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6.3 Sale and leaseback: determining whether a sale has occurred
Publication date: 30 Sep 2021
us Leases guide
A transaction is accounted for as a sale of an underlying asset and a leaseback of that underlying asset only if the initial transaction qualifies as a sale in accordance with ASC 606, Revenue from Contracts with Customers (the "revenue standard").
To qualify as a sale of an asset under the revenue standard, the seller-lessee needs to ensure the customer (in this case, the buyer-lessor) obtains control of the asset. ASC 842-40-25-1 references the revenue standard for purposes of evaluating whether the transfer of an asset should be accounted for as a sale.
An entity shall apply the following requirements in Topic 606 on revenue from contracts with customers when determining whether the transfer of an asset shall be accounted for as a sale of the asset:
a. Paragraphs 606-10-25-1 through 25-8 on the existence of a contract
b. Paragraph 606-10-25-30 on when an entity satisfies a performance obligation by transferring control of an asset.
Sale and leaseback transactions must also be evaluated to determine whether the classification of the leaseback or the existence of a seller-lessee repurchase option prevent accounting for the transfer of the asset as a sale. See LG 6.3.4 for information on the impact of lease classification on qualification as a sale and LG 6.3.5 for information on repurchase rights and obligations and renewal rights in a sale and leaseback transaction.
6.3.1 Sale and leaseback: Existence of a contract
The first step is to identify the contract. A contract can be written, oral, or implied by an entity’s customary business practices. Generally, any agreement that creates legally enforceable rights and obligations meets the definition of a contract.
ASC 606-10-25-1 lists the criteria that must be met for a reporting entity to conclude that a contract exists.
Excerpt from ASC 606-10-25-1
An entity shall account for a contract with a customer… only when all of the following criteria are met:
a. The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations.
b. The entity can identify each party's rights regarding the goods or services to be transferred.
c. The entity can identify the payment terms for the goods or services to be transferred.
d. The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract).
e. It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
See RR 2.6 for information on identifying and evaluating the existence of a contract.
6.3.2 Sale and leaseback: Control indicators
When evaluating if control has been transferred to the buyer-lessor in a sale and leaseback transaction, ASC 842 requires a reporting entity to look to the five transfer of control indicators in the revenue standard, which are:
- The reporting entity has a present right to payment
- The customer has legal title
- The customer has physical possession
- The customer has the significant risks and rewards of ownership
- The customer has accepted the asset
This is a list of indicators, not criteria. Not all of the indicators need to be met for a reporting entity to conclude that control has transferred to the buyer-lessor in a sale and leaseback transaction; the factors should be evaluated collectively to determine whether the buyer-lessor has obtained control. This assessment should be focused primarily on the buyer-lessor’s perspective. Judgment will be required to determine whether a sale has occurred. The conclusion will be based on the facts and circumstances of the transaction. See RR 6.2 for information on determining whether control of an asset has been transferred.
The sections that follow describe how each of the indicators are applied in the context of a sale and leaseback transaction.
6.3.2.1 Sale and leaseback: Present right to payment
A buyer-lessor’s present obligation to pay could indicate that the seller-lessee has transferred the ability to direct the use of the asset and the buyer-lessor has obtained substantially all of the remaining benefits from the asset. The seller’s motivation in a typical sale and leaseback transaction is to generate liquidity. Accordingly, the buyer-lessor typically pays the agreed upon purchase price for the asset upfront, in which case this indicator would be satisfied. In instances where the buyer-lessor does not make an upfront payment, the seller-lessee will need to further evaluate whether a present right to payment exists.
6.3.2.2 Sale and leaseback: Buyer-lessor has legal title
The party that has legal title is typically the party that can direct the use of and receive the benefits from an asset. The benefits of holding legal title include the ability to sell an asset, exchange it for another good or service, or use it to secure or settle debt, all of which indicate that the holder has control.
While not determinative in isolation, we believe the transfer of legal title to a buyer is an important indicator when distinguishing between whether a transaction results in a sale or a lease of an asset.
6.3.2.3 Sale and leaseback: Buyer-lessor has physical possession
Physical possession of an asset typically gives the holder the ability to direct the use of and obtain benefits from that asset; therefore, it is an indicator of which party controls the asset. However, physical possession does not, on its own, determine which party has control. A reporting entity should consider the facts and circumstances of each arrangement to determine whether physical possession coincides with the transfer of control.
