Sale and leaseback transactions are a strategic financial tool businesses use to unlock cash flow while retaining operational control of critical assets. In such an arrangement, a seller transfers ownership of an asset to a buyer and immediately leases it back. This type of transaction can provide significant benefits to both parties: the seller-lessee gains liquidity and operational flexibility, while the buyer-lessor secures a steady income stream and potential tax advantages. However, determining whether a transaction qualifies as a sale and leaseback under Generally Accepted Accounting Principles (GAAP) involves navigating a complex set of criteria.
This two-part blog series explores the mechanics of sale and leaseback transactions, their benefits, and the key considerations accountants must address to ensure compliance with ASC 606 and ASC 842.
What is a Sale and Leaseback Transaction?
A sale and leaseback transaction involves two parties: the seller-lessee and the buyer-lessor. The seller sells an asset to the buyer and leases it back under a lease agreement. This arrangement enables the seller-lessee to access immediate cash, often at a lower borrowing cost, while retaining the asset's use for business operations. Additional benefits include deductible rental payments and a reduction in asset ownership risks. For the buyer-lessor, advantages include stable rental income, potential asset appreciation, and tax benefits.
Identifying a Sale and Leaseback Transaction
Accountants often face challenges in determining whether a transaction qualifies as a sale and leaseback under GAAP. Simply labeling an arrangement as such in business terms does not guarantee it meets the criteria for sale and leaseback accounting. The critical question is: does the transaction satisfy the revenue recognition requirements under ASC 606 before being evaluated under the lease standards of ASC 842?
Requirements Under ASC 606: Revenue from Contracts with Customers
- A Contract Exists:
- The contract must be approved by both parties, with commitments to perform obligations.
- The rights of each party regarding the goods or services must be clearly identified.
- Payment terms must be defined.
- Control of the Asset is Transferred:
- ASC 606-10-25 outlines five indicators (not criteria) to determine if control has been transferred:
- Present right to payment by the seller-lessee.
- Legal title obtained by the buyer-lessor.
- Physical possession by the buyer-lessor.
- Transfer of significant risks and rewards of ownership to the buyer-lessor.
- Asset acceptance by the buyer-lessor.
- ASC 606-10-25 outlines five indicators (not criteria) to determine if control has been transferred:
These indicators should be evaluated collectively, requiring professional judgment focused on the buyer-lessor's perspective.
Additional Considerations Impacting Sale Qualification
Beyond meeting ASC 606 requirements, other factors may affect the transaction's classification:
- Prospective Lessee Control Before Lease Commencement Date:
- If the lessee obtains legal title and control of the asset before its transfer to the lessor, the transaction qualifies as a sale and leaseback.
- Conversely, if the lessee has legal title but lacks control, it does not qualify as a sale and leaseback.
- Repurchase Options:
- A repurchase agreement included in the transaction may preclude the recognition of a sale, as it implies a future return of control to the seller-lessee.
- Lease Classification:
- The lease type determines whether the transaction is recognized as a sale and leaseback.
- An operating lease qualifies, while a finance lease does not. The following criteria classify a lease as a finance lease, disqualifying it from sale and leaseback treatment:
- Ownership transfer at the end of the lease term.
- Reasonably certain purchase option exercised by the lessee.
- Lease term constitutes a major portion (75%) of the asset’s remaining economic life.
- Present value of lease payments equals or exceeds substantially (90%) the asset’s fair value.
- Specialized asset nature precluding alternative use by the lessor at lease end.
Sale and leaseback transactions offer valuable opportunities for businesses, but navigating the accounting requirements can be complex. Understanding the detailed criteria of ASC 606 and ASC 842 ensures proper classification and compliance.
In Part 2 of this blog series, we’ll explore how to account for a sale and leaseback transaction. If you have questions about sale and leaseback transactions, leave a comment below or feel free to contact me directly. I’m happy to help!