A sale-leaseback transaction basically occurs when an owner of an asset sells the asset and immediately leases it back from the buyer.
A sale-leaseback option provides a liquidity boost to the company. It also helps a company is managing its debt ratio. These transactions offer several benefits to both parties.
The accounting treatment of a sale-leaseback transaction is regulated by the US GAAP rules ASC 610 and ASC 842.
Let us analyze the concept and the accounting treatment for both parties in the transaction.
What is a Sale-Leaseback Transaction?
A sale-leaseback transaction basically occurs when an owner of an asset sells it to another party and leases it back.
The transaction does not affect the continued use of the asset owner practically. However, the ownership of the asset transfers from the first party to the second party after the transaction.
It means the first party now becomes the seller-lessee and the second party becomes the buyer-lessor.
Determining a Sale-Leaseback Transaction Occurred
Sale-leaseback transaction is accounted for under ASC 606 and ASC 842 US GAAP rules.
The first step for both parties is to determine whether the sale occurred or not. In that, the first point is to evaluate the existence of a contract.
Existence of a Contract
Both parties can use the guidelines provided by ASC 606 –10-25-1 for the existence of a contract:
- Both parties have approved the contract and commit to the obligations of the contract. The approval can be in the written, oral, or customary form for both parties.
- Each party’s rights to the transfer of goods or services can be identified.
- The payment terms of the transaction can be identified.
- The contract between both parties has an economic substance (risk, cash flow, timing, etc.)
- It is probable that the lessor will collect substantially all of the considerations from the lessee in exchange for the asset ownership transferred.
The buyer-lessee will recognize the sale-leaseback contract with the seller-lessor if all of the above conditions are satisfied.
Control of Leased Asset
Both entities need to determine the control transfer of the asset in a sale-leaseback transaction under the ASC 842 rules.
ASC 842 provides a few key indicators to determine the transfer of control. Both parties can use these indicators to make an assessment.
Present Right to Payment
Often in sale and leaseback transactions, the buyer-lessor makes an upfront payment for the asset purchase transaction. The present right to make the payment can be used as an indicator in determining the occurrence of a sale transaction.
Legal Title with the Buyer-Lessor
Holding the legal title of the asset is another indication of receiving the benefits from the asset. The legal title also enables the buyer-lessor to sell or transfer the asset to another party.
Buyer-Lessor has Physical Possession
The buyer-lessor holds the physical possession of the asset. The seller-lessee is then granted the right-of-use interest in the asset.
Risks and Rewards are Transferred to the Buyer-Lessor
The seller-lessee will also transfer the risks and rewards related to the underlying asset to the buyer-lessor. However, in a lease contract, it is a delicate task to fully determine the transfer of risks and rewards from one party to another.
Buyer-Lessor has Accepted the Asset
The acceptance of the buyer-lessor can be determined with an evaluation of other indicators such as control and physical possession.
Identifying the Sale-Leaseback
Basically, when the buyer-lessor obtains control of the asset, the sale/purchase transaction and the leaseback contract should be accounted for separately.
ASC 842-40-25-4 provides the following guidelines if the transfer of ownership results in a sale.
The seller-lessee shall:
- Recognize the transaction price when the buyer-lessor obtains control of the asset. The price determination should be carried out as per guidelines in ASC 606-10-25-30.
- Derecognize the underlying asset amount.
The buyer-lessor shall:
- Account for the asset purchase, and
- Recognize the lease in accordance with ASC 842.
Accounting by the Seller-Lessee
In the first step, the seller-lessee should derecognize the asset from its books. Then, gain or loss on the sale transaction should be recorded.
If the transaction happened at the fair value of the asset, then the transaction does not incur a gain or loss.
Example
Suppose ABC owns a property worth $ 10 million at its current market value. It sells the property to XYZ for $ 12 million and leases it back for 10 years for an annual lease amount of $ 50,000.
The seller-lessee ABC will first derecognize the asset. It will then record a gain of $2 million arising from the transaction.
ABC will record the lease contract in accordance with lease guidelines as per ASC 842 usually.
Accounting by the buyer-Lessor
The buyer-lessor will determine whether the transaction resulted in a business combination as per ASC 805 or an asset acquisition.
The buyer-lessor can record the acquisition of the asset as per ASC 360: Property, Plant, and Equipment.
The asset should be valued at the fair market value independently from the leaseback contract. The contract should then be recognized as any other lease contract.
Off-Market Sale and Leaseback
A sale and leaseback transaction with the off-market arrangement should be adjusted to reflect the fair market value of the asset.
Both parties can determine the fair market value of the transaction through:
- Comparing the sale price of the asset with the market price.
- Comparing the PV of contractual lease payments with PV of market value lease payments.
If the sale-leaseback transaction does not occur at a fair market value, both parties should make adjustments according to ASC 842-40-30-2.
- Any increased amount to the sale price should be recorded as prepayment of rent (lease amount).
- Any reduction in the sale-leaseback should be recognized as additional financing provided by the buyer-lessor to the seller-lessee.
Example – Sale Price or Lease Payments are less than Fair Value
Suppose a company ABC and XYZ enter into a sale-leaseback transaction for a property.
ABC is Seller-Lessee and XYZ is Buyer-Lessor. The following data is available.
Property Sale amount = $ 5 million
Fair Market Value = $ 6 million
Lease Period = 10 years
Annual Lease Payment = $ 300,000.
Interest rate = 5%
The seller-lessee sold the property at 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 $ 300,000 for 10 years at 6% interest rate is $ 2,316,000. The difference in the market value and sale price is $ 1,000,000.
ABC will record the following journal entries for this transaction.
| Account | Debit | Credit |
|---|---|---|
| Cash | $ 5,000,000 | |
| Right-of-Use Asset | $ 3,316,000 | |
| Property | $ 6,000,000 | |
| Lease liability | $ 2,316,000 |
Example – Sale Price or Lease Payments are greater than Fair Value
Conversely, all other things equal from the previous example, if the transaction had resulted in a gain of $1 million instead of loss, then, ABC would have recorded the following journal entries.
| Account | Debit | Credit |
|---|---|---|
| Cash | $ 6,000,000 | |
| Right-of-Use Asset | $ 1,316,000 | |
| Property | $ 4,500,000 | |
| Lease liability | $ 1,316,000 | |
| Finance Liability | $ 1,000,000 | |
| Gain on Sale | $ 500,000 |
Note: Property is recorded at carrying value with the seller-lessee ABC. Gain on sale is the difference in the sale price ($6 m) and carrying value ($4.5 m) of the property less the off-market adjustment ($1 m).
