📊 Accounting for Sale-Leaseback Agreements — Intermediate Accounting

Hello and welcome to this session. This is professor Farad in which we will discuss sales lease back transaction. Now you have to know this if you are taking the CPA exam, the CMA exam and if you're taking college accounting, taking intermediate accounting, you have to learn about leases and part of the leases is sales lease back. Now sales lease back is considered a complicated or a challenging topic. I will try to simplify this. I'll try to explain it step by step. But the first thing I want to explain about sales lease back is the purpose of a sales lease back. If you understand the purpose why do companies under undertake a sales lease back then it's easier to understand the rules that follow as well as the journal entries that follow. So let's start in the business context. Why do companies go through the sales lease back transaction? Well, here's why. The simple reason is you need money. Let's put it that way. Company needs money. So if you need money, what can you do as a company? Well, you have many options. One is you issue stocks. What's it? What are the advantages? You don't have to pay anything back. There's no uh payment like of interest. You only pay dividend when you make money. The bad news is your shares are diluted and it's very costly in a job market. But it appeals if you need cash. This is what you can do. What else can you do if you need money? Well, you could issue a loan. You keep the asset. It's a straightforward. You borrow money from the bank. But the problem is you need to make payment. It it would require collateral. The bank will impose covenants on you. It affects your financial ratios. But if you need the cash, you might have to go with it. Third is to sell some assets that you are not using. You have a warehouse that you are not using. Land. It's very easy, clean transaction. You sell it. You immediately get the cash but you cannot use the asset anymore. Again, it appeals to people who needs the cash, companies that needs the cash or you can mortgage the asset. Yeah, you can keep the asset. You can go to the bank tell them look I want to put this building as a collateral and I need money. So, it's easier for you to get the loan because you put the collateral at the as as a you put the building as a collateral. So you'll keep the building then you have the interest burden of course then again if you need money that's the case. Now those are all ways to finance your company and obviously the best way to finance your companies through revenue obviously but that's the problem. We don't have the enough revenue to grow. So the last option or this option is a sales lease back. So what is a sales lease back? Guess what? You can keep using your asset. So notice here you have to sell it. It's better than this option because you can keep using it and better than a bank loan. Why? Because when you have a sales lease back, usually you can raise 100% of the asset value. If you get a bank loan, what happen is is they might give you 80 or 70 or 90% of the value of your collateral. Here you might be able to raise 100%. You get more money and you keep the asset. So notice it's better than selling the asset and have no control over it and you are using the asset and it's a long-term lease obligation and you could have this lease back as a long-term. You know, you could have a loss of ownership, but you don't care as long as you can use it for long-term. You want to run your business. You're not in the business of, you know, keeping the asset. You're in the business of running it. Therefore, it's a good option. So the purpose of it is to raise money and keep using the asset. So let's dive into a little bit more about how does it work. What's a lease back agreement? What does it look like? But this is why we have a leaseback agreement. You have to understand the business context. Let's go ahead and get started. Before we proceed any further, I have a public announcement about my company, Farhatlectures.com. My AI turns any lecture into a complete study system. You can create summary table, formulas and example from each lecture. Flashcard builds from the lesson itself. A quiz build on the lesson and as a bonus convert any lecture into a portable short audio on the go. So it helps you with the retention. No noise, no generic responses, just clarity based on that specific lecture. Don't just watch, interact, test yourself, and retain the material using Farhat AI. Now go to faradlectures.com now and see how the AI can help you understand, practice, and retain the material. So what is a lease back sales leaseback agreement? Well, the definition is it's a transaction where the company sells an asset to another party, then immediately lease it that same asset back, allowing the company to continue using it while raising cash. I'm going to give you a more not simpler, but a personable example. Think if you own a home, great. What you do is you sell your home to someone and you tell that someone, look, I'm going to sell you the home, but