Educational Report: Sale-Leaseback Transactions (12/11/02)

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1 In an August 2001 educational report, CFRA discussed accounting for lease transactions. In this report we highlight sale-leaseback transactions and discuss how companies can utilize saleleaseback transactions to obtain cash financing without recording new debt or equity on the balance sheet. This educational report answers the following questions: What is a sale-leaseback transaction? Why should sale-leaseback transactions be viewed as financing arrangements? What is the difference between a capital lease and an operating lease? How does a sale-leaseback transaction affect a seller-lessee s financial statements? How can a seller-lessee use a sale-leaseback to generate a current gain? Why is there cause for concern if the buyer-lessor is a related party? What is a sale-leaseback transaction? A sale-leaseback transaction is an arrangement in which a company sells an asset to a buyer and then immediately leases the asset back from the buyer. A sale-leaseback arrangement is viewed as a single transaction in which the sale and leaseback are interdependent and negotiated together as a package. In these transactions, the company selling and leasing back the asset is often referred to as the seller-lessee, and the purchaser is often called the buyer-lessor. Sale-leaseback transactions are governed by SFAS 13, Accounting for Leases; as amended by SFAS 28, Accounting for Sales with Leasebacks; SFAS 66, Accounting for Sales of Real Estate; and SFAS 98, Accounting for Leases. This report primarily discusses the general rules surrounding sale-leasebacks related to traditional equipment (i.e. not real estate) in which substantially all of the rights of use are retained by the seller-lessee. Substantially all means that the present value of the minimum lease payments exceeds 90% of the fair value of the asset. Why should sale-leaseback transactions be viewed as financing arrangements? Companies often enter into sale-leaseback transactions in order to obtain cash financing. Many sale-leaseback transactions are essentially financing arrangements that enable the seller-lessee to borrow money without classifying it as debt on the balance sheet. To understand this logic, consider the following example which outlines the financial position of a seller-lessee before and after a sale-leaseback transaction in which the seller-lessee retains all rights to use of the asset., Rockville Pike, Suite 640, Rockville, MD, 20852; Phone: (301) ; ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the Company mentioned. 1

2 Assumptions: SellCo (seller-lessee) sells aircraft with a book value of $100 million to BuyCo (buyer-lessor) and immediately leases the aircraft back from BuyCo. BuyCo pays $100 million for the aircraft, and as such, no gain or loss is incurred by ABC. The lease agreement requires SellCo to pay BuyCo $20 million annually for six years. The aircraft has a useful life of six years. Discussion: Before the transaction, SellCo owns the aircraft and therefore has the right to use the aircraft over its useful life. After the transaction, SellCo still owns the aircraft (via capital lease) and still has the right for full use of the aircraft (in fact, SellCo never relinquishes possession). The only element of SellCo s financial status that changed as a result of the transaction is that SellCo received $100 million in cash and incurred an obligation to pay $120 million in cash over the life of the aircraft. Since the true substance of this transaction is the exchange of cash, not the sale of aircraft, it should be viewed as a financing arrangement. What is the difference between a capital lease and an operating lease? As illustrated below, accounting treatment is different for sale-leasebacks that involve a capital lease and sale-leasebacks that involve an operating lease. A capital (or salestype) lease, which is sometimes referred to as a disguised sale, transfers all the risks and rewards of ownership in the leased asset to the lessee. If the risks and rewards of ownership are not transferred, the lease is classified as an operating lease. A lessee accounts for a capital lease by recording the leased asset on its books and depreciating the asset over the life of the lease. Contrarily, in an operating lease, the leased asset is not recorded on the lessee s books. Rather, the lessee simply records rent expense in each period of the lease. For further details about capital leases and operating leases, please refer to the CFRA research report, Accounting for Leases, published on August 9, How does a sale-leaseback transaction affect a seller-lessee s financial statements? Sale-leaseback transactions have a profound effect on a seller-lessee s balance sheet, income statement and statement of cash flows. Since the sale-leaseback is a financing transaction, any gain or loss on the sale will be deferred and amortized into the income statement. Additionally, just like traditional debt financing, the sale-leaseback will result in increased cash flow in the current period and decreased cash flow in future periods. Sale-leasebacks involving capital leases (also called direct-financing leases) are recorded differently from sale-leasebacks involving operating leases. In a sale-leaseback with a capital lease, the leased asset remains on the seller-lessee s books (however it is now carried at the sale value), and the seller-lessee records depreciation expense and interest expense over the life of the lease. The seller-lessee also amortizes the deferred gain or loss as a part of depreciation expense in the same proportion that the leased asset is being depreciated. (See Table 1a for an example.) In a sale-leaseback with an operating lease, the leased asset is not carried on the seller-lessee s books, and the seller-lessee only records rent expense over the life of the lease. The deferred gain or loss is amortized as a part of rent expense in proportion with each year s rental payment. (See Table 1b for an example.) 2

