Sale and Leaseback Accounting

Transcript

Shreeya

Hello, and welcome back to our podcast series “On the top shelf”, which deals with topical issues when engaging with the IFRS accounting standards that impact clients operating in the retail and consumer industry. 

My name is Shreeya and I am a Senior Manager in PwC’s Corporate Reporting Services.

Today I’ve got Renshia van Noordwyk on the podcast. Renshia is a Partner in the Corporate Reporting Services team. She is a specialist in financial instruments, including IFRS 16 (the leasing standard) - which will come in handy today when we unpack the concept of sale and leaseback accounting. Welcome to the podcast Renshia!

Renshia 

Thank you, Shreeya. 

Shreeya

Renshia, there has been an increasing trend of unlocking value within the retail space by divesting oneself of non-core property. For example, distribution centers or other large fixed properties that don’t necessarily need to be ‘owned’ by a retailer. 

These non-core assets create value by being sold to a third party, sometimes a REIT or other property investors. The assets are then leased back by the retailer. 

Renshia 

Yes, that’s correct. 

A sale and leaseback transaction is normally a way for the seller-lessee to raise capital.

They sell an underlying asset - a fixed property like you just mentioned - and then they lease the asset back from the entity that purchased the asset.

The seller effectively gets proceeds from the sale of the asset without losing the right to use that asset (when they lease it back). 

In this manner, a seller obtains the value of that asset in cash upfront and generally also transfers the related obligations to manage and maintain the properties to the buyer - which can make it attractive from both a commercial and operational perspective.  

Shreeya

I understand why this might be a good value proposition from a commercial perspective. The accounting, though, can get tricky sometimes, right?

Could you talk us through some of the basic points to think about?

Renshia 

Yes, it sometimes can become quite tricky. 

To start off, it’s important to identify ‘what’ is being sold.

For example, some companies might move the asset (or group of assets)  being sold into a corporate wrapper (like a new company) and sell the shares in that company to another entity while at the same time entering into lease agreements for the right of use of the asset (or some of the assets).  

The question is then whether the loss of control principles of the consolidation standard (being IFRS 10) or the sale-and-leaseback guidance of the leasing standard (or potentially both) should apply, as the end result between these standards are quite different.  

Remember, under loss of control principles, the full gain/loss would be recognised upon loss of control, whereas under the sale-and-leaseback principles a portion of the gain/loss should be deferred, which we will explain a bit later.

Shreeya

Okay, so in other words: what are you selling? Are you selling an asset, are you selling an investment in a subsidiary?

It would also be important to check, when setting up a sale and leaseback with a shelf-company, to what extent the seller-lessee controls the buyer - you don’t want the right hand selling an asset to the left-hand, right?

If a transaction involves both the loss of control of a subsidiary and a sale and leaseback, it is not clear whether a full gain or loss should be recognised (in accordance with IFRS 10) or only the gain or loss that relates to the rights transferred (in accordance with IFRS 16).

A similar matter was considered by the IFRS Interpretations Committee (‘IFRS IC’) in September 2020, when the IFRS IC issued a tentative agenda decision. However, in February 2021, the IFRS IC subsequently decided to refer this matter to the International Accounting Standards Board (IASB) and recommended that the IASB undertake narrow-scope standard-setting to address this and similar transactions. This matter is currently ongoing.

But we’re not going to be deep-diving into this matter on today’s podcast - this is more of a ‘heads up’ or giving you some thinking points around areas that could be complicated when dealing with a sale and leaseback.   

The bottom line is to determine the nature of the asset that is disposed in the transaction: do I have a disposal of a business ? Or the asset?

Renshia

Correct, but let’s come back to the basics: 

Once you’ve established that you are selling an asset, typically, the next question to think about is whether or not the transfer of the asset to the buyer-lessor in the sale and leaseback transaction would qualify as a ‘sale’ under the accounting guidance.

In order to determine that, entities need to look to the guidance in the revenue standard (IFRS 15).

In other words, the  seller-lessee applies the requirements for determining when a performance obligation is satisfied, i.e. does the buyer obtain control of the asset, to determine whether the transfer of the asset should be accounted for as a sale of the asset.

A sale and leaseback transaction qualifies as a sale for accounting purposes if the buyer-lessor obtains control of the underlying asset.

Shreeya

Are there any common pitfalls to watch out for in this step?

Renshia

Unfortunately, yes.

