) to additional financing liability.
Sale-leaseback accounting examples
Now that we know the theory, let’s go through a practical example of how sale-leaseback accounting works.
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 buyer-lessor. Let’s see what it looks like if the sale price is lower than fair value and higher than fair value.
Sale price or lease payments are lower than fair value
Let’s say the seller-lessee sold the asset at a discount or less than market value. Thus, they should recognize the difference and adjust for it with the right-of-use asset amount for lease accounting.
- Asset sale amount: $78.5 million
- Fair-market value: $84 million
- Lease period: 18 years
- Annual lease payment: $3 million
- Interest rate: 6%
The ROU present value of $3 million 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.
Sale price or lease payments are greater than fair value
Now, let’s say the seller-lessee sold the asset at a premium or more than market value.
- Asset sale amount: $86 million
- Fair market value: $84 million
- Lease period: 18 years
- Annual lease payment = $3 million
- Interest rate: 6%
The ROU present value of $3 million for 18 years at 6% interest rate is $32,482,810. The difference in the market value and sales price is $2 million.
Blue Sky Airlines will record the following journal entries for this transaction.
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).
Simplify lease accounting with NetLease
As you can see, sale-leaseback transactions can be time-consuming to manage, especially if you’re accounting for them manually.
But there’s a better way. Accounting software can simplify the process, helping you comply with lease accounting standards and manage leases seamlessly.
For lessees, NetLease automates the drudgery of lease accounting in one centralized platform and guarantees compliance with standards like ASC 842, whether you use NetSuite or another ERP.
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