Since the global financial crisis, ship financing has evolved significantly. The instability of the shipping markets has seen a number of shipping companies looking for ways to inject some cash into their business and finance their fleets. Traditionally, shipping companies relied on bank debt and equity financing, but there is a growing trend towards sale-and-leaseback arrangements, especially following the COVID-19 pandemic’s impact on the sector. In these arrangements, a ship-owning company sells a vessel to another entity and leases it back, becoming a lessee while the buyer acts as the lessor. Transactions may include a purchase option for the lessee to repurchase the vessel at lease end.
Benefits
Sale-and-leaseback arrangements benefit both lessors and lessees. The lessee, or original ship owner, can raise cash and improve liquidity by selling their ships, using the funds for investments or operating expenses. These arrangements help shipping companies acquire new builds or second-hand vessels without increasing debt or diluting equity. For lessors, ownership of the asset provides increased security. In case of default, lessors can quickly terminate the lease and reclaim the vessel, avoiding the lengthy process of enforcing a mortgage.
Drawbacks
Although the arrangement offers prompt capital and can enhance short-term liquidity, it also presents disadvantages. These drawbacks may encompass the loss of asset ownership including strategic control, as well as long-term financial obligations, all of which should be carefully evaluated when determining the most suitable financing options for your company.
Common accounting issues
Sale and leaseback arrangement present several accounting challenges which are often incorrectly accounted for. These being:
1. Determining Whether a Sale Has Occurred
One of the first steps management need to determine is whether the transaction is genuinely a sale with a leaseback, or a financing arrangement. If the risks and rewards of ownership are not substantially transferred to the buyer, it may not qualify as a sale. FRS 102 follows the principle of substance over form. Some sale and leaseback arrangements are structured in legal form to show a sale, but the substance indicates continuing control and use, especially with options to repurchase or with lease terms that span the asset’s useful life.
2. Recognition of Profit or Loss on Sale
If the transaction does qualify as a sale, the seller should recognise a gain or loss on disposal of the asset.
When the sale price is not at fair value, FRS 102 requires adjusting the gain or loss. Common issues usually involve management misjudging the fair value or failing to defer inappropriate amounts can misstate profits.
3. Lease Classification
On the leaseback arrangement, management need to determine whether the lease is classified as either operating or finance leases based on whether risks and rewards of ownership are transferred. If the leaseback is a finance lease, then effectively, there is no sale from an accounting perspective. It’s often that management apply the incorrect judgment in the lease classification which can have a significant impact on the financial statements.
Upcoming changes to UK GAAP
The FRC has issued amendments to UK GAAP. There is a new model of lease accounting, based upon IFRS 16’s on balance sheet model. For lessees, this removes the differentiation between finance and operating leases and creates a right- of-use asset on the balance sheet with a corresponding liability, meaning most lessees with operating leases will be impacted. The right-of-use fixed asset will be subject to depreciation and interest based on the liability will be charged to profit and loss, affecting the presentation of financial information.
This change would apply only to entities reporting under FRS 102 and small companies reporting under FRS 102 1A. Micro entities reporting under FRS 105 are not required to adopt this model.
Here is access to our latest technical recording on the upcoming FRED82 changes.
How can we help?
At Menzies LLP we have a depth of knowledge and wide-ranging experts who can provide guidance on the debt financing and how this will affect your business and the accounting treatments surrounding these.
Here’s how we can help with sales and leaseback arrangements:
- Feasibility Analysis and Strategic Advice
- We can assist in evaluating the financial implications of doing a sale and leaseback versus other financing options
- Advise whether the transaction will improve cash flow, debt ratios, or return on assets.
- Accounting Treatment and Structuring
- Review the contract and assess whether the transaction qualifies as a genuine sale under the applicable accounting framework
- Advise on how to structure the deal to achieve desired accounting outcomes
- Give guidance to ensure the transaction is structured to meet accounting standards and minimise adverse impacts on financial statements.
- Tax Advice
- Evaluate capital gains tax, VAT, and corporation tax implications.
- Consider tax-efficient structuring of sale and lease payments.
- Address any differences between tax treatment and accounting treatment of the transaction.
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