Understanding sale-leaseback transactions

Given our current state of economic uncertainty, sale-leasebacks can help businesses raise cash without disrupting use of essential assets. In this arrangement, a company sells a property, such as real estate, vehicles, or equipment, to a buyer and then leases it back. This provides immediate funding while allowing the company to continue using the asset.

Since lease payments work similarly to loan payments, sale-leasebacks often offer a lower financing cost than traditional borrowing. Companies with older properties recorded below market value may also benefit from a sale-leaseback, as it allows them to recognize a gain on the sale without taking on new debt or giving up ownership stakes.

Accounting Criteria and Considerations

For a sale-leaseback to qualify as a sale under ASC 606 – Revenue from Contracts with Customers, two conditions must first be met:

• A formal contract must exist.
• Ownership control of the property must be transferred to the buyer/lessor.

If these conditions aren’t met, the asset remains on the seller’s books, and any cash received is treated as a loan rather than a sale. Additionally, if the seller has an option to buy back the asset, it may indicate that ownership hasn’t truly transferred.

Debt and Legal Considerations

Before entering a sale-leaseback, companies must review existing loan agreements for restrictions on asset sales, mandatory prepayment clauses, or financial covenant impacts. Lease obligations may also be considered on-balance sheet debt, potentially affecting financial ratios.

In the event of bankruptcy or restructuring, courts may reclassify a sale-leaseback as a secured loan. To reduce this risk, agreements often include a precautionary lien on the property that protects the lessor’s rights if ownership is questioned.

Lease Classification: Operating vs. Finance Lease

Lease classification impacts the determination of whether a sale has occurred in a potential sale-leaseback. A lease is either an operating lease or a finance lease based on:

• Ownership Test – As noted above, if the lease transfers ownership of the asset to the lessee by the end of the lease term or grants the lessee an option to purchase the underlying asset that the lessee will likely exercise, it is a finance lease.
• Lease Term Test – If the lease lasts for most of the asset’s economic life, it is a finance lease.
• Present Value Test – If the present value of the total lease payments equals 90% or more of the asset’s fair value, it is a finance lease.

If the lease is classified as a finance lease, the transaction does not qualify as a sale because the seller/lessee retains too much control over the asset.

Present Value Test and Valuation Considerations

Lease classification depends heavily on assumptions, such as:

• Expected lease renewal periods.
• Future lease payments.
• Discount rates used to calculate present value.

The choice of discount rate significantly impacts the present value test. Companies using a higher incremental borrowing rate may lower the calculated value enough to keep it under 90%, qualifying the lease as an operating lease instead of a finance lease. However, realistic financing quotes should be used to support this calculation.

Additionally, fair market value plays a role in sale-leaseback accounting. Since sale and lease terms are often negotiated together, they may not always reflect true market values. Independent appraisals or valuation specialists can help ensure fair pricing and lease terms.

We Can Help

The closer a transaction is to the limits for operating lease qualification, the higher the risk of audit scrutiny. Sale-leaseback accounting requires careful financial modeling, judgment, and regulatory compliance.

At Elliott Davis, our team of auditors and specialists supports businesses in maintaining accurate reporting and complying with the latest accounting standards.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.