In a typical sale and leaseback transaction, the buyer-lessor obtains legal title to the asset concurrent with commencement of the leaseback term. The buyer-lessor obtains the rights of ownership and is deemed to have physical possession of the asset, but grants the seller-lessee a right-of-use interest (i.e., a lease) in the underlying asset.
6.3.2.4 Buyer-lessor has significant risks and rewards of ownership
A seller-lessee that has transferred risks and rewards of ownership of an asset has typically transferred control to the buyer-lessor, but not in all cases. Both parties to the arrangement will need to determine whether control has transferred in the event the seller-lessee has retained some of the risks or rewards of ownership.
Judgment may be required when determining if the buyer-lessor has obtained the significant risks and rewards of ownership or if certain risks have been retained by the seller-lessee that would preclude the buyer-lessor from controlling the asset.
6.3.2.5 Sale and leaseback: Buyer-lessor has accepted the asset
Whether the buyer-lessor has accepted the asset, as with all indicators of transfer of control, should be viewed from the buyer-lessor’s perspective. Whether the buyer-lessor has formally accepted the asset should be taken into consideration along with the other indicators that control has been obtained by the buyer-lessor in a sale and leaseback transaction. See RR 6.5 for information about customer acceptance.
6.3.2.6 Prospective lessee obtains control prior to commencement
Depending on the terms of an arrangement, a prospective lessee may obtain control of an underlying asset prior to lease commencement. If a lessee obtains control of an underlying asset before the lease commencement date, the transaction should be accounted for as a sale and a leaseback. When assessing control, a key factor to consider is whether the lessee has obtained legal title to the asset; however, this factor is not necessarily determinative, as discussed in ASC 842-40-55-2.
A lessee may obtain legal title to the underlying asset before that legal title is transferred to the lessor and the asset is leased to the lessee. If the lessee controls the underlying asset (that is, it can direct its use and obtain substantially all of its remaining benefits) before the asset is transferred to the lessor, the transaction is a sale and leaseback transaction that is accounted for in accordance with this Subtopic.
Excerpt from ASC 842-40-55-2
If the lessee obtains legal title, but does not obtain control of the underlying asset before the asset is transferred to the lessor, the transaction is not a sale and leaseback transaction.
Example LG 6-1, Example LG 6-2, and Example LG 6-3 illustrate the assessment of whether a lessee has obtained control of the underlying asset prior to lease commencement.
EXAMPLE LG 6-1
Sale and leaseback transaction – lessee obtains control prior to lease commencement
Sale and leaseback transaction – lessee obtains control prior to lease commencement
Contractor Corp wants to lease a new vehicle for five years. The vehicle manufacturer is not willing to enter into lease arrangements, so Contractor Corp identifies a bank that is willing to purchase the vehicle and enter into a lease under an agreement that Contractor Corp expects to classify as an operating lease.
Contractor Corp purchases the vehicle from the manufacturer, takes possession and obtains legal title. Shortly thereafter, Contractor Corp sells the vehicle to the bank. The sale agreement requires the bank to reimburse Contractor Corp for all costs incurred to acquire the vehicle from the manufacturer and provides the bank with legal title to the vehicle. Concurrent with the sale, Contractor Corp and the bank enter into a five-year lease of the vehicle.
Should Contractor Corp account for the transaction as a sale and leaseback?
Analysis
Because Contractor Corp purchased the vehicle from the manufacturer, obtained legal title, accepted the asset, had physical possession of the asset, and had the significant risks and rewards of ownership, Contractor Corp obtained control of the asset prior to selling the asset to the buyer- lessor (the bank). Although Contractor Corp intended to lease the vehicle and only temporarily obtained control, the transaction should be accounted for as a sale and leaseback because Contractor Corp obtained control of the underlying asset prior to lease commencement.
EXAMPLE LG 6-2
Sale and leaseback transaction – lessee obtains title, but not control prior to lease commencement
Sale and leaseback transaction – lessee obtains title, but not control prior to lease commencement
Contractor Corp wants to lease a new vehicle for five years. The vehicle manufacturer is not willing to enter into lease arrangements, so it arranges for a lease between Contractor Corp and a bank. Contractor Corp expects to classify the lease as an operating lease. For tax reasons, Contractor Corp obtains legal title, immediately transfers it to the bank, and concurrently enters into a five-year lease of the vehicle with the bank.
Should Contractor Corp account for the transaction as a sale and leaseback?
Analysis
No. Contractor Corp should account for the transaction as a lease arrangement with the bank and not a sale and leaseback. Contractor Corp obtained legal title to the asset prior to the lessor (the bank) and prior to the commencement of the lease, but did not obtain control of the underlying asset. Although Contractor Corp had temporary title, it did not obtain the significant risks and rewards of ownership and none of the other indicators of control were present.
