Report April 19, 2017 Center for Plain English Accounting AICPA s National A&A Resource Center available exclusively to PCPS members Sale-Leaseback Transactions Involving Real Estate Navigating the Twists and Turns We often receive inquiries from our members related to the proper application of the authoritative guidance associated with sale-leaseback transactions. The basic structure of a sale-leaseback is evident from its name the transaction involves the transfer of an asset by an entity (the seller-lessee) to another entity (the buyer-lessor) and the leaseback of the same asset by the seller-lessee. Since the topic is complex, we are covering various aspects of sale-leaseback transactions over multiple reports. In our March 2017 report, we covered the basics of sale-leasebacks that do not involve real estate. In this report, we cover the current guidance for sale-leasebacks that involve real estate. In a future report, we will address the accounting for build-to-suit leases and their relationship to sale-leasebacks. Practice Note: The FASB issued Accounting Standards Update (ASU) 2016-02, Leases, in February 2016 (codified in FASB ASC 842, Leases). Among other things, ASU 2016-02 amends the guidance related to sale-leasebacks. Importantly, because ASU 2016-02 requires lessees to recognize most leases on their balance sheets (i.e., all leases except for short-term leases if the lessee makes an accounting policy election to use this exception), sale-leasebacks will not provide lessees with a source of off-balance sheet financing under the new guidance. However, sale-leasebacks still may attract interest because a seller-lessee generally will be able to recognize any gain on the sale in full at the sale date and the balance sheet effect of the leaseback may be less significant than that of the asset and related financing. It s also important to understand how existing saleleasebacks will transition to the new lease accounting guidance. For more information, see the Transition to New Lease Accounting Guidance section below.
Authoritative Guidance The real estate subsections of FASB Accounting Standards Codification (FASB ASC) 840-40, Leases Sale-Leaseback Transactions, provide the authoritative guidance for sale-leasebacks involving real estate, including real estate with equipment. Saleleaseback accounting requires a seller-lessee to record a sale, remove the property from the balance sheet and recognize profit in accordance with the provisions of FASB ASC 840-40-25-3 through 25-4. In addition, FASB ASC 360-20, Property, Plant, and Equipment Real Estate Sales, contains criteria for profit recognition for sales of real estate. It precludes sales recognition in certain circumstances and limits the amount of profit that can be recognized in other circumstances. What is Real Estate? According to FASB ASC 360-20-15-3, the term real estate includes real estate with property improvements or integral equipment that cannot be removed and used separately from the real estate without incurring significant costs. FASB ASC 360-20-15-3 further clarifies that integral equipment should be evaluated as real estate for purposes of applying the provisions of FASB ASC 840. CPEA Observation: Determining whether equipment constitutes integral equipment is important for reaching a conclusion under FASB ASC 840-40 as to whether to apply the more stringent provisions for real estate sale-leasebacks rather than the sale-leaseback provisions pertaining to equipment. The phrase cannot be removed and used separately without incurring significant cost contains two distinct concepts: (a) the ability to remove the equipment without incurring significant cost and (b) the ability of a different entity to use the equipment at another location without significant decrease in utility or value. As such, companies should base their assessment of the significance of costs to remove and use equipment separately on an estimate of both: The cost to remove the equipment from its existing location, which includes the cost of repairing damage done to the existing location as a result of the removal The decrease in the value of the equipment as a result of the removal, which, at a minimum, should include the cost to ship and reinstall the equipment at a new site CPEA Observation: Companies should consider the nature of the equipment and the likely use of the equipment by other potential users in determining whether any additional decrease in value exists beyond that associated with the costs to ship and install the equipment.