3 Tables 1a and 1b show the journal entries surrounding a sample sale-leaseback transaction using the below assumptions. Table 1a assumes that the sale-leaseback transaction involves a capital lease, while Table 1b assumes that it involves an operating lease. Additionally, Tables 1c, 1d and 1e show how the balance sheet, income statement and statement of cash flows, respectively, are affected by a sale-leaseback transaction involving a capital lease and a sale-leaseback transaction involving an operating lease. Assumptions: SellCo (seller-lessee) sells aircraft with book value of $80 million to BuyCo (buyer-lessor) and immediately leases the aircraft back from BuyCo. BuyCo pays $100 million for the aircraft. The lease agreement requires SellCo to pay BuyCo back in equal annual installments over five years, at an interest rate of 10%. Table 1a: Journal Entries Surrounding a Sales-Leaseback Transaction Involving a Capital Lease At inception of the lease, SellCo records the following journal entries: Journal Entry to Record the Sale of the Aircraft: Dr. Cash 100 Cr. PP&E (Aircraft) 80 Cr. Deferred Gain 20 Journal Entry to Record the Leaseback: Dr. PP&E (Leased Property) 100 Cr. Lease Liability 100 One year from the inception of the lease, SellCo records the following journal entries: Journal Entry to Record Interest Expense for the Year ($100 x 10%) Dr. Interest Expense 10 Cr. Lease Liability 10 Journal Entry to Record Lease Payment in Year 1 (PMT: $100, 5 years, 10%, annual) Dr. Lease Liability 26 Cr. Cash 26 Journal Entry to Record Depreciation Expense, Assuming Straight-Line ($100 / 5 years) Dr. Depreciation Expense 20 Cr. Accumulated Depreciation 20 Journal Entry to Record Amortization of Deferred Gain ($20 / 5 years) Dr. Deferred Gain 4 Cr. Depreciation Expense 4 3

4 Table 1b: Journal Entries Surrounding a Sales-Leaseback Transaction Involving an Operating Lease At inception of the lease, SellCo records the following journal entries: Journal Entry to Record the Sale of the Aircraft: Dr. Cash 100 Cr. PP&E (Aircraft) 80 Cr. Deferred Gain 20 Journal Entry to Record the Leaseback: No journal entry because this is an operating lease. One year from the inception of the lease, SellCo records the following journal entries: Journal Entry to Record the First Lease Payment (PMT - $100, 5 years, 10%, annual) Dr. Rent Expense 26 Cr. Cash 26 Journal Entry to Record Amortization of Deferred Gain ($20 / 5 years) Dr. Deferred Gain 4 Cr. Rent Expense 4 Table 1c: Effect of the Transaction on the Balance Sheet, At Inception No (Capital) (Operating) Cash 100 Cash 100 PP&E 80 PP&E 100 Liabilities Lease Liability 100 Deferred Gain 20 Liabilities Deferred Gain 20 4

5 Table 1d: Effect of the Transaction on the Income Statement Over the Life of the Lease Year 1 Year 2 Year 3 Year 4 Year 5 Total Expense over Lease Life No (Capital) Interest Exp. 10 Interest Exp. 8 Interest Exp. 7 Interest Exp. 5 Interest Exp. 2 (Operating) (rounding) 110 Table 1e: Effect of the Transaction on the Statement of Cash Flows, At Inception and Annually No Sale- Leaseback (Capital) (Operating) Cash inflow at inception Annual cash outflow 0 (26) (26) How can a seller-lessee use a sale-leaseback to generate a current gain? The above commentary discusses sale-leasebacks in which substantially all of the rights of use are retained by the seller-lessee. If the sale-leaseback transaction is structured such that the seller-lessee does not retain substantially all of the rights of use, then a portion of the gain on sale may be recognized as current income rather than deferred over the life of the lease. Why is there cause for concern if the buyer-lessor is a related party? When evaluating the effect of a sale-leaseback transaction, analysts should review the relationship between the seller-lessee and the buyer-lessor. If the buyer-lessor is a related party, such as a special purpose entity (SPE), concern should be heightened surrounding corporate governance issues. A sale-leaseback transaction could be used as a vehicle through which a company funds itself with off-balance sheet debt that was borrowed by an unconsolidated SPE. 5

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