EXAMPLE LG 6-3
Sale and leaseback transaction – lessee sells or transfers its purchase option
Sale and leaseback transaction – lessee sells or transfers its purchase option
Lessee Corp holds an option to purchase an asset and sell or transfer the option (without obtaining title of the asset) to Lessor Corp provided Lessor Corp will exercise the purchase option and lease the asset to Lessee Corp. Lessor Corp, a third party, exercises the purchase option and leases the asset to Lessee Corp.
Should Lessee Corp and Lessor Corp account for the transaction as a sale and leaseback?
Analysis
There are mixed views on accounting for this type of transaction. To be in the scope of sale and leaseback accounting, Lessee Corp should have control of the underlying asset before the purchase option is exercised by Lessor Corp. To do this, Lessee Corp and Lessor Corp should analyze various factors, such as the substance of the purchase option, whether it is exercisable immediately, and whether the option strike price is at the current fair value. The transfer of an immediately exercisable option at a fixed price would presumably be within the scope of the sale leaseback rules. In contrast, the transfer of an option whose strike price is at prevailing fair value at the time of exercise may not fall within the sale leaseback rules, particularly when substantially similar assets are readily available in the marketplace. The evaluation is judgmental and needs to be based on facts and circumstances.
6.3.3 Lessee involvement in construction of leased asset
When a prospective lessee is involved in the construction or design of an underlying asset prior to lease commencement (commonly referred to as a “build-to-suit” lease), the lessee should evaluate whether it controls the asset during the construction period. Generally, the evaluation of whether a lessee controls an asset under construction is similar to the evaluation in the revenue recognition standard to determine whether a performance obligation is satisfied over time.
ASC 842-40-55-5 lists several examples that demonstrate when a lessee has obtained control during the construction period.
If the lessee controls the underlying asset being constructed before the commencement date, the transaction is accounted for in accordance with this Subtopic. Any one (or more) of the following would demonstrate that the lessee controls an underlying asset that is under construction before the commencement date:
a. The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period (for example, by making a payment to the lessor).
b. The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use (see paragraph 842-10-55-7) to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased.
c. The lessee legally owns either:
1. Both the land and the property improvements (for example, a building) that are under construction
2. The non-real-estate asset (for example, a ship or an airplane) that is under construction.
d. The lessee controls the land that property improvements will be constructed upon (this includes where the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale in accordance with paragraphs 842-40-25-1 through 25-3) and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements.
e. The lessee is leasing the land that property improvements will be constructed upon, the term of which, together with lessee renewal options, is for substantially all of the economic life of the property improvements, and does not enter into a sublease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to sublease the land for substantially all of the economic life of the property improvements.
The list of circumstances above in which a lessee controls an underlying asset that is under construction before the commencement date is not all inclusive. There may be other circumstances that individually or in combination demonstrate that a lessee controls an underlying asset that is under construction before the commencement date.
There have been questions raised as to the meaning of "at any point during the construction period". Those questions focus on whether the provision requires the lessee to have the right to obtain the asset either (1) at all times during the construction period (which could include contingent events that are only triggered upon events within the lessee's control) or (2) only based on some contingency or stated event. We believe a lessee would be considered the owner of the asset during the construction period if the lessee has the right to obtain the partially-constructed asset at some point during the construction period (i.e., a call/purchase option). If the lessee does not have the right at all times, ownership of the asset would be imputed at the point in time that the lessee has the right to obtain the partially-constructed asset (e.g., when a purchase option becomes exercisable).
We believe a lessee's call option that becomes exercisable solely due to the passage of time would cause the lessee to have control of the partially-constructed asset immediately. If the option is contingent upon any other event, and that event is within the lessor's control or based on the occurrence of an external event, control does not pass to the lessee until the contingency is resolved.
There may be circumstances in which the purchase option becomes exercisable only upon contingent events occurring, such as when the lessee or the lessor is in default. In these cases, the lessee would generally be considered to have the right to obtain the partially-constructed asset if the contingent event were within the control of the lessee. All facts and circumstances should be considered carefully. For example, a lease that provides a lessee the right to acquire the partially-constructed asset if the lessee is in default may be considered within the control of the lessee. However, a lessee default under the lease contract may result in economic consequences to the lessee, such as triggering cross defaults in the lessee's other arrangements. The right to acquire the partially-constructed asset in this circumstance may not be considered substantive.