I'm going to stay in the home and rent that home back from you. That's basically what a sales lease back agreement. Why did you do that? Because you needed the money. You need the money now and you need the home. But for a business, they need the money for capital budgeting, for operating the business, but they also need the asset. So the solution is is a sales lease back agreement. So the company the seller becomes the lei. So the company that originally owned the asset becomes called the seller lei owns the asset but needs the cash sells the asset receives the cash to the and the buyer will pay them the cash. The buyer becomes the buyer and the leour. Then they acquire the asset. Then they lease it back to you and they collect lease payments. And we have a seller le and a buyer leour. So you need to be familiar what's a seller le what's a buyer le? The seller le will use the asset make the payments. Think about the seller le is the original owner of that house. But don't think about a house but it's easier for you. Or think about a car. Let's assume you have a car. Maybe it's easier for you as a college students or CPA or CMA candidate. You don't own a home. But if you own a car, you sell your car to your friend. Your your friend pays for it. Then you tell them, "Look, I'm going to rent that car from you. I want to keep on using it. I I'll make rent payment to you." That's basically what what it is. I'll give you a real world example just kind of uh to put this down, you know, once and for all. Uh there are many examples of this but United Airline in April 2020 to survive COVID what they did they sold 22 aircraft to the Bank of China then leased them back. Well United Airlines needs the cash to survive during CO. So what they did they sold in quote sold and not in quote they sold the aircraft then they leased it back because they need the aircraft to operate their business. So they they got the cash that they need. Um the Bank of China is happy because they have they they bought them. They bought them and now they're earning interest on the payments. So everybody's happy. Uh this is what a seal sales lease back. So the goal is to raise capital while retaining the use of asset. The buyer leur does not operate or use the asset. Now the Bank of China don't run those 22 aircraft. Although they bought them, they're a buyer, but they lease them back. who controls and operate them still United Airlines. They need those they need those aircraft to fly customers. So the first thing we have to understand or we have to know about a sales lease back is does the transfer qualify as a sale? This is very important. So we're going to spend maybe 5 to 10 minutes explaining the importance of this and rules that revolve around this. So when you have a sales lease back, it's a sale. So it has to be a sale. Does the transfer qualify as a sale? Well, you have to have a contract and the control has transferred to the se from the seller to the buyer to qualify as a sale. So revenue recognition requirement must be met. Okay, that's great. Now sometime within a sale, why are we emphasizing this? Because sometime within a sale, you could have what's called a repurchase option. What is a repurchase option? I sell you something and I would say, um, you look, I'm going to sell it to you, then I have the right to buy it back from you at any point and maybe at a discounted price. That if that's the case, you can buy it at any point and especially at a discounted price, then it's not really a sale. All what you're doing is it looks like a sale, but it's not a sale. So, it has to be a sale. But can you have a repurchase option? Yes, sometime you could have a repurchase option. Does have a repurchase option automatically disqualify a sale? No. You could have a repurchase option and still have a sale if you meet two criteria. The first criteria is the option to buy back the to buy back those assets is the fair value at the time of the exercise. If you have to buy back that asset, you will pay full price for it. You're not getting any discount. You know, bargain purchase. We'll talk about that in a moment. So when you buy it back, you could have a repurchase option, but you have to buy it at full price. That's one. And the second option is, and not the second option, the second criteria to have the repurchase option is you can go outside and buy the same asset from somewhere else to use it for your business. So in other words, there's a market for what you need. There's a substantially equivalent alternative asset that's readily available in the marketplace. Why is that important? Because if I'm selling you an asset and that asset is unique to my business, unique in a sense, if I give control of that asset, then I cannot run my business. Then no one in the right mind would really give up that asset. I mean, you can, but you cannot run your business anymore because you technically sold the asset that you need for that business and you cannot replace this asset. So as long as in the repurchase agreement they will sell it back to you at the