When ASC 842 Leases was issued, the headlines read: “All leases must now be recorded on the balance sheet” and “Corporate balance sheets set to blow-up by trillions of dollars.” However, lost in these headlines was a change in the accounting for sale and leaseback transactions. Specifically, entities are now required to recognize an immediate gain for transactions that qualify for sale and leaseback accounting under ASC 842, a significant change from prior GAAP (ASC 840).
I’m here to tell you that this “nugget” isn’t buried anymore! I’ve recently talked to several companies, both on the buyer-lessor and seller-lessee sides, looking to structuring sale and leaseback transactions to take advantage of immediate gain recognition. There are many reasons why entities enter into sale and leaseback transactions including increasing liquidity, generating tax savings, and reducing the exposure to owning physical, non-income producing assets. However, if you think you can also automatically generate income and recognize a gain on a sale and leaseback transaction, just remember what Lee Corso says:
In this post we’ll discuss 5 “red flags” which might result in a failed sale and leaseback transaction and prevent immediate gain recognition on such transactions.
Overview of the Accounting
Before we talk about the “red flags,” let’s quickly discuss the related accounting. As we discussed in this blog post, for a transaction to qualify for sale and leaseback accounting under ASC 842, an entity needs to determine whether the transfer of the underlying asset meets the definition of a sale under ASC 606 Revenue from Contracts with Customers. In making this determination, there are two key criteria that an entity must assess:
- Whether a contract exists; and
- Whether control of the asset has been transferred.
If a transaction qualifies for sale and leaseback accounting under ASC 842, the accounting for seller-lessee and buyer-lessor is as follows:
- Recognize transaction price (determined under ASC 606) when buyer-lessor obtains control, adjusted for any off-market terms
- Derecognize the carrying amount of the underlying asset
- Recognize gain or loss in full, subject to any off-market terms
- Account for the (operating) lease in accordance with ASC 842-20
- Account for the purchase of underlying asset as either a business combination or an asset acquisition
- Account for the (direct financing or operating) lease in accordance with ASC 842-30
If a transaction does not qualify for sale and leaseback accounting, it is considered a failed sale and leaseback transaction. As such, the asset remains on the balance sheet of the seller-lessee and there is no gain or loss recognition. The transfer of cash is simply accounted for as a financing transaction, which increases the financial liabilities recorded by the seller-lessee.
“Red Flags” To Look for In Sale and Leaseback Transactions
Nobody wants more debt on their balance sheet. Here are the 5 “red flags” that might cause a sale and leaseback transaction to fail:
1. No upfront payment by buyer-lessor
As noted above, in order to be considered a sale, control over the transferred asset must be transferred to the buyer-lessor. ASC 606 provides the following list of indicators when considering whether control has transferred:
- Entity (seller-lessee) has a present right to payment
- Customer (buyer-lessor) has legal title
- Customer (buyer-lessor) has physical possession
- Customer (buyer-lessor) has the significant risks and rewards of ownership
- Customer (buyer-lessor) has accepted the asset
One of the main reasons a seller-lessee enters into a sale and leaseback transaction is to generate liquidity. As such, a buyer-lessor generally pays the seller-lessee the purchase price of the asset at the start of the transaction. If for some reason this payment wasn’t received upfront, the seller-lessee would need to consider whether or not they actually have a present right to payment. If not, sale and leaseback accounting would not be appropriate.
2. Significant risks and rewards of ownership have not been transferred to buyer-lessor
Another indicator is that the significant risks and rewards of owning the asset have transferred from the seller-lessee to the buyer-lessor. Has the seller-lessee retained any of the risks and rewards of ownership? If so, are they significant? ASC 606-10-25-25 states that to have control the buyer-lessor must have “the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.” This makes it clear that whether control has transferred should be viewed from the buyer-lessor’s perspective.
One of things to be on the lookout for are guarantees. The seller-lessee may guarantee to the buyer-lessor that the residual value will be a stipulated amount at the end of the lease term. ASC 842-40-55-21 states “a significant residual value guarantee by the seller-lessee may affect an entity’s consideration of the transfer of control.” Residual value guarantees may also impact the lease classification.
3. Finance lease (or sales-type lease) classification
The classification of the leaseback matters in determining whether sale and leaseback accounting can be applied. If the leaseback is classified as a finance lease (by the seller-lessee) or a sales-type lease (by the buyer-lessor), sale accounting (and, therefore, sale and leaseback accounting) would not be appropriate. Why? Because in a finance lease the seller-lessee is effectively purchasing the asset.
One of the biggest “red flags” that might cause a leaseback to be classified as a finance lease are renewal options. If the seller-lessee has an option to renew the lease, these optional renewal periods must be included in the lease term if the lessee is “reasonably certain” to exercise them. When included, the lease term may now be for a major part of the remaining economic life of the underlying asset causing the lease to be classified as a finance lease.
Finally, be careful of sale and leaseback transactions with off-market terms. ASC 842 requires entities to make adjustments for off-market terms so that the sale is recorded at fair value. However, these off-market adjustments might cause a lease, which otherwise is an operating lease, to be classified as a finance lease.
4. Repurchase agreements and seller-lessee call options
Generally, repurchase options held by the seller-lessee and forwards (i.e. the requirement of the seller-lessee to repurchase and the buyer-lessor to sell) would fail sale accounting.
Per ASC 606-10-55-68:
“If an entity has an obligation or a right to repurchase the asset (a forward or a call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset.”
However, there is an exception! ASC 842-20-25-3 states a repurchase option does not preclude sale and leaseback accounting if both of the following criteria are met:
- Repurchase option is exercisable by the seller-lessee only at the then-prevailing fair value of the asset; and
- Alternative assets are readily available in the marketplace, which are substantially the same as the underlying asset
But, don’t get your hopes up! Sale and leaseback transactions involving real estate and integral equipment wouldn’t qualify.
5. Buyer-lessor put options with significant economic incentive to exercise
A put option held by the buyer-lessor gives them the right, but not the obligation, to sell the asset back to the seller-lessee. Generally, such put options do not preclude sale accounting. However, if the buyer-lessor has a significant economic incentive to exercise the put option, then sale accounting would not be appropriate, and the transaction should be recorded as a financing transaction. A buyer-lessor has significant economic incentive when the repurchase price is expected to significantly exceed the fair value of the asset at the time of purchase.
Be wary when people come to you with a deal that’s “too good to be true.” I’m not saying immediate gain recognition on sale and leaseback transactions is impossible, but, as with most accounting issues, the “devil is in the detail.” Therefore, be sure to read the entire contract, looking for these “red flags” that might cause a sale and leaseback transaction to fail. As always, if you have any questions, please feel free to contact us. We’re here to help!
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