An example of a ‘pitfall’ that a seller-lessee should watch out for are repurchase rights being built into the contract. This might take the form of an option by the seller to buy back the asset being sold. 

The revenue standard specifies that an obligation or a right to repurchase the asset would preclude the buyer from obtaining substantially all of the remaining benefits of the asset and it is also limited in its ability to direct the use of the asset. 

Thus, an option for the seller to repurchase an asset means that it would not qualify as a sale in accordance with the revenue standard  as the buyer is not seen as having obtained control of the asset, even though legal title and physical possession of the asset has transferred.

Shreeya

What are the consequences if the transfer of the asset is not a sale?

Renshia

In that case, the arrangement would be considered an in substance a financing arrangement.

In other words, if the transfer does not qualify as a sale, the seller-lessee does not de-recognise the transferred asset, and it accounts for the cash received as a financial liability. 

Shreeya

Okay, so thus far we understand that the first step in evaluating sale and leaseback transactions …. Is to assess whether the transfer of the asset is a sale.

To do that, we turn to the revenue standard’s indicators of control. 

And - if we find that the transfer of the asset is not a sale - then we ultimately account for the arrangement as a financing transaction. 

Renshia

Yes - that is correct.

Shreeya

What about if the revenue standard’s indicators are met - in other words - if we qualify for sale and leaseback accounting in terms of the leasing standard?

Renshia

In that instance, where we qualify for a sale, then  the seller-lessee derecognises the asset sold and recognises a right of use asset for the lease rights retained.  

It measures a right-of-use asset arising from the leaseback as the proportion of the previous carrying amount of the asset that relates to the right of use retained. 

Therefore, the gain (or loss) that the seller-lessee recognises is limited to the proportion of the total gain (or loss) that relates to the rights transferred to the buyer-lessor.

Shreeya

What happens if there is a difference in the sale consideration earned by the seller-lessee and the actual fair value of the asset sold?

For example, a building is sold for R2 million when the fair value is around R1,5 million. 

Renshia

Good question

Any difference between the sale consideration and the fair value of the asset needs to be considered.  

It is either a prepayment of lease payments (in the scenario where the purchase price is below market terms) or an additional financing (in the scenario where the purchase price is above market terms). 

In the example you just mentioned - when a building is sold for R2 million when the fair value is around R1,5 million - the R500k above the fair value should be accounted for as additional financing.

As a practical tip, we would encourage preparers to really understand the different values involved in these types of transactions and ensure there is appropriate oversight from experienced members of the finance team. Do not just assume the sales price is fair value for the asset sold.

Shreeya

I agree, these transactions tend to be for high-values and can be quite material. I think we can agree when there are high-value transactions - these shouldn’t pop up as a surprise at year end. Early engagement with assurance providers - such as the auditor - might be very useful to ease any pressure at year end.

But, speaking of year ends, Renshia, I understand that there have been some proposed amendments to the leasing standard for sale and leaseback transactions for annual periods beginning on or after 1 January 2024? 

Renshia 

Yes, there have been some developments in this area.

This started a while back in March 2020, when the IFRS Interpretations Committee (generally referred to as the IFRIC for short) discussed a submission about a sale and leaseback transaction with variable payments that do not depend on an index or a rate.

This could, for example, be a function of revenue or turnover - i.e. you pay the lessor a rental based on a portion of turnover generated. 

The question was how the seller-lessee measures the right-of-use asset arising from the leaseback and, thus, determines any gain or loss recognised at the date of the transaction. .

Shreeya

I can see how that could be a tricky question.  

For example, if all of the lease payments in the leaseback depend on the future sales of the seller-lessee (that is, they are fully variable payments like you mentioned), the question arises if it would be acceptable for the lessee to measure the right-of-use asset and lease liability at zero and, therefore, recognise a full gain or loss on the sale at the date of the transaction.

There’s going to be a bottom-line effect to this question.

Renshia

Yes, exactly. To address this question, an agenda decision was issued by the IFRIC in June 2020. 

The agenda decision notes that, because the right of use that the seller-lessee retains is measured as a proportion of the previous carrying amount of the property, plant and equipment (PP&E) sold, the amount of the gain or loss recognised must relate only to the rights transferred to the buyer-lessor.

In other words, it would not be acceptable for the seller-lessee to recognise a full gain or loss at the date of the sale and leaseback transaction in the scenario you just described, merely because all the lease payments are variable.

