A common financing transaction is a sale and leaseback whereby the owner of an asset sells it to a financier who then leases the asset back to the original owner. Analysis is required to determine if the leaseback is finance or an operating lease. This post discuss “sale and leaseback transactions involving the legal form of a lease

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Very often entities enter into complex financing arrangements involving lease-like arrangements. Careful analysis of such arrangements needs to be undertaken to ensure that the substance of the transaction is properly reflected, not just the legal form. A finance lease results in the lessee having to defer any profit on disposal over the lease term.

If the leaseback is an operating lease and the entire transaction is at fair value, gain or loss on disposal is recognized immediately.

 

Other more complex transactions need to be analyzed for their substance and often involve a series of transactions involving leases. On occasion, just tax benefits arise; sometimes there is no real transaction when the series of transactions is viewed in its entirety. In such cases the substance needs to be clearly reflected in the financial statements.

In the case of an operating lease, if the sale price is below fair value and the loss is compensated by future lease payments at below market price, then the loss should be deferred and amortized in proportion to the lease payments over the useful life of the asset.

If the loss is not compensated by future lease payments, it should be recognized immediately. If the sale price is above fair value and the rentals are above the normal market rates, the excess over fair value should be deferred and amortized over the useful life of the asset.

 

Case Example:

An entity sells a piece of plant to a 100% owned subsidiary and leases it back over a period of 4 years. The remaining useful life of the plant is 10 years. The selling price of the plant was 20% below its carrying and market value. The lease rentals were based on market rates. The entity has no right to buy the plant back.

The question is: How should this transaction be dealt with in the entity’s financial statements?

The lease will almost certainly be an operating lease, as the lease period is not for the majority of the plant’s life and the rentals are based on market rates. However, the selling price was below the carrying and market value, and this loss has not been compensated by future rentals. Therefore, the loss should be recognized immediately.

The transaction will be eliminated on consolidation, but the individual entity accounts will recognize it. Also, the entities are related parties; therefore, the substance of the transaction will have to be carefully scrutinized. Although the entity has no right to reacquire the asset, it can exercise the right through its control of the 100% subsidiary. This control may change the designation of the lease.

Let’s have a look at the next case example….

 

Case Example-2:

An entity leases a motor vehicle over a period of five years. The economic life of the vehicle is estimated at seven years. The entity has the right to buy the vehicle at the end of the lease term for 50% of its market value plus a nominal payment of 0.5% of the market value at that date. This nominal payment is to cover the selling costs of the vehicle.

The question is; How should the lease be classified in the financial statements of the entity?

The lease will be a finance lease as the entity is likely to buy the vehicle at the price stated because it will be sold at 50% of the market value of the vehicle plus a nominal charge. SIC 15, Operating Lease—Incentives, clarifies the recognition of incentives related to operating leases by both the lessee and lessor. Lease incentives should be considered an integral part of the consideration for the use of the leased asset.

IAS 17 requires an entity to treat incentives as a reduction of lease income or lease expense. Incentives should be recognized by both the lessor and the lessee over the lease term, using a single amortization method applied to the net consideration.

IFRIC 4, Determining Whether an Arrangement Contains a Lease deals with agreements that do not take the legal form of a lease but which give rights to use assets in return for payment. Such agreements would include outsourcing arrangements and telecommunication contracts.

If the agreement conveys a right to control the use of the underlying asset then it should be accounted for under IAS 17. This is the case if any of the following conditions are met:

  • The purchaser in the arrangement has the ability or right to operate the asset or direct others to operate the asset.
  • The purchaser has the ability or right to control physical access to the asset.
  • There is only a remote possibility that parties other than the purchaser will take more than an insignificant amount of the output of the asset and the price that the purchaser will pay is neither fixed per unit of output nor equal to the current market price at the time of delivery.

 
SIC 27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease, states that the accounting for arrangements between an enterprise and an investor should reflect the substance of the arrangement. All aspects of the arrangement should be evaluated to determine its substance, with weight given to those aspects and implications that have an economic effect. When the overall economic effect cannot be understood without reference to the series of transactions as a whole, the series of transactions should be accounted for as one transaction.