Accounting for sale-leaseback transactions

September 6, 2014

In the first two parts of this article series, we discussed general capital lease accounting. For this final article, we’ll take a brief look at a special kind of transaction called a sale-leaseback.

1. What is a sale-leaseback transaction?

Consider the example in the first two articles of this series - Friends Company leases a machine from XYZ Corporation in exchange for ten annual payments. How might the situation change if Friends sold the machine to XYZ, then immediately signed a lease for it? Such a transaction is referred to as a sale-leaseback. A leaseback is useful for a company that wants to convert an asset into cash but also wants to keep using it. In fact, often times the asset never changes hands right away -- it remains in the original owner’s possession after the sale. The situation creates an accounting conundrum - should the seller book a gain on the sale only to give it all back later in the form of rent or lease payments? Under U.S. GAAP, there are five possible scenarios for sale-leasebacks. Note that exact accounting entries for sale-leasebacks are beyond the scope of this article.

2. Gain and loss on sale-leaseback transactions

There may be several situations related to sale-leaseback transactions which we will review below.

Gain – Seller essentially retains ownership

If the present value of the lease payments is more than 90% of the asset’s fair value (you may recognize this as one of the possible characteristics of a capital lease), the substance of the transaction tells us that the seller never truly gave up the asset. In this situation, the sale-leaseback is more like a loan, and any gain on the sale is deferred and recognized over the life of the lease.

Gain – Seller does not retain substantial ownership

Conversely, if the present value of future lease payments is less than 10% of the asset’s fair value, the seller can immediately record profit on the sale. This form of sale-leaseback is usually an operating lease, and the seller surrenders its right to enjoy most of the asset’s ownership benefits.

Gain – Between the two extremes

If the present value of the lease payments falls somewhere in between, the seller records any profit greater than that the present value of the lease payments. Any gain up to that point is deferred and recognized over the life of the lease.

Losses

If the asset’s fair value is lower than its carrying value in the seller’s records, a real loss has occurred and must be recognized immediately. On the other hand, if for some reason the seller’s price is below fair value, that type of loss can be deferred like the gains described above.

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