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Sale and leaseback transactions

EXAMPLE 6-11

Failed sale and leaseback – buyer-lessor does not obtain control of the underlying asset prior to the
end of the leaseback term

A seller-lessee sells a building for $950,000 cash and agrees to lease the building back for five years.
Consider the following facts about this transaction:

□ The net carrying amount of the building as of the date of sale is $800,000

□ The annual leaseback payment is $100,000

□ Annual depreciation expense is $80,000

□ The seller-lessee does not guarantee the residual value of the asset at the end of the leaseback term

□ The seller-lessee has a repurchase option that allows it to buy the building at the then-prevailing
fair market value at any time during the lease term

□ The seller-lessee’s incremental borrowing rate is 9.3% and the interest rate implicit in the
leaseback is not known

□ The buyer-lessor does not obtain control of the underlying asset prior to the end of the leaseback
term

□ There are no alternative assets that are substantially the same and readily available in the
marketplace

How should the seller-lessee account for the sale and leaseback of the building?

Analysis

Because the seller-lessee has a repurchase option and there are no alternative assets that are
substantially the same and readily available in the marketplace, the transaction does not qualify for
sale accounting. It should be accounted for as a financing. The net carrying amount of the asset would
remain on the seller-lessee’s books and the seller-lessee would continue to record annual depreciation
expense of $80,000.

The cash proceeds received from the buyer-lessor would be recorded as a financial liability and the
annual lease payments allocated between interest expense and a reduction of the financial liability.
Interest expense should be calculated by multiplying the beginning balance of the financial liability by
the incremental borrowing rate of 9.3%. In year 1, the seller-lessee would record interest expense of
$88,350 ($950,000 × 9.3%). The reduction of the financial liability is calculated as the difference
between the annual leaseback payment and the allocation of interest expense ($100,000 payment –
interest expense of $88,350 = $11,650).

At the end of the fifth year, the leaseback and repurchase option expire and the buyer-lessor would
obtain control of the asset. At that time, the seller-lessee would recognize the sale of the asset and any
gain that resulted from removing the underlying asset and financial liability from its books.

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