The leasing standard changes unveiled with the Financial Accounting Standards Board (FASB) Accounting Standards Update No. 2016-02, Leases (Topic 842) will change the way many organizations account for their leases. In addition to modifying the lessee and lessor accounting models, the new standard also introduces changes to the accounting model for sale-leaseback transactions, as well as other leasing concepts. Organizations with leasing arrangements should take note of how the changes will affect their lease accounting processes.
Sale and Leaseback Accounting
A sale and leaseback transaction involves the transfer of an asset by an entity (called the seller-lessee) to another entity (the buyer-lessor) and the leaseback of that same asset by the seller-lessee. Sale and leaseback transactions are frequently seen with real estate—the seller-lessee sells its property to a buyer-lessee, and then rents it back from the buyer-lessee for a contracted period of time.
The practice may be less desirable for the seller-lessee than in the past because lessees must now recognize all leases except short-term leases on their balance sheet. As such, sale and leaseback transactions will no longer provide lessees with a source of off-balance sheet financing. In addition, sale and leaseback accounting will be the same for all assets, which does away with the real-estate-specific guidance in current U.S. Generally Accepted Accounting Principles (GAAP).
Accounting for sale and leaseback transactions received an update with the new leasing standard in part because of the changes to revenue recognition. A seller-lessee and a buyer-lessor will use ASC Topic 606, Revenue from Contracts with Customers, to determine whether a sale has occurred by evaluating whether a transaction meets the definition of a contract, as well as determining when an entity satisfies the performance obligation in the transaction to transfer the control of an asset. The concepts of ASC Topic 606 are used even if the seller-lessee and the buyer-lessor have not adopted the new revenue recognition standard yet.
If a sale has occurred, the seller-lessee will recognize gain or loss immediately in accordance with the new revenue recognition standard. The buyer-lessor will account for the purchase of the asset under ASC Topic 360, Plant, Property and Equipment. Then, both the seller-lessee and buyer-lessor will classify and account for the leaseback as a lease in accordance with the new leasing standard, just like any other lease that is evaluated.
When a transaction is negotiated with a sales price that is above or below the asset's fair value and with lease payments that are above or below market rates, the off-market adjustments impact the accounting of the sale and leaseback. Below-market terms increase the sales price and initial measurement of the right-of-use asset and should be accounted for as a lease prepayment. Above-market terms decrease the sales price and should be recorded as additional financing received separately from the lease liability.
If a sale has not occurred, the seller-lessee and buyer-lessor will not record the transfer of the asset. Instead, the seller-lessee will recognize a financial liability equal to the proceeds received. The buyer-lessor will record a receivable equal to the amounts paid. It is important to note that the existence of a leaseback, in isolation, does not preclude a sale. A sale is precluded if:
- The leaseback is classified as a finance lease under lessee accounting or a sales-type lease under lessor accounting; or
- The seller-lessee has a repurchase option (subject to the exception below).
There is an exception to the repurchase option sale-preclusion. If the option is only exercisable at the prevailing fair market value at the time of the lease's commencement and the lease asset is non-specialized, then the sale is not precluded. There should be alternate assets substantially similar to the transferred assets that are readily available in the marketplace. The FASB observed that a real estate asset is generally not substantially the same as any other real estate asset because, by its nature, real estate is unique. As a result, repurchase options with the sale and leaseback of real estate would likely not constitute a sale.
Lessee Involvement in Construction ('Build-to-Suit' Transactions)
The leasing standard provides guidance on when a lessee's involvement during the construction of an underlying asset makes the lessee, in substance, the owner of the asset during the construction period. The old model was based on a risk approach that used quantitative and qualitative considerations. The new model is based on control. The following are some examples of circumstances that demonstrate that the lessee controls an underlying asset that is under construction before the commencement date of the lease:
- The lessee has the right to obtain the partially constructed asset at any point during the construction period (such as by making a payment to the lessor).
- The lessor has an enforcement right to payment for its performance-to-date, and the asset does not have an alternative use to the owner-lessor.
- The lessee legally owns both the land and the property improvements (e.g. a building) that are under construction or the non-real-estate asset (e.g., a ship or piece of machinery) that is under construction.
- The lessee controls the land that property improvements will be constructed upon and does not enter into a lease of the land before the beginning of construction that permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements. This circumstance also includes when the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale under the concepts discussed previously.
- The lessee is leasing the land that property improvements will be constructed upon, the lease term is for substantially all of the economic life of the property improvements and the lessee does not enter into a sublease of the land before the beginning of construction that permits the lessor or another unrelated third party to sublease the land for substantially all of the economic life of the property improvements.
When the lessee has control over the asset during construction, it will recognize the entire construction project on its statement of financial position during the construction period. At completion of the construction, generally when the lease commences, the lease is subject to sale and leaseback accounting. If the lessee does not have control over the asset during construction, any amounts paid by the lessee will be treated as prepaid lease payments.
Subleases
When an entity enters into a sublease, the original lease (often referred to as the head lease) should be accounted for separately from the sublease. There is a narrow exception when the two lease contracts meet the contract combination guidance. However, if a sublease relieves the original lessee of the primary obligation of the head lease, the sublease triggers a lease termination.
For the original lessor, the accounting for the head lease does not change when the lessee enters into a sublease unless the original lease agreement is replaced by a new agreement with a new lessee. In that case, the lessor would account for the original lease as a termination and the new lease as a separate transaction.
The lessee of the head lease must take into consideration the lease classification of the head lease and the sublease in order to determine the proper accounting treatment of the head lease. If the sublease is an operating lease, then the original lessee should account for the head lease as it did before the sublease.
For sales-type or direct-financing subleases, the lessee of the head lease should derecognize the original right-of-use asset but retain the original lease liability. If the head lease is a finance lease, then the lessee continues to account for the original lease liability as it did before commencement of the sublease. However, if the head lease is an operating lease, then the subsequent measurement of the original lease liability is accounted for as of the commencement date of the sublease.
Lessees should classify their subleases with reference to the underlying property, plant or equipment asset being leased. This guidance marks a difference from international standards, which requires subleases to classify subleases with reference to the head lease's right-of-use asset.
Impairment
Right-of-use assets are considered long-lived assets and must be tested for impairment. If a triggering event occurs that would reduce the fair value of an asset beneath its carrying amount, the lessee should test the affected right-of-use assets for impairment. If one exists, the impairment should be recognized in accordance with ASC Topic 360-10-35, Impairment or Disposal of Long-Lived Assets. Furthermore, the impaired right-of-use asset would be amortized on a straight-line basis. As discussed in earlier editions of our Understanding the Leasing Standard serial, finance leases are already amortized on a straight-line basis. Normally, the right-of-use assets for operating leases are not straight-lined. As a result, impairment changes the expense recognition pattern for operating leases.
Evaluate Leasing Arrangements Early
Although the leasing standard begins its rollout in the 2019 calendar year, entities should begin to evaluate how their financial statements may be affected by the new standard. The next installment of our Understanding the Leasing Standard Serial will discuss lease modifications, transition and implementation considerations in more detail.
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