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Assessing whether a sale has occurred
Contract considerations under ASC 606
Not every sale fulfills the accounting definition of a sale under U.S. GAAP. To qualify for sale accounting, the sale component of a sale and leaseback transaction must meet certain criteria under ASC 606, “Revenue From Contracts With Customers.” Specifically, control of the asset must be transferred from the seller-lessee to the buyer-lessor.
If a contract does not exist, or if control is ultimately determined to have been retained by the seller-lessee, the transaction is considered a failed sale. In such scenarios, the asset remains recognized in the financial statements, and any cash received from the buyer is characterized as a financing obligation.
Lease considerations under ASC 842
In assessing whether control of the underlying asset has been transferred, an entity must consider the classification of the leaseback component of the transaction. Critically, a leaseback that is classified as a finance lease indicates that a transfer of control has not occurred, since a finance lease classification would indicate that the seller-lessee retains control because it has the ability to 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.
Practical considerations
Determining the lease classification might require considerable judgment – particularly in assessing the lease term, payments, discount rate, and fair value of the underlying asset. Entities might find the following considerations useful when classifying the lease.
Lease term and lease payments
Under ASC 842, a lease is classified as a finance lease if the lease term constitutes a major part of the economic life of the underlying asset (the “lease term test”). Notably, the lease term is not necessarily limited to the initial stated noncancelable term; rather, it includes any subsequent renewal periods that are “reasonably certain” to be exercised. Management’s judgment plays a role in determining which renewal periods, if any, it is reasonably certain to exercise and therefore include in the lease term. An entity must weigh factors such as the costs it would incur seeking out a new lease, relocation costs, the pricing of renewal period rents, and investments in leasehold improvements that are expected to have significant remaining economic value at the end of the stated term.
The role of judgment in determining the lease term also can have an impact on management’s assessment of other lease classification criteria. For example, a lease must be classified as a finance lease if the present value of the lease payments exceeds substantially all of the fair value of the underlying asset (the “fair value test”). Because this present value amount is based on payments made throughout the lease term – thus including any reasonably certain renewal periods – management should take care in assessing its likelihood to renew any such periods.
Discount rate
Management also must be aware of the potential impact of the discount rate on the lease classification. Under the fair value test, a lease is classified as a finance lease if the present value of the lease payments and any residual value guarantee constitute substantially all (commonly interpreted as 90% or more) of the fair value of the underlying asset. Because this test is contingent on the present value of payments, the accounting outcome can be sensitive to the discount rate ultimately selected by the entity.
Private companies using a risk-free rate (as permitted under the practical expedient) should note that this election typically results in a lower discount rate than an incremental borrowing rate (IBR), making it more likely that the “substantially all” threshold is met. For other entities using an IBR, determining this rate typically requires the use of management’s judgment – which in turn could affect the lease classification. In addition, an entity must consider holistic factors such as economic conditions as well as entity- and transaction-specific characteristics.
Crowe observation: Many will already be familiar with the complexities of calculating the IBR, which must approximate a collateralized borrowing rate for the lease amount over its term. Because the lease term itself might also be subject to management’s judgment (as described in previous paragraphs), both determining and providing adequate, auditable support for the IBR can be especially challenging.
Fair value
If the transaction qualifies as a sale, the seller-lessee records the sale and leaseback, along with any associated gain or loss, based on fair value. However, because the sale price and lease payments in a sale and leaseback transaction typically are negotiated as a package, the sale price and related lease payments could be “off market,” even if multiple bids are received.
The recognition of any off-market terms depends on whether the transaction terms are above or below market terms. To make this determination, the entity may compare either 1) the sale price of the asset versus its fair value, or 2) the present value of contractual lease payments versus the present value of market lease payments, whichever is more readily determinable.
Once the entity has determined the difference between the sale price and the fair value, it accounts for the difference as follows:
- If the sale price is less than the fair value (that is, below fair value terms), the “discount” to the buyer is accounted for as a prepayment of the seller-lessee’s rent.
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If the sale price is greater than the fair value (that is, above fair value terms), excess proceeds over fair value received by the seller are accounted for as a financing obligation.
Importantly, in a sale and leaseback transaction involving below fair value terms, the prepaid rent is also included in the present value of lease payments when conducting the fair value test.
Crowe observation: Determining the fair value in a sale and leaseback transaction and providing sufficient evidence to support the valuation can be complex and has significant downstream implications. Depending on an entity’s circumstances, it might be helpful to engage the services of a third-party valuation specialist.
Accounting treatment
Sale accounting
If an entity concludes that sale accounting is appropriate, the seller-lessee accounts for both the sale and the leaseback components of the transaction. That is, the entity derecognizes the asset and will typically recognize a gain, given that it is common for the asset’s book value to sit below market at the time of sale. The entity then records an operating lease for the asset leased back.
Failed sale
As already described under “Contract considerations under ASC 606,” if the transaction results in a failed sale, the asset is not derecognized, no gain (nor loss) is recorded, and the proceeds received in the transaction are accounted for as a financing obligation.
Looking ahead
Determining the appropriate accounting for a sale and leaseback transaction requires a multifaceted assessment – often including complex, interrelated, and highly transaction-specific considerations that can be difficult to pin down. Because of the challenges they present, entities entering or contemplating a sale and leaseback could benefit from the help of a team of experienced specialists.