Once the costs to remove equipment from its existing location and the decrease in value of the equipment have been calculated, the seller must determine if these costs are significant. When the combined total of both the cost to remove plus the decrease in value exceeds 10 percent of the fair value of the equipment (installed) the equipment is considered integral equipment. The following illustrates the integral equipment calculation: (Costs incurred on removal, including repairs) + (Greater of loss in fair value upon removal or cost to ship and reinstall) = Total costs Equipment would be considered integral if the total costs are greater than 10% of fair value of equipment (installed). The following example illustrates this calculation: Richards, Inc. leases equipment to Acme Company for use in a manufacturing facility. The fair value of the production equipment (installed) at lease inception is $1,075,000. The estimated cost to remove the equipment after installation (estimate is as of the beginning of the lease term) is $80,000, which includes $30,000 to repair damage to the existing location as a result of the removal. The estimated cost to ship and reinstall the equipment at a new site (estimated as of the beginning of the lease term) is $85,000. Assume that the equipment would have the same fair value (installed) to the seller and a potential buyer. Therefore, there is no decrease in fair value of the equipment beyond the discount a purchaser would presumably require to cover the cost to ship and reinstall the equipment. Richards, Inc. would assess whether or not the production equipment is integral equipment as follows: ($80,000 + $85,000) $1,075,000 = 15.3 percent. Because the cost of removal combined with the diminution in value exceeds 10 percent of the fair value (installed) of the production equipment, the cost to remove the equipment and use it separately is deemed to be significant. Therefore, the production equipment is integral equipment. Is the Sale a Sale? FASB ASC 840-40 provides that a seller-lessee may only apply sale-leaseback accounting to a transaction involving real estate if the transaction first qualifies as a sale under FASB ASC 360-20. FASB ASC 360-20-40-3 lays out the underlying principles,
indicating that profit on a real estate sale may be recognized in full on the date of sale, only if both of the following conditions are met: The profit is determinable (i.e., collectibility is reasonably assured or the amount that will not be collected can be estimated) The earnings process is virtually complete (i.e., the seller does not have substantial continuing involvement) If these general principles are not met, full profit recognition (and, in some cases, sales recognition) is postponed. FASB ASC 360-20 describes how to determine whether these general principles have been satisfied and the appropriate accounting to apply in other circumstances. In general, if collectibility is not reasonably assured, profit recognition is deferred until such time as collectibility is assured or cash is collected. If the earnings process is incomplete, profit recognition generally shifts from the time of sale to the time of the seller s performance on the contract. Importantly, a sale would not be recorded if a seller s continued involvement in the property carries essentially the same risks as ownership of the property. FASB ASC 360-20-40-4 provides general guidance on assessing collectibility. In assessing collectibility, a seller must consider the buyer s commitment to pay for the property based on the buyer s initial and continuing investments in the property sold. The seller should also consider other collectibility factors, such as the credit standing of the buyer, the age and location of the property, and the adequacy of cash flow from the property, even if the initial and continuing investments are considered adequate. FASB ASC 360-20-40-5 provides an overview of the detailed guidance that should be followed to meet the conditions set forth above, noting that profit cannot be recognized by the full accrual method until: A sale is consummated (FASB ASC 360-20-40-7) The buyer s initial and continuing investments are adequate to demonstrate a commitment to pay for the property (FASB ASC 360-20-40-8 through 40-24) The seller s receivable is not subject to future subordination (FASB ASC 360-20- 40-25) and The seller has transferred to the buyer the usual risks and rewards of ownership in a transaction that is in substance a sale, and does not have a substantial continuing involvement with the property sold (FASB ASC 360-20-40-26) Practice Note: If the transaction does not qualify as a sale, the seller must account for the transaction as a financing transaction or by using the deposit method, depending on which criteria in FASB ASC 360-20 have not been satisfied. For example, if the initial investment test is not met, the deposit method should be applied. Alternatively, if a
