Sale and repurchase of a warehouse: has the asset really been sold?
On 1 October 20X5 Halden Co sold a warehouse to Kestrel Bank for $8.0m cash and on the same day signed a binding agreement to repurchase it on 30 September 20X8 for $9.2m. The warehouse's carrying amount was $6.0m, its fair value was independently assessed at $8.0m, and its remaining useful life is 20 years. Legal title has passed to Kestrel, but Kestrel cannot sell or pledge the building during the term, and any shortfall in the building's residual value at the repurchase date is borne by Halden. Halden continues to insure, maintain and occupy the property. The finance director has derecognised the building, recognised a $2.0m gain in profit or loss and presented the $8.0m received within operating cash flows. Halden's year end is 31 December and the draft statements are due for board sign-off next week.
1. Assess whether the finance director's treatment is acceptable. Support your answer with the Conceptual Framework and the derecognition criteria.
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Conclusion: the treatment is not acceptable. In substance this is a secured borrowing, not a sale.
Framework analysis
- An asset is a present economic resource controlled by the entity. Halden continues to control the future economic benefits of the building: it occupies and maintains it, and it bears residual value risk.
- The repurchase price is fixed at $9.2m regardless of the building's value at that date, so Kestrel's return is a lender's return ($1.2m over three years), not an equity owner's return.
- Halden retains substantially all risks and rewards of ownership (price risk, obsolescence, residual value); Kestrel has none of the upside or downside.
- Substance over form (IAS 1/Framework): legal title passing does not by itself justify derecognition. Derecognition requires the transfer of control of the economic resource.
Therefore: do not derecognise the building; recognise a financial liability of $8.0m at inception and accrue finance cost to $9.2m over the term; reverse the $2.0m 'gain'; and present the $8.0m as a financing inflow, not an operating inflow, in the statement of cash flows. Amounts are material to profit (a $2.0m gain on operating profit of that size is not trivial), so this is not a disclosure-only matter.
2. Prepare the correcting entries at 1 October 20X5 and at 31 December 20X5, and quantify the net effect on 20X5 profit and on net assets at 31 December 20X5.
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1 October 20X5 – reinstate the asset and recognise the liability
| Dr | Cr | $m |
|---|---|---|
| Property, plant and equipment | 6.0 | |
| Profit or loss (reversal of the $2.0m gain) | 2.0 | |
| Financial liability | 8.0 |
31 December 20X5 – accrue three months
Effective interest rate: 8.0 × (1 + r)³ = 9.2, so r ≈ 4.77% per annum. Finance cost for 3 months: 8.0 × ((1.0477)^0.25 − 1) ≈ $0.094m; liability at year end ≈ $8.094m.
| Dr | Cr | $m |
|---|---|---|
| Finance cost | 0.094 | |
| Financial liability | 0.094 | |
| Depreciation ($6.0m ÷ 20 × 3/12) | 0.075 | |
| Accumulated depreciation | 0.075 |
Net effect on 20X5
- Profit: −$2.000m (gain reversed) − $0.094m (finance cost) − $0.075m (depreciation) = down $2.169m.
- Net assets: PPE +$5.925m, liability −$8.094m = down $2.169m.
- Cash flows: reclassify $8.0m from operating to financing; no gain on disposal is reported.
Accept straight-line accrual of the $1.2m finance cost ($0.1m for three months) as an approximation only if the effective-interest basis is discussed and rejected.
3. The board asks whether the $1.2m difference between the sale proceeds and the repurchase price could instead be treated as a lease payment under IFRS 16. Explain briefly why that is not the right answer.
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A sale and leaseback under IFRS 16 requires a genuine sale to have occurred first; the seller-lessee must transfer control of the underlying asset to the buyer-lessor. Here there is no transfer of control, so IFRS 16 sale-and-leaseback accounting cannot be applied.
Equally, this is not a lease from Halden's side: Halden is not obtaining the right to use an asset owned by someone else in exchange for consideration - it already owns the economic resource and has simply used it as collateral.
Correct model: IFRS 9 financial liability at amortised cost, with the building retained at its $6.0m carrying amount and depreciated over its remaining 20-year life. The point being tested is that the label chosen by the parties ('sale', 'lease', 'rent') never determines the accounting; the rights and obligations do.