Lease Classification and Sale-and-Leaseback Judgement
Harbour Logistics Ltd sells its warehouse to an investor for $5,000,000 (fair value $5,000,000) and immediately leases it back for 10 years. Annual payments are $420,000, payable in arrears. The warehouse's carrying amount before the sale is $3,200,000. The interest rate implicit in the lease is 6%. The present value of the 10 lease payments at 6% is approximately $3,090,000. Harbour retains the right to use the warehouse for 10 years, which represents substantially all of the warehouse's remaining economic life. The CFO argues that because the sale proceeds equal fair value, the entire $1,800,000 gain should be recognised immediately in profit or loss. Harbour's year-end is 31 December.
1. Assess whether the transaction qualifies as a sale under the revenue standard and determine the accounting for the right-of-use asset retained.
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Under the sale-and-leaseback guidance, Harbour must first determine whether the transfer qualifies as a sale under the revenue standard. Indicators that a sale has occurred include: the buyer obtains control of the warehouse, the leaseback terms are consistent with market terms, and the leaseback is not a financing arrangement. Here the sale is at fair value and the leaseback is a genuine 10-year lease, so a sale has occurred.
Because the seller retains a right of use, the transaction is accounted for as a partial sale:
- Harbour derecognises the warehouse at its carrying amount of $3,200,000.
- It recognises a right-of-use asset measured at the proportion of the previous carrying amount that relates to the retained right of use: $3,200,000 × ($3,090,000 / $5,000,000) = $1,977,600.
- It recognises a lease liability of $3,090,000 (PV of lease payments).
- The gain on the rights transferred to the buyer is recognised: total gain $1,800,000 × [(5,000,000 − 3,090,000)/5,000,000] = $1,800,000 × 0.382 = $687,600.
The CFO is wrong to recognise the full $1,800,000 gain: the portion relating to the retained right of use is deferred and recognised over the lease term through depreciation of the right-of-use asset.
2. Prepare the journal entries at inception and explain the subsequent measurement of the lease liability and right-of-use asset.
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At inception:
Dr Cash 5,000,000
Dr Right-of-use asset 1,977,600
Dr Accumulated depreciation (derecognise warehouse)
Cr Warehouse (carrying amount) 3,200,000
Cr Lease liability 3,090,000
Cr Gain on sale-and-leaseback 687,600
Subsequent measurement:
- The lease liability is measured at amortised cost using the 6% implicit rate. Year 1 interest = $3,090,000 × 6% = $185,400; payment $420,000 reduces the liability by $234,600 to $2,855,400.
- The right-of-use asset is depreciated over the 10-year lease term (or useful life if ownership transfers), i.e. $1,977,600 ÷ 10 = $197,760 per year. Depreciation and interest are recognised in profit or loss.
Harbour should disclose the sale-and-leaseback transaction, the gain recognised, and the maturity analysis of the lease liability.