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Sale and leaseback transactions

Interest on the financial liability greater than the principal payments on the financial liability will
cause the carrying amount of the financial liability to increase rather than decrease (“negative
amortization”). This generally occurs when a seller-lessee’s incremental borrowing rate results in an
allocation of interest expense that exceeds the seller-lessee’s rental payments to the buyer-lessor.
When the use of a lessee’s incremental borrowing rate results in negative amortization of the financial
liability at the end of the amortization period (the shorter of the lease term or the term of the
financing), the seller-lessee should instead use an imputed interest rate that will eliminate the negative
amortization. See Example 6-12.

A projected net book value of the underlying asset that exceeds the carrying amount of the financial
liability at the earlier of (1) the end of the lease term or (2) the date the buyer-lessor obtains control of
the asset would have the effect of deferring a loss until that time. Similar to adjusting the interest rate
to ensure that negative amortization does not occur, a seller-lessee that determines a loss will result
from the application of its incremental borrowing rate should use the imputed interest rate. Generally,
the imputed interest rate should be the rate that would result in the net carrying value of the
underlying asset and the carrying amount of the financial liability being equal at the earlier of the end
of the lease term or the date the buyer-lessor obtains control of the asset. See ASC 842-40-55-31
through 55-38 for a detailed example of a failed sale and leaseback transaction requiring adjustment to
the seller-lessee’s incremental borrowing rate due to a projected built-in loss.

If a seller-lessee accounts for a sale and leaseback transaction as a financing arrangement because
there is a repurchase option, unless the purchase option price is fixed and exercise is determined to be
reasonably certain at lease commencement, the effective interest rate applied to the financial liability
will typically require adjustment when it becomes probable that the repurchase option will be
exercised. This is because the effective interest rate determined at lease commencement did not factor
in the price of the purchase option. Accordingly, the seller-lessee should adjust the effective interest
rate such that the carrying value of the financial liability upon exercise of the option is equivalent to
the exercise price of the purchase option. If the repurchase option price is not fixed, the seller-lessee
should estimate the exercise price and reflect any subsequent revisions as adjustments to the effective
interest rate.

The carrying amount of the asset should not be changed as a result of a financing transaction;
therefore, the asset should not be written up upon exercise of the repurchase option.

6.5.1.2 Accounting by a seller-lessee when the buyer-lessor obtains control of the asset after
lease commencement

A sale may occur at any point in time when the buyer-lessor obtains control of the asset during or at
the end of a leaseback period. When the sale is ultimately recognized in a previously failed sale and
leaseback transaction, the seller-lessee should recognize any remaining balance of the financial
liability as the proceeds on the final sale of the underlying asset. The gain or loss equals the difference
between those proceeds and the carrying amount of the underlying asset.

If the buyer-lessor obtains control of the underlying asset prior to the end of the leaseback period, the
date that control transfers to the buyer-lessor is the lease commencement date for purposes of the
seller-lessee initially classifying the lease and measuring the right-of-use asset and lease liability.

Example 6-11, Example 6-12, Example 6-13, and Example 6-14 illustrate the accounting by the seller-
lessee both when the buyer-lessor does and does not obtain control prior to the end of the leaseback
term.

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