The existence of a lessee-provided indemnification for preexisting environmental contamination does not, in isolation, result in the lessee obtaining control of the underlying asset prior to lease commencement regardless of the likelihood of loss as a result of the indemnity.
The list of circumstances provided by ASC 842-40-55-5 is not all inclusive; there may be other circumstances that individually or in combination demonstrate that a lessee controls an underlying asset under construction before the lease commencement date. As additional circumstances have not yet substantially developed in practice, entities will be required to carefully evaluate the facts and circumstances of each arrangement. For example, we believe if a lessee is required to make lease payments regardless of whether the lessor completes construction of the asset (i.e., a date-certain lease) and the lease is expected to be classified as a finance lease, the lessee has obtained control of the asset from lease inception, rather than the lease commencement date. Additionally, we believe a lessee that is required to fund substantially all (i.e., 90% or more) of the costs of construction that are probable of being incurred during the construction period may have obtained control. However, we do not believe this example is similar to the prescriptive rules in ASC 840. For example, we do not believe a lessee has obtained control of the asset under construction solely because it is required to pay the first costs of construction or is responsible for cost overruns that are unlimited when such cost overruns are not probable of representing substantially all of the costs of construction.
We believe a put option held by the lessor to put the asset under construction to the lessee should be assessed to determine whether the lessor has a significant economic incentive to exercise its put right consistent with the guidance regarding repurchase agreements in the new revenue standard. If an incentive exists, the lessee would be assumed to control the construction in process and would be considered the owner of the asset during the construction period. For further guidance, refer to RR 8.7.
Example LG 6-4 and Example LG 6-5 illustrate the assessment of whether a lessee has obtained control of the underlying asset under construction prior to lease commencement. See ASC 842-40-55-39 through ASC 842-40-55-44 for additional examples.
EXAMPLE LG 6-4
Sale and leaseback transaction – lessee obtains control of construction in progress
Sale and leaseback transaction – lessee obtains control of construction in progress
University would like to construct a new library on a parcel of land next to its campus. University acquires the parcel of land and enters into an agreement with Developer Corp, an independent third party, under which Developer Corp will lease the parcel of land from University, construct the library, and lease the completed library to University. Both the ground lease to Developer Corp and the library lease to University have 20-year lease terms. Rental rates on both leases are consistent with prevailing market rents for similar leased assets. The economic life of the library is 40 years.
Does University control the underlying asset during the construction period?
Analysis
University controls the underlying asset during the construction period because the ground lease to Developer Corp is for a term that is less than substantially all of the economic life of the property improvements (20-year ground lease/40-year economic life = 50%). Accordingly, University should account for the underlying asset during the construction period similar to any other owned asset under construction (i.e., under ASC 360, Property, Plant, and Equipment). Additionally, any construction costs paid for by Developer Corp should be recorded by University as a financial liability.
In symmetry with University's accounting, Developer Corp should not recognize the asset under construction. Rather, Developer Corp should account for any payments it makes during the construction period as a collateralized loan to the lessee in accordance with ASC 310, Receivables.
EXAMPLE LG 6-5
Sale and leaseback transaction – lessee does not obtain control of construction in process (real estate)
Sale and leaseback transaction – lessee does not obtain control of construction in process (real estate)
Law Firm enters into an arrangement with Developer Corp to lease an office building for 10 years contingent upon Developer Corp completing construction of the asset in accordance with the construction plan. The construction plan includes Law Firm-specific improvements necessary for Law Firm to begin operations at the lease commencement date. The budgeted cost of construction is $10 million. The useful life of the asset is 40 years. Law Firm is obligated to reimburse Developer Corp for increases in the cost of steel from the inception date of the arrangement to the completion date of the construction project up to a maximum of $250,000. During the construction period, Law Firm has access to the building in order to inspect the progress of the construction and to make discretionary improvements.
During the construction period, Law Firm reimburses Developer Corp for $200,000 due to increases in the cost of steel during the construction period. In addition, Law Firm incurred $100,000 of additional construction costs related to discretionary tenant improvements, including branding elements.
Does Law Firm control the underlying asset during the construction period?
Analysis
Law Firm did not obtain control of the underlying asset during the construction period, therefore it should account for the transaction as a lease arrangement with Developer Corp. Although Law Firm had access to the asset, incurred costs related to both structural and normal tenant improvements, and had financial risks related to the construction of the asset, Law Firm did not obtain control of the asset under construction before the lease commencement date (i.e., the construction completion date). Except for the payment for increases in the cost of steel, Developer Corp does not have an enforceable right to payment unless and until construction is completed. Law Firm’s exposure to steel costs is insignificant relative to the overall construction budget. In addition, none of the other indicators of control in ASC 842-40-55-5 are present.
