Sale and Leaseback under International Financial Reporting Standard 16

Overview of IFRS 16

IFRS 16 was introduced in January 2016 by International Accounting Standards Board (“IASB”) to provide a more transparent and consistent accounting treatment for leases. Unlike its predecessor IAS 17, IFRS 16 mandates that nearly all leases be recognised on the balance sheet, eliminating the distinction between operating and finance leases for lessees. Under IFRS 16, lessees recognise a right-of-use (“ROU”) asset and a lease liability for most leases, and lessors classify leases as either operating or finance leases, with distinct accounting treatments.

In the context of a sale and leaseback transaction, the challenge is to determine how the sale is recognised and how the leaseback arrangement is measured, particularly with respect to the lease liability and the right-of-use asset.

Key Issues in Sale and Leaseback

In a sale and leaseback arrangement, the primary accounting concerns include:

1. Criteria for Recognising a Sale

The first step in a sale and leaseback is determining whether a sale has occurred under IFRS 15. For a transaction to qualify as a sale, control of the underlying asset must have transferred from the seller to the buyer. If the transfer of control is not achieved, the transaction would be treated as a financing arrangement rather than a sale, meaning no gain is recognised, and the asset remains on the seller-lessee’s balance sheet.

2. Measurement of Lease Liability and ROU Asset

Once the transaction qualifies as a sale, the lessee needs to measure the lease liability at the present value of future lease payments. The ROU asset is then measured at the amount of the lease liability adjusted for any prepaid or accrued lease payments, any lease incentives received, or the value of the underlying asset sold.

3. Handling Variable Lease Payments

In many sale and leaseback transactions, the leaseback includes variable lease payments that depend on factors such as usage or performance. Under the recent amendments to IFRS 16, seller-lessees are required to account for these payments by using an estimate of the expected lease payments over the lease term, ensuring that the lease liability is measured accurately. This can result in changes to the recognised lease liability during the lease term.

Recent Amendments

In September 2022, the IASB issued amendments to IFRS 16 that provide clearer guidance on the accounting treatment of sale and leaseback transactions, particularly regarding the measurement of lease liabilities.

The key change is that seller-lessees in sale and leaseback transactions are prohibited from recognising a gain on the sale of the asset if the leaseback does not qualify as a finance lease. Instead, they must measure the lease liability based on the lease payments and adjust the ROU asset accordingly.

Under the amendments:

• The lease liability for a sale and leaseback transaction must be measured using the present value of the lease payments, including any variable lease payments that are not linked to an index or rate.
• The seller-lessee should ensure that no gain is recognised when the lease liability and right-of-use asset are measured. This avoids any accounting mismatch that might otherwise arise if the lease liability is measured based on a price higher than the fair value of the asset sold.

Practical Example

Let’s consider a practical example to demonstrate the accounting treatment of a sale and leaseback transaction.

Assumptions:

• A company sells an asset for $1,000,000 and immediately enters into a 10-year leaseback agreement with annual lease payments of $100,000, subject to variable payments based on the performance of the asset.
• The expected variable payments are estimated at $10,000 per year.

Accounting Treatment:

1. Sale Recognition: The company needs to determine whether control of the asset has transferred to the buyer. If it has, the transaction is considered a sale under IFRS 15.
2. Lease Liability and ROU Asset Measurement: The lease liability is calculated as the present value of the lease payments ($100,000 per year for 10 years) plus the expected variable lease payments ($10,000 per year). Using a discount rate of 5%, the present value of the lease liability is calculated at approximately $1,028,000. The ROU asset is then measured at the same amount as the lease liability, adjusted for any prepaid lease payments or other factors.
3. Subsequent Measurement: The company will continue to adjust the lease liability for any changes in the expected variable payments and will depreciate the right-of-use asset over the lease term.

Impact on Financial Statements

Sale and leaseback transactions under IFRS 16 impact several areas of the financial statements:

1. Balance Sheet:
   • The ROU asset and lease liability are both recognised on the balance sheet.
   • The gain on sale is deferred, with any potential gain recognised over the lease term based on the amortisation of the lease liability.
2. Income Statement:
   • Lease payments are recorded as lease expenses in the income statement.
   • Depreciation of the right-of-use asset and interest on the lease liability are recognized as part of the financial expenses.
3. Cash Flow Statement:
   • Lease payments will appear as part of financing activities in the cash flow statement, reflecting the financing nature of the transaction.
4. Key Financial Ratios:
   • Debt-to-equity ratio may increase due to the recognition of lease liabilities.
   • EBITDA could improve since operating lease expenses are replaced with interest and depreciation.

Conclusion

Sale and leaseback transactions under IFRS 16 present unique challenges, particularly in measuring the lease liability and ensuring proper recognition of gains. The recent amendments, effective from January 2024, provide clarity on the accounting treatment, especially concerning variable lease payments. Companies engaging in such transactions must ensure they understand the new rules and apply them correctly to maintain compliance and ensure accurate financial reporting.

By adhering to these guidelines, entities can avoid financial misstatements and maintain transparency in their reporting. If you’re considering a sale and leaseback transaction, consulting with an experienced accounting professional is crucial to navigate these complexities effectively.