November 12, 2016
Build-To-Suit Lease Accounting – Part 5 – Real Estate Sale Leaseback Accounting
Sale Leaseback accounting for real estate
The point of this post is not to go through every iteration of sale leaseback accounting, but to focus on how sale leaseback accounting will most likely affect your build to suit lease. First a few important notes that will help you make sense of the guidance.
The guidance (ASC 840-40) refers to “Sale Leaseback Accounting”, and is synonymous with how most people refer to either “normal sale leaseback accounting” or “non-failed sale leaseback accounting.” Essentially the guidance is laid out so that you do normal leaseback accounting unless you fail it, so when it says “sale leaseback accounting” it is not the accounting that typically results from build to suit leases.
The second thing to point out is that ASC 840-40-15 (Scope) specifies that the “Real Estate” subsections of ASC 840-40 apply to the following
The guidance in the Real Estate Subsections applies to the following transactions:
- Sale-leaseback transactions that qualify for sales recognition under the guidance in paragraphs 360-20-40-57 through 40-59
- Sale-leaseback transactions involving real estate with equipment or equipment integral to real estate
- Sale-leaseback transactions involving only real estate
- Sale-leaseback transactions involving real estate with equipment in which the equipment and the real estate are sold and leased back as a package, irrespective of the relative value of the equipment and the real estate
- Sale-leaseback transactions in which the seller-lessee sells property improvements or integral equipment to a buyer-lessor and leases them back while retaining the underlying land
- Sale-leaseback transactions involving real estate with equipment that include separate sale and leaseback agreements that meet both of the following conditions:
- They are with the same entity or related parties.
- They are consummated at or near the same time, suggesting that they were negotiated as a package.
Essentially this means that when looking through the codification, and if the sale leaseback transaction includes any real estate, you need to focus on the “Real Estate” subsections.
With that said, instead of going through the guidance word by word, let’s try to focus on the concept underlying sale leaseback transactions. The entire point of this part of the codification is to prevent companies from disguising loans as “sales” and then subsequent “leases”. For one, this would not portray the economics of many transactions, and two, this may allow for companies to manage their earnings. For example, let’s say that I want to $10,000, however, I already have a debt outstanding with a financial covenant that requires a certain current asset to liability ratio that I’m VERY close to. In this scenario, let’s assume that we’ve concluded that $10,000 would essentially cause us to violate our financial covenant and put us in default. However, save for the covenant in questions, the bank would have allowed us to borrow the $10k at our incremental borrowing rate (10%) with a repayment period of 5 years. So we devise a plan where we take a company vehicle and “sell” it to a bank, and then subsequently “lease” it back for 5 years. The sales price is $10k. We agree to pay $2,640 each year (which is approximately what payments would be if compounded annually on a similar $10k loan). In this way, the company will be able to put a loan on their books, and potentially avoid any balance sheet recognition all together of the financing arrangement, if papered in a way that the lease would have been classified as an operating lease. To my second point, if the other counterparty is viewing this transaction as a loan (and their interest rate is commensurate with the risk as if it were an uncollateralized loan), then they may not have a strong opinion on the “sale price”, and therefore the sale price may not accurately reflect a fair market value of the underlying asset. In the previous example, if the bank was comfortable loaning $100,000 instead of $10,000, then this most likely would have resulted in a large gain on the date of sale. In this way, without special rules in place, sale leaseback arrangements present significant risk that Management can both manage earnings and misrepresent financial arrangements.
Let me stop here and say that these situations above are not these far fetched ideas that only rarely happen. In fact, sale leasebacks are very common ways to paper loans and have them be collateralized. If the seller/lessee doesn’t pay their “rents”/”debt payments” then the buyer/lessor can take the underlying assets back. In practice, I have seen this many times where a company will sell and then leaseback its personal property such as desks, chairs, laptops, etc.. Often, at the end of these “leases” the buyer/lessor will not even care enough to come and pick up the assets, and will just leave them there, which is further evidence that the transaction was not economically similar to an actual sale and then leaseback, but was, in essence, a financing arrangement.
However, there are times where you are legitimately trying to sell something, and for multiple reasons, you want to lease it back for just a portion of the time. For example, you sell a building because the buyer wanted to lock in future plans in terms of space, so that they effectively manage their business, but they don’t need to actually take possession of the space until later. Likewise, you want a short period of time to wrap things up and move out. These are often papered as a legitimate sale and a subsequent leaseback of the space. The purpose of me saying this is that the guidance focuses on distinguishing between these two scenarios. The way they distinguish between these scenarios, when involving real estate, is on three main factors per ASC 840-40-25-9: (Remember what I said earlier in that “Sale Leaseback accounting” essentially means a non-failed, which translates to you record the sale as a legitimate sale first, then a legitimate leaseback (mostly):
25-9 Sale-leaseback accounting shall be used by a seller-lessee only if a sale-leaseback transaction meets all of the following criteria:
- It meets the definition of a normal leaseback.
