Sale and leaseback transactions have become more common due to the benefits of this type of financing, especially in a tight capital market. From a seller-lessee perspective, they provide immediate liquidity and a cheaper form of financing. For buyer-lessors, the benefits include a reduced default risk, the ability to terminate the contract more easily, and a guaranteed residual value at termination.

Transaction Overview

In a sale and leaseback transaction, the seller-lessee sells an asset it owns to the buyer-lessor and simultaneously leases back all or a portion of the same asset for all or part of the asset’s remaining economic life. Some transactions are easily identified as sales and leasebacks; however, certain arrangements require more judgment to determine whether they should be accounted for as sale and leaseback transactions.

Accounting Decision Framework

ASC 842 updated the guidance for sale and leaseback transactions, making it applicable to both lessees and lessors and applying it consistently to real estate and other types of assets. The following steps should be followed to determine the appropriate model for the sale and leaseback transaction:

1. Determine whether a sale has occurred

Whether a transaction qualifies as a sale and leaseback transaction centers on whether control has effectively been transferred to the buyer-lessor in accordance with ASC 606, Revenue from Contracts with Customers.

The first step is to identify the contract. A contract can be written, oral, or implied by an entity’s customary business practices. Generally, any agreement that creates legally enforceable rights and obligations meets the definition of a contract.

The second step is to determine whether the customer has obtained control of the asset. ASC 606 lists five indicators that a customer has obtained control of an asset:

• The reporting entity has a present right to payment.
• The customer has legal title.
• The customer has physical possession of the asset.
• The customer has significant risks and rewards of ownership.
• The customer has accepted the asset.

2. Determine the classification of the leaseback

In assessing whether control of the underlying asset has been transferred, an entity must consider the classification of the leaseback component of the transaction. Under ASC 842, leases are classified as either financing or operating. The leaseback must be an operating lease to be eligible for qualified sale accounting. A leaseback that is classified as a finance lease indicates that a transfer of control has not occurred, since a finance lease classification indicates that the seller-lessee retains control because it can direct the use of the asset and receive substantially all its remaining benefits. Thus, if the leaseback is classified as a finance lease, the transaction is considered a failed sale.

If any one of the criteria under ASC 842 is met, control over the underlying asset does not qualify as an effective transfer. The criteria underlying classification of the transaction as a finance lease are:

• 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 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; and
• The underlying asset must be of a specialized nature precluding any alternative use to the lessor at the termination of the lease period.

Generally, repurchase options held by the seller-lessee would fail sale accounting, especially if it’s a fixed repurchase option. However, a repurchase option can lead to sale and leaseback accounting if both of the following criteria are met:

• The exercise price of the option is the fair value of the asset at the time the option is exercised.
• There are alternative assets—substantially the same as the transferred asset—readily available in the marketplace.

If the leaseback is classified as a finance lease, or control has not been transferred, then the transaction is considered a Failed Sale and Leaseback. See below for the accounting impact.

Accounting Models

The recognition and measurement provisions under each model are different; therefore, it is critical to first determine the appropriate model to use.

Other Accounting Considerations

Off-Market Terms – Sale

The sale should be recognized at fair value. Accordingly, some adjustments may be needed if the transaction is entered into under off-market terms. Under ASC 842, an entity shall use the difference between either of the following to evaluate whether the sale is at fair value:

• The asset’s sale price and fair value
• The present value of the lease payments and market rental payments

If the sale is not at fair value, ASC 842 requires an entity to account for both of the following:

• Any increase to the sale price of the asset as a prepayment of rent.
• Any reduction of the sale price of the asset as additional financing provided by the buyer-lessor to the seller-lessee. The seller-lessee and buyer-lessor shall account for the additional financing in accordance with other topics.

Asset Under Construction

When a lessee is involved in the construction of an underlying asset before lease commencement, they should determine whether they control the asset during the construction period, similar to the evaluation under ASC 606 to determine whether a performance obligation is satisfied over time. If a lessee controls the underlying asset under construction before lease commencement, the lessee should account for the underlying asset during the construction period similar to other construction in progress assets and recognize any costs of construction paid for by the lessor as a financial liability. If a lessee does not control the underlying asset under construction, the transaction is not subject to the sale and leaseback guidance. 

Leaseback Commencing after Sale

Typically, the seller-lessee’s lease commences concurrently with execution of the sale in a sale and leaseback transaction. When the lease begins after the sale, the lease cannot be classified at the sale date, and the parties cannot determine if the lessee has transferred control of the asset to the buyer-lessor. Therefore, when the leaseback begins later than the sale, the sale should not be recognized until sale and leaseback transaction can be evaluated.

Costs incurred by Seller-Lessee

Third-party transaction costs that the seller-lessee incurs if the asset was sold outright should be accounted for as part of the sale transaction and reduce the gain (or increase the loss) on the sale. Any incremental costs associated with the leaseback portion should be evaluated to determine if they are initial direct costs. In some cases, the seller-lessee may be required to pay the buyer-lessor’s costs. The seller-lessee will need to use judgment to determine if these costs should be accounted for as a reduction of the sales price or as a cost associated with the leaseback.

Allocation of leaseback payments by a Seller Lessee in a Failed Sale Leaseback

A seller-lessee should allocate the lease payments between interest expense and principal repayment of the financial liability. To determine the amount allocated to interest expense, the seller-lessee should use its incremental borrowing rate. However, the seller-lessee should adjust the interest rate as necessary to ensure that both of the following apply:

• Interest on the financial liability is not greater than the principal payments on the financial liability over the shorter of the lease term and the financing term.
• The carrying amount of the asset does not exceed the carrying amount of the financial liability at the earlier of the end of the lease term or the date at which control of the asset will transfer to the buyer-lessor.

The second criterion (net book value of asset) does not apply when it is reasonably certain at lease commencement that control of the asset will not transfer to the buyer-lessor because the loss would not transpire. This can occur when the leaseback is a finance lease. In such cases, the seller-lessee should apply a discount rate that will amortize the financing liability to zero as of the last payment to the buyer-lessor.