transaction does not qualify as a sale because it includes an option to repurchase the property, it may be appropriate to account for the transaction as a financing transaction, a lease, or a profit-sharing arrangement rather than as a sale. Does the Transaction Qualify for Sale-Leaseback Accounting? Once it is determined that the transaction qualifies as a sale under FASB ASC 360-20, the transaction must be evaluated under FASB ASC 840-40-25-9. For transactions involving real estate to qualify for sale-leaseback accounting, the transaction must satisfy each of the following criteria: The leaseback must be deemed to be a normal leaseback The sale-leaseback agreement must include payment terms and provisions that adequately demonstrate the buyer-lessor s initial and continuing investment in the property acquired Payment terms and provisions must transfer all of the risks and rewards of ownership as demonstrated by the absence of any continuing involvement by the seller-lessee other than a normal leaseback Normal Leaseback A normal leaseback is defined as a lessee-lessor relationship that involves the active use of the property by the seller-lessee in consideration for rental payments, including contingent rents that are based on future operations of the seller-lessee. The property leased back must be used during the lease term in the seller-lessee s trade or business, and any subleasing of the leased back property must be minor, regardless of whether the seller-lessee s business is leasing real estate. Otherwise, the sale and lease do not qualify as a sale-leaseback. Subleasing is considered minor if the present value of the sublease rental payments is not more than 10 percent of the fair value of the property sold. If the present value of the sublease rental payments exceeds 10 percent, the transaction should be accounted for as a financing or by using the deposit method. CPEA Observation: The real estate sale-leaseback provisions apply regardless of whether the seller-lessee leases back all or some portion of the property sold, as well as if the leaseback is a capital or operating lease. For example, if the property sold is a tenfloor office building and five floors are leased back, sale-leaseback accounting for real estate sale-leaseback transactions under the provisions of FASB ASC 840-40 is applicable. If the leaseback is considered minor, (i.e., the present value of the rental payments is less than 10 percent of the total property s fair value and no prohibited forms of continuing involvement exist), the sale and leaseback would be treated as separate transactions and any gain would be recognized currently, assuming that the provisions of FASB ASC 360-20 are met. If a prohibited form of continuing involvement exists, the seller
would account for the transaction under the deposit method or as a financing even if the leaseback is minor. Initial and Continuing Investment The initial and continuing investments should give the buyer-lessor a large enough stake in the property that the risk of loss through default motivates the buyer-lessor to honor its obligation to the seller-lessee. The buyer-lessor s initial investment is considered adequate when the buyer-lessor has demonstrated both: A commitment to pay for the property A reasonable likelihood that the seller-lessee will collect the receivable CPEA Observation: The adequacy of the initial investment is determined by its composition and size. The buyer-lessor also must continue to demonstrate a commitment to pay for the property after the initial investment is made. To show this commitment, the buyer-lessor is required to increase its investment in the property each year. The buyer-lessor s continuing investment is considered adequate when the buyer-lessor is contractually required to pay each year on its total debt an amount at least equal to level annual payments necessary to fund principal and interest. These payments should result in the amortization of the total debt over a maximum term of: Twenty years for land The customary amortization term of a first mortgage loan by an independent, established lending institution for property other than land Continuing Involvement In a real estate sale-leaseback, if the seller-lessee has any continuing involvement with the property at the inception of the agreement (other than a normal leaseback ), the seller would be precluded from accounting for the transaction as a sale. Instead, the transaction would be accounted for either as a financing transaction or by using the deposit method. If a form of continuing involvement discussed below arises at a later date, it should be evaluated to determine if it was initially contemplated when the sale-leaseback agreement originated. CPEA Observation: A contingent form of continuing involvement still is considered continuing involvement that results in a failed sale-leaseback. For example, if the lessee is required to offer to purchase the property from the lessor or the lessor has an obligation or option to offer the property for sale to the lessee as a remedy or consequence of a
