Should cash proceeds from the sale of an asset that is simultaneously [read transactions] leased back should be reported as a financing source of cash?. This post answers the question. Enjoy!
When an asset is sold and simultaneously leased back, the seller gives up ownership but not possession of the asset in question. Such a transaction may be utilized for any number of reasons, including:
- A desire to free up capital for investment
- An interest in an alternative, cost-efficient means of raising cash without using the debt and equity markets
- A belief that the asset in question (often real estate) should be owned by firms who are in that business
- A desire to lower debt as a means of improving financial leverage
- A desire to shed assets as a means of increasing return on assets
Any long-lived asset is potentially available for a sale and leaseback transaction. Examples include a headquarters facility, most any kind of equipment, such as manufacturing, mining, satellite, and office equipment, aircraft and other transportation equipment, restaurants, warehouses, and even rights to motion picture films.
In general, accounting standards for sale and leasebacks are designed to treat them as financing transactions. In effect, the seller has borrowed against its equity in the asset that has been sold. In line with the financing view of the sale and leaseback, it is common for some or all of the realized gain to be deferred and recognized over the term of the leaseback.
Only the gain, if any, that exceeds the present value of the leaseback can be recognized immediately. The leaseback itself is accounted for according to the terms of the underlying lease. If it meets one of these criteria, it is treated as a capital lease:
- The lease transfers ownership of the asset to the lessee by the end of the lease term.
- The lease contains a bargain purchase option, the right to purchase the asset for less than its fair value.
- The lease term is equal to 75 percent or more of the estimated economic life of the leased property.
- The present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property.
Under capital lease treatment, the asset sold and the related lease obligation are immediately restored to the seller’s balance sheet. If the leaseback meets none of the above criteria, it is accounted for as an operating lease. The asset that has been sold remains off the balance sheet and periodic rent expense is recorded. A lease obligation is not recorded.
Illustration of Sale and Leaseback Transaction
Consider these terms for the sale and leaseback of aircraft:
- Book value of the aircraft is $2,500,000.
- Selling price is $4,000,000, resulting in a realized gain to the seller of $1,500,000 ($4,000,000 – $2,500,000).
- Aircraft’s remaining economic life is 10 years and the leaseback term is 72 months.
- The leaseback does not meet any criteria for capital lease treatment and is accounted for as an operating lease.
- The interest rate implicit in the lease as computed by the lessor is 8 percent per annum.
- Monthly lease payments are $58,874 due at the beginning of each month, yielding a present value for the leaseback of $3,380,236.
As a result of the sale and leaseback transaction, the book value of the old aircraft, $2,500,000, is removed from the financial statements and is replaced with cash of $4,000,000 and a deferred gain of $1,500,000, which is reported as a liability. Gain deferral is required because the gain is exceeded by the $3,380,236 present value of the leaseback. The deferred gain will be amortized at the monthly rate of $20,833($1,500,000/72-month lease term) against rent expense over the 72-month term of the underlying operating leaseback. Each month, net rent expense of $38,041 ($58,874 –$20,833) will be reported.
Cash Flow Classification of Sale Proceeds
The financing nature of sale and leaseback transactions notwithstanding, there is no definitive guidance on the classification of sale proceeds, $4,000,000 in the last example, received from such transactions. There does appear to be consistent classification of sale proceeds received in a sale with a leaseback accounted for as a capital lease. When the leaseback is accounted for as a capital lease, a lease obligation is recorded on the balance sheet and the related proceeds are reported as a financing source of cash.
Generally accepted accounting principles do not state explicitly that proceeds received from sale and leaseback transactions are to be reported as cash provided from financing activities. The provisions of GAAP for sale and leaseback transactions only imply that the proceeds received should be reported as financing cash flow. For example, gain deferral and the use of the present value of the leaseback to determine the amount of any gain to defer are consistent with the view that the transaction is more of a financing event.
Certainly a sale with a leaseback of substantially all of the asset being sold is, in substance, a financing. The fact that the seller has given up ownership but not possession of the asset in question attests to the underlying financing nature of the transaction. Like a borrowing, the transaction has been used to generate funds and not to dispose of an asset.
In addition, sale and leaseback proceeds often are used to repay other outstanding borrowings. As noted, however, not all firms classify the proceeds from sales with operating leasebacks as financing events. Some use an investing classification.
Sale with Operating Leaseback Classified as Investing Cash Flow
Investing treatment of the proceeds from a sale and leaseback transaction is somewhat innocuous. After all, such treatment does not affect operating cash flow. However, treating such proceeds as investing cash flow does improve one important measure of financial performance, free cash flow.
Definitions of free cash flow do vary. A common definition is cash provided by operating activities less preferred dividends and capital expenditures. Here capital expenditures typically are calculated as net capital expenditures, that is, gross capital expenditures less proceeds from dispositions. Computing free cash flow using capital expenditures net of dispositions has intuitive appeal because gross capital expenditures generally include the replacement of assets disposed of. As a result, gross capital expenditures overstate incremental capital spending. However, if the proceeds from sale and leaseback transactions were included with asset dispositions in investing cash flow, net capital expenditures would be understated because gross capital expenditures do not include assets leased back after sale. Accordingly, free cash flow computed using capital expenditures net of assets sold and leased back would be overstated.
Sales with Minor Leasebacks
Generally accepted accounting principles permit recognition of the full gain resulting from a sale and leaseback transaction when the leaseback is considered to be a minor one. A minor leaseback is one in which the present value of the leaseback is less than 10 percent of the fair value of the asset sold. In effect, the asset has been sold because the seller has given up possession of virtually the entire asset.
Consider, for example, the sale of an office building owned and occupied by a bank. Assume that after the sale, the bank vacated the entire building except for the leaseback of a small amount of space to be used for a branch outlet. The bank has effectively sold the building and should be permitted to recognize the gain on sale. Importantly, such a transaction is more of an investing event than it is a financing event. In our view, it is appropriate here to report the proceeds from sale as part of investing activities. For analysts, the implication is that in computing net capital expenditures for purposes of determining free cash flow, such proceeds can reasonably be netted against gross capital expenditures.
A question arises as to the appropriate cash flow treatment for sale transactions that are accompanied with leasebacks that do not entail deferral of the entire gain on sale. For example:
- What if the present value of the leaseback were more than 10 percent of the fair value of the asset sold, indicating more than a minor leaseback?; also
- What if it were exceeded by the gain on sale?
For such a sale and leaseback transaction, GAAP would call for deferral of the gain equal to the present value of the leaseback. However, GAAP also would call for current recognition for any gain in excess of the present value amount. Thus, the transaction has elements of both an investing and a financing event. The natural question that arises is: How should the proceeds from sale be treated? One could always split the proceeds, allocating a portion to financing activities based on the percentage that the present value of the leaseback comprises of the total gain and allocating any remainder to investing activities. However, rather than getting that detailed in the calculations, our recommendation is simply to treat the proceeds from sale as financing cash flow and exclude it from any computations of free cash flow. Such a transaction entails a sufficiently significant leaseback that at least a portion of the gain on sale was deferred. Thus, the seller probably had financing in mind when the sale was made.