fair value whatever the fair value is and if you don't they don't sell it back you can go back and buy it from another place as long as there there's a repurchase option and those two criterias are met we still have a sale because it's very important to have a sale. That's the that's the whole key. If either of these conditions fail we have a failed sale and we need to understand what's a failed sale. Failed sale is means you have no sale because the first thing in a sales transaction do we have a sale for it to be a sales lease back transaction? Well, generally speaking, if you sell it and you give up control, the control transfer from the seller to the buyer, but remember the buyer don't use it. They're not supposed to use it. You're supposed to be using it, right? United Airlines supposed to be using it, not Bank of China. So, I'm going to keep referring to this example, but think about, you know, the deal between United Airlines and Bank of China. Can United Airlines go to the market and buy 22 airplanes from Boeing? Sure, they can. So, the the assets that they sold in a sales lease back transaction to uh the Bank of China, they can buy it from somewhere else. So, we're good then. Even even if they have a repurchase option, as long as the repurchase option state, they will sell them those airplanes as if they go to Boeing and buy or go to another party, another airline and buy them. As long as they're selling them at the at that price, then we still have a sale. The other issue that we have to look at is residual value guarantee. What's a residual value? Basically, you are guaranteeing asserting value at the end of the lease. A sale cannot take place if control has not fully transferred. We already talked about this. But how do we what other criteria we look at to determine whether a sale really gave up you gave up a control in the sale or not is looking at the residual value guaranteed. Now for the residual value guaranteed we have to look at it and make a judgment. Basically this is a qualitative judgment. So the more significant the guarantee, the more unlikely that the control has truly transferred. If you are guaranteeing the value of that asset and you're guaranteeing a large amount, why are you doing that? It looks like you you need this. You you want to keep this asset at a certain value. Simply put, we look at the guaranteed uh residual value guaranteed. If it's large, more likely it's not a sale because if you're guaranteeing, you're just basically you want that asset to be back to have a certain value. Why? You're you're still vested in that asset. So, it's more likely a failed sale. Again, this is a judgment. A judgment by whom? Judgment by people who are looking at that sales lease back to determine whether it's truly a sale or not. The smaller or no guarantee, it's even better. More likely it's a valid sale. You're not guaranteeing the value of that asset. So just you sold it, you gave up control and thank you very much, you're not interested in it. It's something you need to be familiar with. So if we met the sales criteria, you're selling something, you record a gain or a loss, then you have right of use asset because you lease it back and you have a lease liability. If the sale failed, you have a financing transaction. What does that mean? It means all what you're doing is in a sense you are giving up the asset as a collateral. You did not selling it. You're giving it up in a in a term of in a sense of a collateral. You are using it as a collateral. Not giving it up. Using it as a collateral to get financing. So it's a failed sale. Therefore, it's a finance transaction. Simpler. And we're going to see we're going to see an example for both illustrate the point. So what happened when the sales criteria met? What would the seller le do? the seller. Let's see if if it's a indeed a sale, they would remove the asset. They would remove the cost as well as accumulated depreciation. Then you would recognize either a gain or a loss. Listen to me carefully. You would look at the sales price and the book value. And this is going to be important later on. Well, shortly. Then what else do we have to do? We have to establish right of use asset for the lease back, which is kind of we know how to do this. And we have to record the lease liability. Again, this is when we have a lease. So, basically, it's two transaction. Selling, leasing back, right? Then there's a fair value adjustments we have to deal with. If the sales price is different than the fair value, we have to adjust either as a prepaid or a financing element. What does that mean? Well, when we sell the asset, we sell it for a price. And sometime you could be giving the fair value. There could be a difference between the fair value and the price. If that's the case, we have to make an adjustment. So, let's take a look at this what we call the fair value adjustments or the adjustment. And this could happen when the sales price is different than the fair value or another thing it could be the present value of the lease payment are different