6.3.3.1 Sale of CIP with a lease for completed building
In certain cases an entity may have begun constructing an asset prior to selling it to a developer. The developer will continue work on the construction in progress (CIP) and will lease the asset back to the seller once construction is complete. As this concept is not specifically addressed by ASC 842, a number of views have evolved regarding whether this type of transaction is in the scope of the sale and leaseback rules. We believe each of the following views is supportable:
- Any sale of CIP is in scope: This view does not consider the stage of completion or the amount of costs incurred. Even if $1 of soft costs, such as planning and architecture, are incurred, the transaction is subject to the sale and leaseback rules.
- Any sale of CIP that includes a physical asset is in scope: This view does not consider how much construction has been done but rather focuses on if there is a physical asset being sold (such as a poured foundation or steel beams). This view would not include a sale if only soft costs or land clearing costs were incurred because these costs do not result in a physical asset.
- Only CIP that represents the underlying leased asset is in scope: Under this view, an entity should qualitatively determine when the CIP is representative of the underlying asset that will ultimately be leased back upon the completion of construction. This analysis will require judgment and should consider quantitative thresholds used elsewhere in GAAP to help with the overall qualitative assessment. For example, if the fair value of the CIP represents 10% or more of the expected value of the completed construction, this would be an indicator that the CIP represents the underlying leased asset.
- Only CIP that is substantially similar to the completed construction project should be in the scope: This view qualitatively determines when the CIP is substantially similar to the underlying asset that will ultimately be leased back upon the completion of construction. This analysis will require judgment and should consider quantitative thresholds used elsewhere in GAAP. For example, if the fair value of the CIP sold represents 90% or more of the expected value of the completed construction, this would be an indicator that the CIP is substantially similar to the underlying leased asset.
An entity should establish an accounting policy based on any of the views above and apply it consistently to all similar transactions.
6.3.3.2 Lessee controls the asset under construction
If a lessee controls the underlying asset under construction before the lease commencement date, the lessee should account for the underlying asset during the construction period similar to any other asset under construction that it controls. For example, if a lessee determines that it controls an underlying real estate asset under construction, the lessee should account for the real estate asset under construction in accordance with ASC 360, Property, Plant, and Equipment. Any costs of construction paid for by the lessor should be recognized by the lessee as a financial liability.
Similar to the lessee’s accounting, a lessor that has not obtained control of the underlying asset should account for payments it makes during the construction period as a collateralized loan to the lessee in accordance with ASC 310, Receivables. In other words, the accounting between the lessee and lessor should be symmetrical. A lessor should not recognize the asset under construction.
Once a lessee is the deemed owner of the asset under construction, the arrangement is within the scope of the sale and leaseback guidance and both the lessee and the lessor should evaluate whether the transaction represents a qualified sale and leaseback or a financing arrangement. Initially, the evaluation should occur as of the date the lessee is determined to have obtained control. Generally, once a lessee has obtained control of an underlying asset under construction, it is unlikely that control will transfer to the lessor before construction of the underlying asset has been completed. Unless, and until, the lessee transfers control of the underlying asset to the lessor, the lessee will continue to be the deemed the accounting owner of the underlying asset.
If the transaction otherwise meets the criteria to qualify for sale and leaseback accounting, as discussed in LG 6.4, the lessee should recognize the sale of the asset when it transfers control of the underlying asset to the lessor.
See LG 6.5 for additional information on the accounting for failed sale and leaseback transactions.
Question LG 6-1 describes the lessee’s accounting for the land when the lessee is the deemed owner of an asset under construction on the land.
Question LG 6-1
What are the accounting implications for land when the lessee is deemed to be the accounting owner of the building under construction but the land on which the building being constructed is either owned by the lessor, or is leased by the lessor from an unrelated third party?
What are the accounting implications for land when the lessee is deemed to be the accounting owner of the building under construction but the land on which the building being constructed is either owned by the lessor, or is leased by the lessor from an unrelated third party?
PwC response
The land on which the building is being constructed would typically meet the definition of a lease (see LG 2.3) and both the lessee and lessor would need to account for the land lease under ASC 842. The commencement date of the land lease would usually be the date on which construction activities begin. Note that if the lessee was not the deemed owner of the building under construction, the land lease would typically commence at the construction completion date.
