Don’t Let These Oddities in Lease Accounting Be the Odd Thing Out of Your Implementation Plan
Certain types of leases and contractual arrangements will be particularly hard to transition in the updates to lease accounting. Changes to Accounting Standard Codification (ASC) Topic 842 will affect both companies that have a lot of leases and companies that manage a lot of leases. Although private companies were recently granted an adoption date extension (subject to approval of the final written ballot by the FASB), they should be wary of the “oddities” in the leasing standard that could make their accounting standard implementation more complicated. Understanding a little bit more about the nuances to sale and leaseback accounting and build-to-suit arrangements in particular can help ensure your company has a successful (and timely) adoption.
Sale and Leaseback Arrangements
Sale and leaseback transactions are frequently seen with real estate. A sale and leaseback transaction involves the transfer of an asset by an entity (the seller-lessee) to another entity (the buyer-lessor) and the leaseback of that same asset by the seller-lessee for a contracted period of time.
These sale and leaseback arrangements may be less desirable for seller-lessees than in the past because the new standard requires them to recognize all leases except short-term leases on their balance sheet — meaning these transactions will no longer provide a source of off-balance-sheet financing. Unlike in legacy U.S. generally accepted accounting principles (U.S. GAAP), sale and leaseback accounting will be the same for real estate and equipment.
One of the reasons why sale and leaseback arrangements will be complicated in the new standard involves the changes to the revenue recognition standard under ASC Topic 606, Recognizing Revenue from Contracts with Customers. Seller-lessees will need to determine whether their arrangement qualifies as a sale transaction under the revenue recognition. That evaluation is not cut-and-dry. The existence of a leaseback in isolation, for example, does not preclude a sale. A sale is precluded if:
- The leaseback is classified as a finance lease under lessee accounting or a sales-type lease under lessor accounting; or
- The seller-lessee has a repurchase option unless the exercise price of the option is the fair value of the asset at the time the option is exercised and the lease asset is non-specialized (i.e., there are substantially similar assets readily available in the marketplace).
Seller-lessees that determine their sale and leaseback arrangement contains an operating lease will need to evaluate the revenue recognition standard to determine if a sale has occurred.
Accounting for Leaseback Arrangements
Seller-lessees will recognize gains and losses immediately on sales that meet the criteria for sale and leaseback accounting in their income statement. The leaseback will be accounted for in the same manner as any other lease. Any failed sale and leaseback transaction will be accounted for as a financing transaction, and the sale of the asset will not be recorded as a sale for accounting purposes.
Transitioning Sale & Leaseback Arrangements
When transitioning to the new lease accounting standard, lessee-sellers will need to consider their sale and leaseback arrangements. Leases that qualified for sale and leaseback accounting under current guidance are not reassessed to determine whether the transfer of the asset would have been a sale under the new standard. Organizations with a sale and capital leaseback will continue to recognize any deferred gain or loss. A sale and operating leaseback will recognize any deferred gain or loss into equity, the right-of-use asset, a financial liability, depending on the reason for the deferred gain or loss. Seller-lessees will then follow the leasing standard transition guidance for the leaseback arrangement. Organizations with failed sale and leaseback transactions will reassess whether a sale would have occurred under the new guidance.
In a typical build-to-suit arrangement, a real property developer builds out space according to a tenant’s specifications. These are sale and leaseback transactions, where a seller transfers the asset to and then leases it back from a buyer for a contracted period of time.
Accounting for Build-to-Suit Arrangements
ASC Topic 842 makes significant changes to current build-to-suit rules. A lessee will now recognize the entire construction project on its balance sheet during construction only if the lessee “controls” the asset during construction. After construction, the arrangement is evaluated under the sale and leaseback guidance.
If the lessee does not “control” the project during construction, any amounts paid by the lessee during construction will be treated as prepaid lease payments.
Transitioning Build-to-Suit Arrangements
Companies will derecognize the assets and liabilities related to the build-to-suit arrangement. If construction is completed before the date of application of the standard, the company will then follow the leasing standard transition guidance. If construction is not completed at the date of application, the company should evaluate the arrangement under the new standard’s build-to-suit guidance and follow the applicable accounting.
What to Do with Leasing Oddities
Companies, particularly lessees, that have sale and leaseback and build-to-suit arrangements should work with their accounting provider to ensure they are appropriately applying the new guidance to their arrangements. Several notable public companies, including Tesla, have reported significant changes with the new leasing standard for these types of leases.
For more information about your leasing standard transition, please contact us.