TECHNICAL EXCELLENCE

FRS 17 VS FRS 116

ACCOUNTING FOR SALE AND LEASEBACK TRANSACTIONS

NG ENG JUAN AND LOW KIN YEW

A COMPARISON BETWEEN FRS 17 AND FRS 116

 

Much has been written on lease accounting under FRS 116: Leases as compared to that under FRS 17: Leases (which will be superseded by FRS 116 on 1 January 2019). However, the focus has been on the accounting treatment for direct leases. This article focuses on the accounting treatment for sale and leaseback transactions.

 

A sale and leaseback transaction is one in which the owner of an asset sells the asset to another party and immediately leases it back.

 

It should be noted at the outset that accounting for sale and leaseback under FRS 116 is quite different from that under FRS 17 and the related INT FRS 27: Evaluating the Substance of Transactions Involving the Legal Form of a Lease.

 

… accounting for sale and leaseback under FRS 116 is quite different from that under FRS 17 and the related INT FRS 27: Evaluating the Substance of Transactions Involving the Legal Form of a Lease.

THE ACCOUNTING TREATMENTS

 

A sale and leaseback transaction may comprise a genuine sale transaction and a genuine lease transaction. However, a sale and leaseback transaction may also be just a single financing transaction.

 

In the seller-lessee’s books, the asset’s carrying amount will most probably not be equal to its fair value, and thus a profit or loss may arise from the selling transaction.

 

In a sale and leaseback transaction, it is common in practice for the selling price to be artificially fixed (that is, not based on the fair value of asset sold) and the lease payments to be also artificially fixed (that is, not based on the fair market rental) as a package deal.

 

Thus, there are three major accounting considerations in relation to a sale and leaseback transaction, as follows:

 

a) whether the sale and leaseback should be accounted for as a sale transaction plus a lease transaction, or just as a financing transaction;

 

b) where the sale and leaseback is accounted for as a sale transaction plus a lease transaction, how the profit or loss from the sale transaction should be accounted for, and

 

c) where the selling price is artificially fixed at lower or higher than the fair value so as to accommodate a higher or lower than market lease rental, how these off-market prices should be accounted for.

“SALE PLUS LEASE” VERSUS “FINANCING”

 

The most important accounting issue in a sale and leaseback transaction is to determine upfront whether the sale and leaseback should be accounted for as a sale transaction plus a lease transaction, or just as one financing transaction. Currently, this issue is addressed in INT FRS 27.

 

INT FRS 27 provides the principle that a series of transactions that involves the legal form of a lease is linked and should be accounted for as one transaction when the overall economic effect cannot be understood without reference to the series of transactions as a whole.

 

Moving forward, this issue of “sale plus lease” versus “financing” will be resolved differently under FRS 116.

 

FRS 116 requires the seller-lessee to determine whether the transfer of the asset is a sale under FRS 115: Revenue from Contracts with Customers (para 99).

 

[Under FRS 115, a sale exists only if and when buyer gains control of the asset (para 31), that is, the buyer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset (para 33). Further, FRS 115 provides that when evaluating whether a customer obtains control of an asset, an entity should consider any agreement to repurchase the asset (para 34).]

 

If the transfer of the asset is a sale, FRS 116 requires the sale and leaseback transaction to be accounted for as a sale transaction plus a lease transaction. If the transfer of the asset is not a sale, FRS 116 requires the sale and leaseback transaction to be accounted for as a financing transaction.

PROFIT OR LOSS ON SALE

 

Under FRS 17, the accounting treatment for the profit or loss from the “sale” transaction (assuming the selling price of the asset is equal to its fair value) depends very much on the nature of the leaseback transaction.

 

If the leaseback transaction qualifies as an operating lease, FRS 17 requires the profit or loss from the sale transaction to be recognised immediately (para 61). However, if the leaseback transaction results in a finance lease, FRS 17 requires the excess of selling price over the carrying amount (book value) to be deferred and amortised over the lease term (para 59). Moving forward, the issue of profit or loss on the sale transaction will be dealt with quite differently under FRS 116.