Example LG 6-6 illustrates a lessor’s derecognition of construction in progress when the lessee is the deemed owner during construction.
EXAMPLE LG 6-6
Sale and leaseback transaction – lessor’s accounting for derecognition of construction-in-progress when lessee is the deemed the owner during construction
Sale and leaseback transaction – lessor’s accounting for derecognition of construction-in-progress when lessee is the deemed the owner during construction
Landlord Corp is constructing a building that is expected to cost $100 million. During the construction period, Landlord Corp enters into an agreement to lease the building to Lessee Corp once construction is complete. The agreement includes an option for Lessee Corp to purchase the construction in progress at any point during the construction period at its then prevailing fair value. Due to the purchase option, Lessee Corp is the deemed owner of the building under construction at the agreement’s effective date. Landlord Corp incurred $15 million in construction costs with a fair value of $18 million at the agreement effective date.
How should Landlord Corp measure the receivable from Lessee Corp upon derecognition of the construction-in progress at the agreement effective date?
Analysis
If Landlord Corp does not have an obligation to complete the construction, we believe it should recognize an $18 million receivable with a gain of $3 million ($18 million - $15 million) upon derecognition of the construction in progress. However, if Landlord Corp has an obligation to complete construction, we believe, consistent with Question 2-3 in Chapter 2 of the Revenue from contracts with customers guide, Landlord Corp should initially measure the receivable at $15 million plus the proportionate profit earned to date based on percentage of construction completion.
6.3.3.3 Lessee does not control the asset under construction
If a lessee does not obtain control of the underlying asset under construction, the transaction is not subject to the sale and leaseback guidance. In those circumstances, the lessee should apply judgment to determine how to account for costs it incurs during construction. Such costs, for example, may relate to its own assets, such as leasehold improvements, or they may relate to the right to use the lessor’s assets. If such costs relate to leasehold improvements, the lessee should generally account for those costs in accordance with ASC 360. Payments made by the lessee for the right to use the asset should be accounted for as lease payments under ASC 842, regardless of when the payments occur or the form of such payments. For example, if the lessee pays for (or contributes) construction materials to construct the lessor’s asset, such payments are included in lease payments.
Example LG 6-7 illustrates the application of this guidance.
EXAMPLE LG 6-7
Sale and leaseback transaction – construction costs incurred by a lessee that does not obtain control of construction in process (real estate)
Sale and leaseback transaction – construction costs incurred by a lessee that does not obtain control of construction in process (real estate)
Law Firm enters into an arrangement with Developer Corp to lease an office building for 10 years contingent upon Developer Corp completing construction of the asset in accordance with the construction plan. The construction plan includes Law Firm-specific improvements necessary for Law Firm to begin operations at the lease commencement date. The budgeted cost of construction is $10 million. The useful life of the asset is 40 years. Law Firm is obligated to reimburse Developer Corp for increases in the cost of steel from the inception date of the arrangement to the completion date of the construction project up to a maximum of $250,000. During the construction period, Law Firm has access to the building in order to inspect the progress of the construction and to make discretionary improvements.
Law Firm reimburses Developer Corp for $200,000 due to increases in the cost of steel during the construction period. In addition, Law Firm incurred $100,000 of additional construction costs related to discretionary tenant improvements, including branding elements.
How should Law Firm account for the costs incurred during the construction period?
Analysis
The $200,000 of construction cost overruns paid by Law Firm are lease payments because they were required per the terms of the lease agreement in order for the lessee to obtain the right to use the underlying asset and do not represent payment for a good or service provided to Law Firm. Accordingly, Law Firm should recognize such costs as prepaid rent. See LG 4.2.2 for information on the accounting for prepaid rent.
Law Firm should account for the $100,000 of construction costs incurred as lessee assets (i.e., leasehold improvements) that would be depreciated over the shorter of their useful lives or the lease term.
6.3.4 Impact of lease classification on qualification as a sale
In evaluating a potential sale and leaseback, whether a sale has occurred can be impacted by the classification of the lease. If a leaseback is classified as a finance lease (seller-lessee) or a sales-type lease (buyer-lessor), then no sale has occurred and the transaction should be accounted for as a failed sale and leaseback. This is because a finance lease is effectively a purchase of an asset and a sales-type lease is effectively a sale of an asset, not a lease. Accordingly, the transaction would result in the seller-lessee effectively transferring control of the asset to the buyer-lessor (i.e., a sale) and immediately reacquiring control (i.e., a purchase). See LG 3 for information on lease classification. See LG 6.5 for information on the accounting for failed sale and leaseback transactions.