- The payment terms and provisions adequately demonstrate the buyer-lessor’s initial and continuing investment in the property as described in paragraphs 360-20-40-9 through 40-24.
- The payment terms and provisions transfer all of the other risks and rewards of ownership as demonstrated by the absence of any other continuing involvement by the seller-lessee described in paragraphs 360-20-40-37 through 40-64, 840-40-25-13 through 25-14, and 840-40-25-17.
The definition of normal leaseback can be found in the glossary section of ASC 840-40:
A lessee-lessor relationship that involves the active use of the property by the seller-lessee in consideration for payment of rent, including contingent rentals that are based on the future operations of the seller-lessee, and excludes other continuing involvement provisions or conditions described in paragraphs 840-40-25-14.
From a build to suit perspective, the issue becomes the concept of continuing involvement. From a theoretical perspective, the guidance is looking for anything that could indicate the “sale” is anything but normal in terms of transferring all of the risks/rewards of ownership as well as having the payment terms match the economics of a normal sale (and leaseback). I recommend looking through the enumerated list provided by the codification, and I will add this to the end of this post. I will point out the three main pieces of continuing involvement that will most likely affect you in your build to suit situation.
1. ASC 840-40-25-13b: The seller-lessee guarantees the buyer-lessor’s investment or a return on that investment for a limited or extended period of time.
I’ve seen this be used when the leaseback period is for a substantial amount of time, and therefore the lease is essentially guaranteeing the landlord a reasonable return on their investment (being the construction project).
2. ASC 840-40-25-14b: The seller-lessee provides nonrecourse financing to the buyer-lessor for any portion of the sales proceeds or provides recourse financing in which the only recourse is to the leased asset.
3. ASC 840-40-25-14d: The seller-lessee provides collateral on behalf of the buyer-lessor other than the property directly involved in the sale-leaseback transaction, the seller-lessee or a related party to the seller-lessee guarantees the buyer-lessor’s debt, or a related party to the seller-lessee guarantees a return of or on the buyer-lessor’s investment. FAS 098, paragraph 12 ][ Except as noted in paragraph 840-40-25-16, an uncollateralized, irrevocable letter of credit is not a form of continuing involvement that precludes sale-leaseback accounting under this Subtopic. The continuing involvement guidance in this Subtopic does not preclude a lessee from providing an independent third-party guarantee of the lease payments in a sale-leaseback transaction. However, all written contracts that exist between the seller-lessee in a sale-leaseback transaction and the issuer of a letter of credit must be considered. For example, a financial institution’s right of setoff of any amounts on deposit with that institution against any payments made under the letter of credit constitutes collateral and, therefore, is a form of continuing involvement that precludes sale-leaseback accounting under this Subtopic.
In order to explain #2 and #3 above, I need to move to firm guidance to explain how these are viewed in the eyes of the firms. The following is taken from PwC’s May 2013 ARM 4650.
The seller-lessee provides nonrecourse financing to the buyer-lessor for any portion of the sales proceeds or provides recourse financing in which the only recourse is to the leased asset (or to the lease itself, i.e., the lease payments). A concern arises whenever (i) the lease payments during the leaseback term are payable in a pattern that reflects substantial acceleration as compared to a straight-line payment pattern (e.g., prepaid rent) and (ii) the acceleration is not justified by estimated increases in the cost of using the leased property. We believe that such an accelerated payment pattern may be indicative of the seller-lessee indirectly providing collateral and/or nonrecourse financing to the buyer-lessor, which may represent continuing involvement sufficient to preclude sale-leaseback accounting. Because accelerated payments, including prepaid rent, are not, in form, either nonrecourse financing or collateral, the significance of the prepayment would be relevant to the determination as to whether it represents continuing involvement. We have seen cases in practice where a seller retains usage for a relatively short period and rents are free or at a nominal amount. Economically, these rents have been netted against the sales proceeds, and represent prepaid rent. Such prepayments generally constitute prohibited continuing involvement.
In determining the amount of accelerated rent paid, the lessee should include any amounts paid during the construction of a build-to-suit asset for which the lessee is considered to be the owner during construction pursuant to ASC 840-40-55. If a future lessee is considered the owner of an
asset under construction due to the fact that there is a cap on the amount of cost to be paid by the lessor, which effectively holds the lessee responsible for all cost in excess of the pre-determined project costs (i.e., including all cost overruns), such excess costs incurred by the lessee are considered to be prepaid rent regardless of the nature of such cost.
Based on the second paragraph above, any rents paid during the construction period (including overruns) as prepaid rent. Based on the first paragraph, this almost always is considered to be recourse financing and/or collateral, which constitute prohibited continuing involvement.
Honestly, it’s pretty safe to bet that if you’ve found yourself in a build-to-suit situation, you probably will fail sale leaseback accounting. Part 6 will walk through the accounting of failed sale leaseback with regarding to build to suit leases.
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