Lease Classification and Sale-and-Leaseback Accounting
On 1 January 20X5, Halcyon Logistics Ltd sells its warehouse to an investor for BDT 40,000,000, its fair value, and leases it back for 10 years. Annual lease payments of BDT 5,200,000 are payable in arrears. The interest rate implicit in the lease is 6%. The present value of the lease payments is BDT 38,270,000. The warehouse's carrying amount before the sale was BDT 28,000,000. The sale price equals fair value. Halcyon retains a right-of-use asset proportionate to the present value of the lease relative to fair value. The finance director proposes to recognise a gain on sale of BDT 12,000,000 (the full difference between fair value and carrying amount) and to treat the leaseback as an operating lease with no liability. The auditor has flagged the classification and the gain measurement.
1. Determine the appropriate accounting for the sale-and-leaseback and quantify the gain to recognise.
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Because the sale price equals fair value, the transaction is a genuine sale. Halcyon retains a right-of-use asset measured at the proportion of the previous carrying amount that relates to the retained right of use.
Retained proportion = PV of lease payments / fair value = BDT 38,270,000 / BDT 40,000,000 = 95.675%.
Right-of-use asset = BDT 28,000,000 x 95.675% = BDT 26,789,000 (approximately).
Gain recognised = total gain x proportion of rights transferred to the buyer. Total gain = BDT 40,000,000 - BDT 28,000,000 = BDT 12,000,000. Proportion transferred = 1 - 95.675% = 4.325%. Gain = BDT 12,000,000 x 4.325% = BDT 519,000 (approximately).
The FD's proposal to recognise the full BDT 12,000,000 gain is wrong because Halcyon has not transferred the whole asset; it retains substantially all of the risks and rewards through the 10-year leaseback. Only the portion of the gain relating to the rights transferred to the buyer is recognised.
2. Explain the lease liability and how the leaseback should be classified, and state the journal entries at inception.
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The leaseback gives Halcyon the right to use the warehouse for 10 years, which is the major part of its economic life, and the PV of payments is 95.7% of fair value. The leaseback is therefore a finance lease from the lessee's perspective, not an operating lease. Halcyon recognises a lease liability of BDT 38,270,000 and a right-of-use asset of BDT 26,789,000.
At inception the entries are:
Dr Cash BDT 40,000,000 Dr Right-of-use asset BDT 26,789,000 Cr Warehouse (carrying amount) BDT 28,000,000 Cr Lease liability BDT 38,270,000 Cr Gain on sale-and-leaseback BDT 519,000
The FD's treatment as an operating lease with no liability understates both assets and liabilities and overstates profit. The auditor should require the liability and the proportionate gain, and disclosure of the sale-and-leaseback terms.