Sale-Leaseback Accounting Under ASC 842

This guide is for companies that report under US GAAP. It is a plain-language map of the rules, not accounting advice, and your own CPA and auditors should reach the conclusion for your transaction.

A sale-leaseback has two halves, a transfer of the asset and a lease back to the seller. ASC 842-40 does not let a company account for the sale half until it has tested whether a sale really occurred. The test borrows from the revenue standard, ASC 606: there must be a contract, and the buyer-lessor must obtain control of the asset. Indicators of control that accounting guides list include legal title, physical possession, the risks and rewards of ownership, and an obligation to pay.

The leaseback alone does not prevent the buyer from obtaining control. Two features of the deal can, however, and both are negotiated business terms.

The first is the classification of the leaseback. Under ASC 842-40-25-2, the buyer-lessor is not considered to have obtained control if the leaseback would be classified as a finance lease by the seller-lessee, or a sales-type lease by the buyer-lessor. In practical terms, an operating leaseback can support sale accounting and a finance leaseback cannot. A lease is a finance lease if it meets any one of five criteria:

• Ownership of the asset transfers to the lessee by the end of the lease.
• The lessee has a purchase option it is reasonably certain to exercise.
• The lease term covers a major part of the asset's remaining economic life.
• The present value of the lease payments, plus any residual value the lessee guarantees, amounts to substantially all of the asset's fair value.
• The asset is so specialized that the lessor is expected to have no alternative use for it at the end of the term.

Renewal options count toward the lease term when the lessee is reasonably certain to exercise them, so a long base term with attractive renewals can tip a lease into finance classification. A significant residual value guarantee by the seller-lessee can also affect the control analysis.

The second is a repurchase option. Under ASC 842-40-25-3, an option for the seller-lessee to buy the asset back precludes sale accounting unless two conditions are both met: the exercise price is the asset's fair value at the time of exercise, and alternative assets that are substantially the same are readily available in the marketplace. Accounting guides note that real estate is treated as unique and does not meet the second condition, so a repurchase option in a real estate sale-leaseback will generally prevent sale accounting.

Lease term, renewal options, purchase options, guarantees and rent level are all negotiated in the letter of intent. Have your CPA review the term sheet before you sign it, not the lease after it is drafted.

When the transfer is a sale, the seller-lessee does three things at closing:

1. Recognizes the transaction price for the sale at the point the buyer-lessor obtains control.
2. Derecognizes the carrying amount of the building and land.
3. Accounts for the leaseback under the normal lessee model, which means recording a right-of-use asset and a lease liability.

The difference between the sale proceeds and the carrying amount is a gain or loss. Under US GAAP the seller-lessee recognizes that gain or loss in full at the sale date, subject to the off-market adjustments described below.

The lease liability is measured from the lease payments, and the right-of-use asset is measured the same way as for any other lease. For an operating leaseback, lease expense is then recognized on a straight-line basis over the term.

This is the point that surprises owners who remember older rules. A sale-leaseback does not make the occupancy obligation disappear from the financial statements. The owned building and any mortgage on it are replaced by cash, a right-of-use asset and a lease liability. Whether that picture is better or worse for your company depends on your facts and on how your lenders read it.

Sale price and rent are negotiated together, so the accounting rules check whether the deal as a whole is at fair value. The company compares either the sale price with the fair value of the asset, or the present value of the contractual lease payments with the present value of market-rate lease payments, whichever is more readily determinable.

• If the sale price is below fair value, the shortfall is treated as prepaid rent. It increases the right-of-use asset, and the gain or loss on sale is adjusted accordingly.
• If the sale price is above fair value, the excess is treated as additional financing from the buyer-lessor. It is recorded as a financial liability separate from the lease liability, and part of each payment is treated as debt service.

The adjustment can also change the lease classification. PwC's leases guide notes that it could cause a lease that would otherwise be operating to be classified as a finance lease, which would preclude sale accounting altogether. A leaseback with rent set well above market in exchange for a higher price is therefore an accounting question as well as a business one.

When the transfer is not a sale, the transaction is accounted for as a financing. The seller-lessee does not derecognize the building, continues to depreciate it, recognizes no gain, and records the cash received as a financial liability. Payments to the buyer-lessor are split between interest and principal.

The conclusion is not necessarily permanent. It is reassessed when facts change. For example, if a repurchase option that blocked sale accounting later expires unexercised, the company would recognize the sale at that point and begin accounting for the leaseback as a lease.

Failed-sale accounting is not a penalty and the cash is the same either way, but the financial statements look quite different, and that difference can matter to lenders and buyers of the business. We cover that in a separate guide on financing treatment.

• ✓Would the proposed leaseback be an operating lease or a finance lease, counting the renewal options we are reasonably certain to exercise?
• ✓Is the proposed term a major part of the building's remaining economic life?
• ✓Does the present value of the rent approach the building's fair value?
• ✓Does the deal include any repurchase option, and if so, are we prepared for financing treatment?
• ✓Are we giving any residual value guarantee or similar support?
• ✓Is the sale price at fair value, and is the rent at market? What evidence supports that?
• ✓What discount rate will we use to measure the lease liability?
• ✓What gain or loss will we report, and in which period?
• ✓How will the new lease liability be treated under our loan covenants?

We are real estate advisors, not accountants. What we bring to this conversation is the market evidence for price and rent and the ability to negotiate term, options and repair obligations with the accounting result in view, working alongside your CPA.