default, this would represent a form of continuing involvement the likelihood of default occurring is not relevant. FASB ASC 840-40-25-12 through 25-17 provides examples of continuing involvement (not all-inclusive) that would prohibit sales recognition and instead require accounting as a financing transaction or by using the deposit method include: The seller-lessee has the right to continue to extend the lease, at a fixed-price rental, for substantially all (i.e., 90 percent or more) of the asset s remaining economic life The existence of an option to repurchase the property sold, even though the exercise price is equal to the then fair value of the property at the date the option is exercised (a right of first refusal generally does not constitute an option to repurchase) An obligation on the part of the seller-lessee to repurchase the property sold, or the ability of the buyer-lessor to compel the seller-lessee to repurchase the property at any time in the future The seller-lessee or a party related to the seller-lessee guarantees the buyerlessor s investment or a return on that investment for either a limited or extended period of time (e.g., a guarantee by the parent company of a lease entered into by a subsidiary of the parent constitutes a form of continuing involvement) Payments required by the seller-lessee for a decline in the fair value of the property, including a guaranteed residual value Any form of continuing ownership in the property (e.g., if the seller-lessee sold the property to a partnership in which the seller has a partnership interest, no matter how minor, sales recognition would be prohibited) The seller-lessee provides non-recourse financing to the buyer-lessor for any portion of the sales price or provides recourse financing in which the only recourse available to the seller is the property sold (this provision also applies to financial institutions that in the normal course of business provide real estate financing) The seller-lessee is not relieved of its obligation under any existing debt related to the property (e.g., if the seller-lessee remains secondarily liable on outstanding indebtedness related to the property sold, sales accounting is prohibited) The seller-lessee provides collateral to lenders or the buyer-lessor other than the property directly involved in the sale-leaseback transaction, or the seller-lessee (or a related party to the seller-lessee) guarantees the buyer-lessor s debt The seller-lessee s rental payments are contingent on some predetermined or determinable level of future operations of the buyer-lessor The seller-lessee enters into a sale-leaseback of real estate that also involves property improvements or integral equipment without selling or leasing the underlying land to the buyer-lessor
The seller-lessee is required to initiate or support operations or continues to operate the property at its own risk, for an extended period, for a specified limited period, or until a specified level of operations has been achieved (e.g., until rentals of a property are sufficient to cover operating expenses and debt service) Any provision or circumstance that allows the seller-lessee to participate in any future profits of the buyer-lessor or the appreciation of the leased property (e.g., a situation in which the seller-lessee owns or has an option to acquire any interest in the buyer-lessor) CPEA Observation: FASB ASC 840-40 expands the definition of prohibited continuing involvement from FASB ASC 360-20 and provides that if a seller-lessee has any continuing involvement with the property, other than a normal leaseback, the seller is precluded from accounting for the transaction as a sale. Therefore, a transaction in which the seller has continuing involvement, such as a support obligation for a limited period or a right to participate in future profits, may qualify as a sale under FASB ASC 360-20, but would not qualify to be accounted for as a sale-leaseback transaction under FASB ASC 840-40. Account for the Transaction If there is a prohibited form of continuing involvement by the seller-lessee, FASB ASC 840-40-25-11 requires that the transaction be accounted for either as a financing transaction or by using the deposit method. CPEA Observation: FASB ASC 840-40-55 includes example journal entries to account for transactions using both the financing and deposit methods; however, the implementation guidance does not provide all supporting calculations. In order to provide additional clarity in understanding how the amounts in those entries are determined, the CPEA has prepared an Excel workbook which includes the journal entries and calculations used for both methods, which can be accessed on our website by clicking here. Financing Transaction When a transaction is accounted for as a financing, the asset subject to the saleleaseback remains on the balance sheet of the seller-lessee and continues to be depreciated. Sale proceeds are recorded as a liability. Lease payments less the portion considered to be interest expense decrease the financing liability, and collections on any buyer-lessor s note increase the financing liability.