Question LG 6-2 describes the accounting when the leaseback of a building is a finance lease and the leaseback of the underlying land is an operating lease in a sale and leaseback transaction involving land and building.
Question LG 6-2
A seller-lessee sells land and building and simultaneously leases them back from the buyer-lessor. The building leaseback is classified as a finance lease, and the land leaseback is classified as an operating lease. Does the finance leaseback of the building preclude sale and leaseback accounting for the land?
A seller-lessee sells land and building and simultaneously leases them back from the buyer-lessor. The building leaseback is classified as a finance lease, and the land leaseback is classified as an operating lease. Does the finance leaseback of the building preclude sale and leaseback accounting for the land?
PwC response
No. Under ASC 842-10-15-29 the right to use the land and building are separate components. Therefore, in this example, the finance leaseback of the building will not preclude sale and leaseback accounting for the land. However, if the land leaseback is classified as a finance lease, it would be unusual for the building leaseback to be classified as anything other than a finance lease because of the retained control of the underlying land.
6.3.5 Repurchase rights and obligations in a sale and leaseback
A repurchase right gives the seller-lessee the right (or obligation) to repurchase the asset after it has been sold to the buyer-lessor. There are three forms of repurchase rights.
- A seller-lessee’s obligation to repurchase and the buyer-lessor’s obligation to sell the asset (a forward)
- A seller-lessee’s right to repurchase the asset (a call option)
- A buyer-lessor’s right to require the seller-lessee to repurchase the asset (a put option)
An arrangement to repurchase the asset that is negotiated between the buyer-lessor and seller-lessee after control of the asset has been transferred to the buyer-lessor is not a repurchase agreement because the buyer-lessor is not obligated to resell the asset as part of the initial transaction. The subsequent decision to repurchase the asset does not affect the buyer-lessor's ability to direct the use of or obtain the benefits of the asset. See RR 8.7 for additional guidance on repurchase rights. Additional consideration should be given to the substance of the arrangement. If the substance of the arrangement suggests that the repurchase agreement was contemplated as part of the initial sales transaction, it may be considered a repurchase right and should be evaluated accordingly.
As discussed in RR 8.7, certain sale transactions that contain a put or call option that cannot be recognized as sales are accounted for as leases to the customer. However, if such a failed sale is accompanied by a leaseback, it should be accounted for as a financing arrangement because the seller retains the right to use the asset. See LG 6.5 for further information on how to account for a failed sale and leaseback transaction.
6.3.5.1 Repurchase options, fixed price renewal options and forwards
The guidance for repurchase rights in the revenue standard should be applied to sale and leaseback transactions with certain clarifications unique to sale and leaseback transactions. In the revenue standard, sale recognition is precluded when the party that would be the seller-lessee has a substantive repurchase option or obligation with respect to the underlying asset. If so, the buyer-lessor has not obtained control. A non-substantive repurchase option does not preclude sale accounting. See RR 8.7 for additional guidance on repurchase rights.
Excerpt from ASC 606-10-55-68
If an entity has an obligation or a right to repurchase the asset (a forward or a call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset.
Despite the prohibition in the revenue guidance, the existence of a repurchase option does not always preclude recognition of a sale in a sale and leaseback arrangement. ASC 842-40-25-3 provides specific guidance on evaluating a repurchase option in a sale and leaseback transaction. A repurchase option does not preclude sale and leaseback accounting if both of the following criteria are met.
- The repurchase option is exercisable by the seller-lessee only at the then-prevailing fair value of the asset
- Alternative assets are readily available in the marketplace, which are substantially the same as the underlying asset
If the underlying asset is real estate or integral equipment as defined in ASC 978 (i.e., any physical structure or equipment attached to the real estate that cannot be removed and used separately without incurring significant cost), the transaction would fail to meet the second criteria regardless of the exercise price of the repurchase option because each location is unique; therefore, alternative real estate assets or integral equipment that are readily available in the marketplace will not be considered substantially the same as the underlying real estate asset or integral equipment.
Judgment may be required to determine whether other types of non-real estate assets are considered substantially the same as the underlying asset. Generally, if alternative assets are readily available in the marketplace, which are substantially the same as the underlying asset, the seller-lessee would be indifferent as to whether it (1) repurchased the asset it previously sold and leased back, or (2) purchased another asset that is substantially the same in the marketplace. Accordingly, we believe the less generic the underlying asset, the more difficult it would be to assert that alternative assets readily available in the marketplace are substantially the same as the underlying asset.