from the present value of the market rent an adjustment is required. Now why is that adjustment required? Because hold on a second. If you're selling something different than the fair value because you're supposed to sell it at the fair value. If they pay you more than the fair value or less than the fair value we have to make an adjustment. Now when do we use the fair value and the sales price? When we use the present value of the lease payment or the present value of the market payment whatever is giving whatever is giving to you in the problem you'll find the difference between those and an adjustment is required. And obviously here we're we're talking about two unrelated parties. So step one identify the more determinable step. It means the one that's clearly given in the problem. You could either look at the asset price and the fair value or the present value of the payment versus the present value of the rental payment. Whichever value is more readily available. Usually it's the sales price and the fair value. You calculate the difference within you calculate the difference between set one or set two only one of them. If the sales price is higher than the fair value, the access is additional financing from the buyer not more gain. What does that mean? Well, if the sales price is 140,000 and the fair value is 120, they pay you an additional $20,000. If you want to go back and sell this asset, you get 120 and but they bought it from you for 140. So, what is that additional 20,000? The additional 20,000 is a form of financing. It's going to be like a financing liability. Now when you when you compute uh the access you don't include the access in the game it's a liability and we we'll look at an example. I just want you to know to see this. Now step three classify the difference. If the selling the sale the sale purchase price too high versus the fair value the seller recorded as a financing liability. Now if the sales price too low versus the fair value the seller record a prepaid which will be an increase in the right of use asset. This basically how you will deal with it. So the adjustment does not change the total cash exchange. It's re label it it's it relabel the access as financing or a prepaid. Now the best way to illustrate this is to do what? Look at an example. So let's take a look at an example. Let's assume Riverside Manufacturing and Capital Lease Partner went into a deal. Well, Riverside is going to sell their asset and lease it back. Okay, the original purchase price of the machinery that Riverside paid 600,000. So far they depreciated the asset 120. It means their book value is 600 minus 120 equal to 480. This is important. This is the book value. The sales price to capital lease is 550. They agree to buy it from you for 550. The fair value of the machinery is 520. Hold on a second. If the fair value is 520, if I want to go out and sell this whatever this asset is, if Riverside wanted to sell it to an outside party, they'll they only they could get 520. Why is capital lease paying them 550? because that additional 30,000 is basically additional financing. They know they need the money to operate this so they pay them more. It's called the financing li it's a financing liability. Therefore, when you compute the gain, be careful. You would compute the gain based on the fair value and the book value. Remember I said you have to compute the gain. You don't you don't if the sales price is different. If they're the same, it doesn't matter. But here it's different. You look at the fair value. The lease term is four years. The annual lease payment is 130. It's given to us here. Sometime you have to compute this. Implicit rate in the lease is 5%. The remaining useful life of the machine is 8 years. And we're going to look at the transaction where we're going to assume it qualify as a sale. So we're going to prepare the journal entries for Riverside. Well, what do you have to do? You have to compute the gain first. So remember they have to compute the gain and we have to know how to account for the additional money um given to us. So remember you find the difference uh first of all there's a 30,000 identify the more determinable set here it's given to us the sales price and the fair value we're not giving the present value so it's easy the difference is 30,000 it's excess therefore how do we treat this we treat this as a liability so the sales price exceeds the fair value treat the additional financing provided by the buyer le sour as a financing liability it's not additional gain on the sale be careful Um what what what happens some students they will take the 550 and they subtract it from the book value. No you subtract the fair value that additional 30,000 is not gain. Now we compute the gain. The gain is 520 minus 480. The gain is 40,000. Not not 70,000. So be careful. That's one of the problem. Okay. Um let's take a look at the let's take a look at the now the transaction the journal entry actually first we are going to what do we debit we are going to debit cash we received the cash 550 this is