Sale-leaseback costs and gain on exchange of assets.

ISSUE NO. 89-16

The EITF was asked to address how to consider executory costs in calculating the profit to be deferred in a sale-leaseback transaction.

A sale-leaseback transaction is a common financing tool that's been around for over two decades. It's been used primarily to infuse badly needed cash into a company and to reduce debt.

In a typical transaction, a company sells, then leases back all or part of its property such as its office building, warehouse or equipment. This perhaps allows it to uncover value hidden in the real estate itself or to increase earnings if monthly lease payments are less than financing costs. In many cases. the company's debt-to-equity ratio is improved.

Why is this issue so important? Most lease transactions provide for the payment by one of the parties of executory costs such as insurance, maintenance and taxes in connection with the leased property. In many cases, such costs aren't significant relative to the total cost of the lease and won't be material in the accounting. However, in a long-term lease of real estate, the FASB staff determined the executory costs could be as high as 30% of the lease's cost. Thus, the accounting for such costs could be a significant issue.

Relevant literature. FASB Statements nos. 13, Accounting for Leases, and 28, Accounting for Sales with Leasebacks, generally require any profit or loss in a sale-lease-back transaction to be deferred.

Statement no. 13 specifically excludes executor costs from the definition of minimum lease payments when determining how to classify a lease (that is, whether the lease should be recorded as a capital lease or as an operating lease). Accordingly, executory costs are excluded from the operating lease amount or the capital lease amount.

Statement no. 28, which amended Statement no. 13 for sale-leaseback accounting, does not address executory costs specifically. Regarding deferral of profit, Statement no. 28 says, for an operating lease, profit may be deferred up to the present value of the minimum lease payments. For a capital lease, profit may be deferred up to the recorded lease amount.

What are the alternatives? The EITF considered three approaches for how executory costs could affect the amount of profit to be recognized or deferred in a sale-leaseback deal.

Under the first approach, executory costs would be excluded in all cases. The second approach would include executory costs if they are included in minimum lease payments under Statement no. 13. The third approach includes executory costs in all circumstances.

Supporters of the first approach point to Statement no. 13, which specifically excludes such costs from minimum lease payments in recording a capital lease, and Statement no. 28, which defers profit recognition only to the extent of the capital lease amount. In their opinion, that Statement no. 28 doesn't discuss executory costs should not be viewed as a change in the rules of Statement no. 13. They therefore believe executory costs should be excluded from the deferred profit calculation.

Others disagree and support the second approach, which would include executory costs in certain cases. They believe those costs would be included in minimum lease payments even under Statement no. 13 unless the lessee has an obligation to pay those costs separately from or in addition to the rental payments. In their interpretation of Statement no. 13, if the lessee's payment includes an amount that is intended to cover the lessor's executory costs, then that payment would be deemed the minimum lease payment.

Those who support the third approach believe the obligation to pay executory costs is contractual and estimable and should be included in the deferred profit calculation.

Consensus: The EITF decided executory costs of the leaseback should be excluded from the calculation of profit to be deferred on a sale-leaseback transaction irrespective of who pays the executory costs or the classification of the leaseback.

An example of the application of the consensus on this issue is shown in the exhibit below.

ISSUE NO. 89-7

In the September 1989 Journal, this column reported a consensus that full gain recognition is inappropriate when an entity transfers ownership of an asset whose value exceeds its basis to a newly created entity in exchange for a minority interest in that entity. EITF members agreed that in some cases partial gain recognition is appropriate but they could not agree on how that gain should be determined.

At the subsequent meeting, the EITF reached a consensus on how that gain should be calculated. See the exhibit on page 91 for an illustration of that calculation.

The EITF emphasized the gain is recognized only if the entity has no actual or implied commitment, financial or otherwise, to support the operations of the new entity in any manner. Further, the investor's basis in the new entity should not be less than zero.

The SEC observer said any gain recognition is heavily dependent on a careful analysis of specific facts and circumstances. Gain recognition would not be appropriate if a significant uncertainty exists for realization or the entity has an actual or implied commitment to support the operations of the new entity in any manner (see, for example, SEC Staff Accounting Bulletin no. 81, Gain Recognition on the Sale of a Business or Operating Assets to a Highly Leveraged Entity).