Arrangements with a fixed price repurchase option d0 not qualify as a sale because the exercise price will not necessarily reflect the then-prevailing fair value of the asset. If an arrangement has a fixed price renewal option that extends to substantially all of the economic life of the asset, the entity may need to evaluate whether the fixed price renewals are economically similar to a fixed price repurchase option that would preclude sale accounting. As this concept is not addressed by ASC 842, a number of views have evolved. One view is that a renewal option is fundamentally not the same as a repurchase option and would therefore not preclude sale accounting. Another view is that a fixed price renewal option that extends to substantially all of the economic life of the asset is equivalent to a fixed repurchase option that would preclude sale accounting. We believe this analysis should be based on facts and circumstances and may involve consideration of the pricing of the arrangement in the renewal period.
6.3.5.2 Buyer-lessor has a put option
A put option allows a buyer-lessor to require the seller-lessee to repurchase the underlying asset at its discretion. Generally, a put option indicates that the seller-lessee has relinquished control over the asset. However, the revenue standard precludes sale accounting when a buyer-lessor has a significant economic incentive to exercise a put option.
If an entity has an obligation to repurchase the asset at the customer’s request (a put option) at a price that is lower than the original selling price of the asset, the entity should consider at contract inception whether the customer has a significant economic incentive to exercise that right. The customer’s exercising of that right results in the customer effectively paying the entity consideration for the right to use a specified asset for a period of time. Therefore, if the customer has a significant economic incentive to exercise that right, the entity should account for the agreement as a lease in accordance with Topic 842 on leases unless the contract is part of a sale and leaseback transaction. If the contract is part of a sale and leaseback transaction, the entity should account for the contract as a financing arrangement and not as a sale and leaseback transaction in accordance with Subtopic 842-40.
The seller-lessee must assess the contract at inception to determine whether the buyer-lessor has a significant economic incentive to exercise its put option. It should consider all relevant factors in its assessment, including the following:
- How the repurchase price compares to the expected market value of the asset at the date of repurchase
- The amount of time until the right expires
A buyer-lessor has a significant economic incentive to exercise a put option when the repurchase price is expected to significantly exceed the market value of the asset at the time of repurchase. See RR 8.7 for additional information.
If it is determined that the buyer-lessor has a significant economic incentive to exercise a put option, no sale has occurred and the sale and leaseback transaction should be accounted for as a financing arrangement. If the buyer-lessor does not have a significant economic incentive to exercise a put option, then sale accounting is not precluded. See LG 6.5 for further discussion of how to account for a failed sale and leaseback transaction.
6.3.5.3 Seller-lessee has a right of first offer
Some sale-leaseback agreements may provide the seller-lessee with a "right of first offer," which allows the seller-lessee to make an offer to purchase the underlying asset at the end of the lease term based on a current valuation of the asset before the buyer-lessor may solicit offers from third parties. We believe that a sale-leaseback agreement containing a right of first offer should be carefully analyzed to determine whether the buyer-lessor is economically or contractually compelled to accept the offer. For example, a buyer-lessor may conclude it is (1) economically compelled if it is required to pay a substantive penalty if it does not accept the offer or (2) contractually compelled to accept the offer per the terms of the lease agreement.
If the buyer-lessor is not compelled to accept the seller-lessee's offer, the right of first offer would typically not prevent sale accounting. If the buyer-lessor is compelled to accept the offer, the right of first offer is effectively a repurchase option held by the seller-lessee, which may, prevent the transaction from qualifying as a sale. See LG 6.3.5.1 for more information on the evaluation of a seller-lessee repurchase option.
A right of first offer may also economically or contractually compel the seller-lessee to make an offer to acquire the underlying asset. If the seller-lessee is compelled to make an offer, the right of first offer is effectively a buyer-lessor put option. See LG 6.3.5.2 for more information on the evaluation of a buyer-lessor put option.
6.3.5.4 Seller-lessee has a contingent repurchase option
Some sale and leaseback agreements may provide the seller-lessee with a repurchase option which allows the seller-lessee the right to repurchase the underlying asset if a specific contingent event occurs. The specific contingent event may be in the seller-lessee’s control, in the buyer-lessor’s control, or outside either party’s control. Examples of contingent events include significant damage or destruction of the leased asset and a lessor’s change of control. We believe all facts and circumstances should be considered to determine if a contingent repurchase option is similar in substance to an unconditional repurchase option or a put option held by the buyer-lessor under the new revenue standard. For further guidance, refer RR 8.7.1.1 for conditional call options.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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