how much we received from the leasing company although the asset is worth 520 if we went somewhere else then we have to remove the asset we are going to debit its accumulated depreciation to eliminate the accumulated depreciation and credit the asset itself and this will remove the asset from the books because we need to remove it from the books. It's a sale. It's a sale. Then we have to book the financing liability of 30,000 for that access. Then we have to do what? Report the gain of 40,000. And I showed you how we computed the gain. So the total, make sure you double check. Total debits equal to total credits of 670. Everything balances. So upon the sale qualification two separate transaction occur okay but the lease back because we have a sale and a lease the lease back is recorded using the same rule as other lease so the lease will have to classify it is it an operating lease or a financing lease well here's what I have to tell you by nature it cannot be a finance lease if we have a sale why because one criteria of the finance lease I want you to think of that criteria the bargain purchase option there's a bargain purchase option. If there's a bargain purchase option, then you can buy back the asset at a bargain purchase, then it it becomes a finance lease. And remember that option will will fail as a will fail it as a sale. It becomes a failed sale. Therefore, when really have when we have a salesback transaction, the lease will becomes most likely an operating lease because if it's a finance lease, then it cannot be a sale. That's why it's it's it's a finance transaction by its nature. It cannot be a finance and a sale. If it's a sale, then the lease back will be an operating lease. If it's a finance lease, then it's a failed sale. So, the sale is recorded. You remember we we just showed you we recognize the asset uh and put everything on the books. Gain recognition. If you have a gain, if it means if you have a gain, it means you have a sale. Require sales lease back to be an operating lease. This is what this is what I'm trying to say. Once we have again once we have an actual sale then we have it as an operating lease. Once again capital lease it's it's going to be an operating it's going to be an operating lease. We we calculate the present value of the future lease payment. Um record right of use asset record the lease liability. Treat it as an operating lease where you know amortization and interest per lease type which is an operating lease. I just want you to understand this. So if the lease back meets a finance lease, the entire transaction is treated as a failed sale and no gain is recognized. And this is important. Now what is a sales criteria not met or failed sale? Sales criteria not met. It means the seller don't recognize the asset. They will continue recording depreciation. If we did not sell it, we still have the asset. We record the the sale, not the sale. We record the transaction as a financing lease. Remember, if it's a financing lease, we don't have a sale, no gain, no loss. We pay back the loan through lease payment, principal, and interest. The buyer does not recognize the asset. They record it as a receivable. We have a lease receivable. They would record interest, income on the financing receivable, and the asset would never appear on the buyer because they never bought it. It's not a sale. There was no sale transaction. Let's take a look at an example where the criteria for the sale is not met. It means it's a failed sale. So we have Summit Logistics and Apex Real Estate Fund. Summit Logistics will have they have a warehouse for a million dollar. So far they depreciated the asset 250. Therefore the book value of the asset is 750. Apex the fund the uh real estate funding company agreed to pay them 800,000. The fair value of the warehouse is 800,000. The remaining useful life of the warehouse is 15 years. 6% is the implicit rate in the arrangement and the lease back qualify for 5 years. Well, let's take a look at more details. Summit has a repurchase option. We have to be careful here to buy back the warehouse at a fixed price of 800,000. So far so good. Notice what it says here. Regardless of the fair value at that time. Hold on a second. Now, what's happening is Summit is getting a deal. They can buy back this warehouse at 800,000. What about if the value of that warehouse went up to 1.5 million? They have a bargain purchase. It's not a sale anymore. It's not a sale anymore. And notice and you just need one. But and no substantially equivalent warehouse are available in the market. If that's the case, Summit will no way in their right mind sell a warehouse that they need for their business if they cannot find another warehouse that served their business in their market. Therefore, this is a failed sale, not a sale. So, a failed sale, what do we have to do? It's a financing transaction. So, did we receive 800,000? Sure, we debit cash 800,000. The cash received from the real estate fund. However, what do we credit? Simply put, we credit a loan. A loan of 800,000. So, the