Deposit Method In certain real estate sales situations, FASB ASC 360-20 specifically requires the use of the deposit method of accounting. For example, use of the deposit method is required if all conditions precedent to closing have not been performed. Under the deposit method, any down payment and payments of principal and interest received are recorded as a deposit liability. Lease payments decrease and collections on any buyer-lessor s note increase the deposit liability account. The property would continue to be recognized in the seller-lessee s balance sheet and the seller-lessee would continue to depreciate the property. Gain Recognition A transaction that qualifies for sales recognition under FASB ASC 360-20 and as a saleleaseback under FASB ASC 840-40 is accounted for using sale-leaseback accounting by the seller-lessee whether the leaseback is classified as a capital lease or an operating lease. The approach is first to determine the gain that would be recognized for the sale of real estate under FASB ASC 360-20 as if the transaction were a sale without a leaseback. The total gain is recognized immediately if the leaseback is considered minor (i.e., the present value of the rental is less than 10 percent of the fair value of the property sold). If the leaseback is other than minor but less than substantially all, the gain to be recognized currently is the amount of gain in excess of (a) the present value of the minimum lease payments if the leaseback is classified as an operating lease or (b) the recorded amount of the leased asset if the leaseback is classified as a capital lease. Any deferred profit where the leased asset is land only is amortized on a straight-line basis over the lease term. Otherwise, any deferred profit is amortized: (a) in proportion to the amortization of the leased asset for a capital lease; and (b) in proportion to the related gross rental charged to expense over the lease term for an operating lease. CPEA Observation: If the rentals under the lease agreement are unreasonable in relation to market conditions at the inception of the lease, FASB ASC 840-40-25-3a requires an appropriate amount be deferred or accrued (by adjusting the profit or loss on the sale) and amortized as an adjustment of those rentals. Transition to New Lease Accounting Guidance As mentioned above, ASU 2016-02 will substantially change the accounting for saleleasebacks. Under the new lease accounting guidance, both the seller-lessee and the buyer-lessor are required to apply FASB ASC 842 and certain provisions in FASB ASC 606, Revenue from Contracts with Customers, to determine whether to account for a saleleaseback as a sale and purchase of an asset, respectively. In other words, the buyerlessor is required to evaluate whether a sale of the underlying asset has occurred based on the sale guidance in the new revenue recognition standard and, if a sale has not
occurred, to account for the transaction as a financing arrangement. Under current U.S. GAAP, a failed sale for the seller-lessee is not accounted for as a failed purchase by the buyer-lessor. Also, under the new standard, there will be no specialized guidance for saleleasebacks of real estate. Importantly, a transaction previously accounted for as a sale and leaseback under FASB ASC 840 will not have to be reassessed to determine whether it would have qualified as a sale (or purchase) under the guidance in FASB ASC 606 (as required by FASB ASC 842). However, a sale-leaseback previously accounted for as a failed sale and leaseback in accordance with FASB ASC 840 should be reassessed to determine whether a sale would have occurred at any point on or after the beginning of the earliest period presented in the financial statements under the guidance in FASB ASC 842. If a sale would have occurred, the seller is required to recognize any deferred gain or loss that exists as of the later of (1) the earliest period presented or (2) the date of the sale of the underlying asset as follows: If the underlying asset is land only, on a straight-line basis over the remaining lease term If the underlying asset is not land only and the leaseback is a finance lease, in proportion to the amortization of the right-of-use asset If the underlying asset is not land only and the leaseback is an operating lease, in proportion to the total lease cost The seller recognizes any deferred gain or loss resulting from off-market terms as an adjustment to the leaseback right-of-use asset (loss) or lease liability (gain) as of the date of initial application. Any deferred gain or loss not resulting from off-market terms is recognized as a cumulative-effect adjustment to opening equity (if the transaction occurred before the earliest year presented) or earnings in the comparative period (if the transaction occurred within one of the comparative periods presented). Center for Plain English Accounting aicpa.org/cpea cpea@aicpa.org The CPEA provides non-authoritative guidance on accounting, auditing, attestation, and SSARS standards. Official AICPA positions are determined through certain specific committee procedures, due process and extensive deliberation. The views expressed by CPEA staff in this report are expressed for the purposes of providing member services and other purposes, but not for the purposes of providing accounting services or practicing public accounting. The CPEA makes no warranties or representations concerning the accuracy of any reports issued. Copyright 2017 by American Institute of Certified Public Accountants, Inc. New York, NY 10036-8775. All rights reserved. For information about the procedure for requesting permission to make copies of any part of this work, please e-mail cpea@aicpa.org with your request. Otherwise, requests should be written and mailed to the Center for Plain English Accounting, AICPA, 220 Leigh Farm Road, Durham, NC 27707-8110.