If a company wishes to free up cash on its balance sheet it may consider a sale and leaseback arrangement.

Here, the seller (lessee) decides to sell an asset, which it still requires operational use of, whilst at the same time contracting to lease the asset from the purchaser (lessor).

Real estate tends to be a classic target for companies looking to release capital tied up in operational assets. A few years ago, the large UK retailer Tesco raised a massive £900m via a sale and leaseback of part of its store portfolio. Financial leases for real estate can last for up to 25 years – significantly longer than standard commercial loans.

Under previous accounting standards, we could have delved into a discussion on operational leases and taking the asset and liability “off balance sheet”, however, with the advent of IFRS 16 all leases beyond one year in length are recorded on a company’s balance sheet.

The accounting for sale and leaseback transactions under IFRS 16 – Leases, is significantly different from the treatment under the outgoing IAS 17 standard, not least in the way in which gains on sale are treated.

The first step in establishing the appropriate accounting treatment is to confirm whether a transaction actually qualifies as a sale under IFRS 15 – Revenue from Contracts with Customers.

Failure to meet these criteria would mean that the amounts received from the supposed “buyer” would be treated by the seller as a financial liability under IFRS 9 – Financial Instruments, with the transaction behaving more like a collateralized loan.

Accounting for sale and leasebacks

Let’s take an example transaction and work through the numbers. Firstly, we’ll assume we have a transaction that is eligible to be treated as a sale and leaseback arrangement with the following details:

Book value of PP&E 15.0m
Fair value of PP&E 20.0m
Cash proceeds from sale of PP&E 20.0m
Lease period 10 years
Annual lease payment 1.8m
Borrowing rate 5.0%

So, what would happen at the point the company entered into a sale and leaseback contract? Presumably, a gain on disposal of 5.0m will be recognized at the point of sale.

Actually no.

The company hasn’t really, fully disposed of the PP&E since the lease contract means it retains a “Right of Use” interest in the asset.

So, what proportion of the PP&E has been disposed of? To answer this, we need to compare the fair value of the asset with the present value of the lease payments (see Excel).

If we assume a borrowing rate of 5.0%, the PV of the lease payments equals 13.9m, representing 69.5% of the 20.0m fair value of the PP&E.

So, the lease represents 69.5% of the asset’s fair value, and the asset is accounted for on the balance sheet at 15.0m, then the company should continue to recognize a “Right Of Use” asset of 10.4m (15.0m * 69.5%).

Let’s summarize the numbers using the accounting equation and calculate the gain as the plug.

A = L + E

Assets Liabilities Equity
Cash up 20.0m Lease Liability up 13.9m RE up 1.5m (Gain)
Right of Use Asset up 10.4m
PP&E down (15.0)m

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