 

FRS 116 basically requires the seller-lessee to look at the whole sale and leaseback transaction and determine whether any rights in the underlying asset has been transferred to the buyer-lessor. If so, FRS 116 requires the seller-lessee to recognise profit or loss that relates to the rights transferred to buyer-lessor (para 100).

 

Thus, for example, if the asset has a 10-year useful life, and the seller-lessee enters into a sale and leaseback transaction to lease the asset for eight years, then the seller-lessee has, in substance, sold the last two years’ right to the buyer-lessor. Consequently, the seller-lessee will have to recognise profit or loss for the last two years’ right transferred. However, if the seller-lessee enters into a sale and leaseback transaction to lease the asset for 10 years, then the seller-lessee has, in substance, not sold any part of the asset to the buyer-lessor, and consequently, there is no profit or loss to be recognised.

 

The profit or loss may be calculated using the formula below:

 

OFF MARKET PRICING

 

Where the selling price is fixed artificially lower or higher than the fair value so as to accommodate a lower or higher than market lease rental, FRS 17 treats the off market selling price as part and parcel of the profit or loss on sale of the asset, whereas FRS 116 treats the off market selling price as a financing issue.

 

Under FRS 17, the general accounting treatment is to defer the difference between the selling price and the fair value and amortise it over the lease term or the period for which the asset is expected to be used, so as to adjust the off market lease rental to be approximately equal to the market lease rental.

 

Moving forward, FRS 116 requires the sales proceeds to be adjusted on the bases that any below-market selling price is accounted for as a prepayment of the lease payments, and any above-market selling price is accounted for as additional financing provided by the buyer-lessor to the seller-lessee (para 101).

 

To illustrate paragraph 101 of FRS 116, assume that the seller-lessee has an airplane with a fair value of $100 million.

 

If, in the sale and leaseback transaction, the airplane was sold for $80 million (instead of at its fair value of $100 million), FRS 116 requires the sale to be recognised at $100 million, except that the seller-lessee has paid $20 million of the lease payment upfront on the commencement of the lease. Also, the lease liability would be recognised initially at $100 million (present value of the lease payments of $80 million plus $20 million of upfront payment) and immediately reduced by an assumed upfront prepayment of $20 million.

 

If the above aeroplane was sold for $110 million (instead of at its fair value of $100 million) in the sale and leaseback transaction, FRS 116 requires the sale to still be recorded at $100 million, and the lease liability to be recognised at $100 million, except that the seller-lessee is deemed to have additionally taken a loan from the buyer-lessor of $10 million. The lease is to be accounted for under FRS 116, whereas the loan is to be accounted for under FRS 109: Financial Instruments.

 

CONCLUSION

 

The accounting treatment for sale and leaseback transactions under FRS 116 will be quite different from that under FRS 17.

 

Whether the sale and leaseback transaction is to be accounted for as a sale transaction plus a lease transaction or as a financing transaction will be determined based on different criteria. The profit or loss on sale of asset (where the selling price is equal to the fair value of the underlying asset) will be calculated differently and accounted for differently. Also, where the selling price is fixed artificially lower or higher than the fair value so as to accommodate a lower or higher than market lease rental, the off market selling price is viewed at differently and accounted for differently.

 

Further, consistent with the general requirement of FRS 116, where the sale and leaseback transaction is to be accounted for as a sale transaction plus a lease transaction, the lease will have to be on the balance sheet (unlike FRS 17 where majority of the leases are off balance sheet).

 

Entities that expect to have sale and leaseback transactions in the year 2019 and beyond will have to take note of these differences and their impacts thereof.

 


 

Ng Eng Juan is Associate Professor, School of Business, SIM University, and Low Kin Yew is Associate Professor, Nanyang Business School, Nanyang Technological University.