Therefore, a gain or loss is only recognised to the extent that relates to the rights transferred to the buyer-lessor.  

The initial measurement of the lease liability that arises is a consequence of how the seller-lessee measures the right-of-use asset and the gain or loss recognised at the date of the transaction.

Therefore, the initial measurement of the lease liability is determined as a balancing figure once the right-of-use asset and gain (or loss) have been determined.

This means that the seller-lessee should always recognise a lease liability at the date of the transaction, even if all of the payments for the lease are variable (whether or not they depend on an index or a rate).

The IFRIC concluded that the current leasing standard provides an adequate basis for an entity to determine the accounting for the sale and leaseback transaction at the date of the transaction and therefore no amendments were made to the standard in this regard.

Shreeya

I see - okay, so the crux of the matter is if you’re entering into a sale and leaseback where the lease payments are variable that do not depend on an index or a rate, an area of complexity can be determining the proportion of the asset retained versus transferred to the buyer.

Were there any other subsequent developments on this topic?

Renshia

Yes, there have been some developments in this area. 

In contrast to the initial accounting we just discussed, for subsequent accounting, the original leasing standard didn’t include any specific subsequent measurement guidance for sale and leaseback transactions.   

Consequently, it was not always clear how to subsequently measure the liability arising from a leaseback transaction, particularly where the payments for the lease include variable lease payments that do not depend on an index or a rate that normally would not be considered lease payments included in the lease liability.

Remember, generally variable lease payments that are not based on an index or a rate are not part of the lease liability, they are recognised in the income statement when the event or condition that triggers those payments occurs.

To address this question, around September 2022, the International Accounting Standards Board (or IASB) issued an amendment to the leasing standard which added some guidance on how an entity accounts for a sale and leaseback transaction after the date of the transaction.

Shreeya

Oh, I can see why they’d want to clarify the accounting in that instance!

Renshia

Yes, exactly. 

The amendments to the leasing standard now provide some clarity on the subsequent measurement for these lease liabilities.  

However, due to our time limitations, I will not attempt to explain the detailed requirements as it is best explained working through numerical examples.  

The key takeaway for today, is to be aware that there is an amendment to the leasing standard that provides us with additional guidance in this area.  The amendment includes numerical examples that listeners can refer to.

Shreeya

Thanks Renshia for breaking down the issue for us. For our listeners, if you would like to read more about this, we have illustrative guidance published - which will be linked in this podcast script on the PwC website. Lease liability in a sale and leaseback: amendments to IFRS 16

We’ve covered a lot thus far. We touched on some of the points to think about when assessing a sale and leaseback transaction - such as firstly assessing whether or not a transfer of property qualifies as a sale under the revenue standard.

We also briefly discussed an amendment to the Leases standard dealing with cases where there are variable lease payments that do not depend on an index or rate.

Is there anything you’d like to add?

Renshia

Maybe in closing I can share a practical tip for preparers.  

Always perform an overall sense check once the journals have been posted..

If you think about the balance sheet: what have you essentially done if you’ve sold and leased back the asset? You’ve sold an asset - often real estate - i.e. you’re letting go of PPE and you’ve retained a portion of an asset- the right of use asset - which comes back as a leased asset.

Depending on the renewal options you’ve taken into account when calculating your lease term - you can do a quick sense check of relative values.

For example: if you’ve previously owned a building and your lease term is for a short period because you’ve taken no lease renewal options into account (if you have any), you’ll see a much smaller right of use asset come back onto the balance sheet compared to the original PPE.

Shreeya

That’s a great point Renshia. It talks to the broader issues of not letting the pre-existing IFRS 16 principles go out the window! Don’t become so focused on the sale and leaseback that you lose sight of the other principles in the standard.

The lease term is the non-cancellable period of a lease, together with any optional periods that the lessee is reasonably certain to use.

For example, if it’s a key site that you have sold and leased back - like a distribution center- then one would anticipate renewal options to be taken into account when determining the lease term.

Renshia

That is correct. 

Periods covered by an option to extend the lease term are included in the lease term if the lessee is reasonably certain to exercise that option. 

The same rationale applies to termination options. Periods covered by a termination option are included in the lease term if the lessee is reasonably certain not to exercise the option.

Shreeya

Speaking of the duration of the lease - our time is now up on the podcast! Thanks Renshia for joining me today and for sharing your insights on sale and leaseback accounting.

Renshia

Thank you for inviting me.

Shreeya

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