full proceed is a financing liability. We keep the warehouse on our books. We're going to depreciate the warehouse. And that's the end of it. Basically, um, Summit warehouse of 750. We'll stay on the books. We'll continue depreciating and life goes on. Very easy. Notice no gain. Um, you remember the selling in quote the selling price was higher than the book value. It's not really a sale. there is no gain. The 50,000 is, you know, potential gain until the repurchase option issue is resolved. But we cannot we're not going to resolve that. So compared with example A, let's take a look at example A, which is the first example. We had a gain and that's what made this we had a gain and basically once we have a gain, we're looking at a sales lease back, an operating lease. Now let's take a look at the entry on December 31st year 1 December 31st they have to acrew the interest the liability is 800,000 the interest rate is 6% we have to acrew interest of 48,000 so that's the interest acral debit interest expense credit interest liability now also we will keep on carrying the books on our record therefore we have a depreciation expense also of 50 50,000 have a depreciation expense credit accumulated depreciation as everything is happening normally as far as the summit where the summit company they're just nothing has happened except they got a loan for 800,000 now they have interest expense to worry about nothing else okay the 48,000 acral grows the financing liability to 848 and the following day we'll take care of that they'll pay it the following day they'll make the payment we're not giving the payment here. We don't need to, but you guys get the point. And this is a sideby-side comparison between when a sale criteria is met and when we have a failed sale, what we have to do. Now, here are some key terminology you need to be familiar with. Again, because this is slightly a uh an odd lesson, I'll have to say what's a control transfer, failed sale, residual value, guaranteed, fair value adjustment. You you should know the lease criteria, finance, liability, repurchase option. Just basic terms you need to be familiar with. And this is basically a lesson summary what we did so far. What's a sale qualification? Sales. This is just definition you need to be familiar with. Let's take a look at this mini exercise to test our basic knowledge for sales lease back transaction. On January 1st, Horizon Data Center sells a server farm facility. Here's the data. Original cost 2 million. accumulated depreciation 400,000. The book value is cost minus accumulated depreciation of 1.6 million. They sold it to Northern Capital Real Estate Investment Trust for 1.8 million and the fair value at that date is 1.8 million. So the sales price and the fair value are the same. We don't have to worry about any fair value adjustment. The lease deal is 6 year 180,000. The implicit rate is 4%. Remaining useful life is 20 years. Does the transfer qualify as a sale? Well, we're not giving any other conditions. We are told it's a sale. We'll go with it as a sale. So, we're not told that there's any repurchase agreement. Uh we're not told anything about residual value. So, most likely we're going to have to assume it's a sale unless you are giving otherwise. So, is this a true sale? Yes. Once it's a true sale, it's an operating lease for us. So the fair value equal the sale price. The control transferred we have a sale. Yes. Calculate the gain or the loss on the sale. How do we compute the gain or the loss? We look at the fair value and we compare that to the book value. Now the fair value and the sale price here are the same 1.8 million. That may not be true in other in other exercises because the fair value could be different than the sales price because the financing company may pay you a little bit more or they'll pay you a little bit less. You have to care. You have to be careful. The gain or the loss is based on the fair value versus the book value. 1 1.8 minus 1.6 will give us a gain of 200,000. Prepare the journal entry for Horizon. Well, they received cash 1.8 million. We will debit cash, debit accumulated depreciation 400,000 to get rid of that. Credit the building for 2 million to get rid of the building and we have a gain of 200,000. There's no fair value adjustment to make. What happen if the lease back has been a finance lease instead? So, let's assume this was a failed sale. How do we how would Horizon book this transaction? Once again, it's a failed sale. It means it's not a sale anymore. What do we do? It's a financing transaction. We debit cash 1.8 million. We credit a liability. Financial liability 1.8 million. It's a liability. It's a loan. There is no gain. It's a failed sale. Pretty much an easy peasy transaction. What should you do now? Whe whether you are an accounting student, CPA candidate, CMA candidate, go to Farhat lectures, look at additional resources, multiplechoice exercises, simulations, uh true false cases, AI resources. The best investment you can make is invest in yourself. Invest in your education. And God bless.