Lease Classification and Sale-and-Leaseback Judgement
Meridian sells a warehouse to a bank for BDT 50m cash and leases it back for 15 years. The warehouse's fair value is BDT 50m and its carrying amount is BDT 38m. Annual lease payments are BDT 5.2m, payable in arrears; the incremental borrowing rate is 9%. The present value of the 15 payments at 9% is approximately BDT 41.9m. The lease transfers no ownership and contains no purchase option, but the lease term is 15 years against an estimated economic life of 20 years. Meridian's directors argue the transaction is a financing because 'we still occupy the building', and propose recognising a BDT 12m gain immediately.
1. Determine whether the sale-and-leaseback qualifies as a sale under the applicable standard and quantify the right-of-use asset and liability.
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Step 1 – Does a sale occur? A sale-and-leaseback is accounted for as a sale only if the transfer satisfies the revenue recognition criteria (control passes to the buyer-lessor). Here the bank obtains legal title and pays fair value; Meridian retains use through the leaseback. The leaseback is a lease, not a retention of control that defeats sale, provided the leaseback is not a finance lease that effectively returns substantially all risks and rewards. The 15-year term is 75% of the 20-year life, and the PV of BDT 41.9m is 84% of fair value – indicators pointing to a finance lease. If the leaseback is a finance lease, the transfer does not qualify as a sale; it is a financing. On these facts, the 75% and 84% tests strongly suggest finance lease, so no sale and no gain.
Step 2 – If treated as financing. Recognise a financial liability of BDT 50m and keep the asset at BDT 38m (no gain). Interest at 9% on the outstanding balance; payments of BDT 5.2m split between interest and capital.
Step 3 – If a sale were established. Recognise a right-of-use asset at the proportion of previous carrying amount relating to the retained right: 38 × (41.9/50) = BDT 31.8m; recognise a lease liability of BDT 41.9m; and recognise gain only on the rights transferred: (50 – 38) × (1 – 41.9/50) = 12 × 0.162 = BDT 1.94m.
The directors' BDT 12m immediate gain is wrong under either route: under the financing route there is no gain at all; under the sale route the gain is only about BDT 1.94m.
2. Explain the judgements the auditor should challenge and the disclosure implications.
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Judgements to challenge: (1) Whether control transferred – examine the leaseback terms, any repurchase options, residual value guarantees, and whether the bank retains substantive decision-making. (2) Lease classification of the leaseback – the 75% term test and 84% PV test are close to the finance-lease thresholds; small changes in the discount rate or term flip the classification. (3) Fair value of the property – an independent valuation is needed; if the sale price is not at fair value, adjust to fair value and treat any excess as additional financing. (4) The discount rate – 9% IBR must reflect the lessee's incremental borrowing rate.
Disclosure: nature of the transaction, the fact that it is a sale or financing, the gain recognised and its calculation, the lease liability maturity analysis, variable payments, and significant judgements. If classified as financing, disclose the secured borrowing and the pledged asset. The exam point: sale-and-leaseback gain is limited to rights transferred, never the full gain, and a finance-leaseback collapses the transaction into a secured loan.