Download How the New Accounting Rules Affect Your Branch Real Estate

Whitepaper: How the New Accounting Rules Affect Your Branch Real
Estate (BRE)
Since 2002, the Financial Accounting Standards Board (FASB) has been working in concert with the International
Accounting Standards Board (IASB) on a convergence project designed to develop a more universal, understandable, and
transparent set of accounting standards. As a part of that project, FASB had been working to issue updated revenue
recognition and lease accounting standards. While both the revenue recognition and lease accounting standards have
wide-ranging applications far beyond the subject matter of this paper, properly utilizing these standards together should
allow banks a unique opportunity to generate value from the sale of their branch real estate in a way that was formerly
not possible.
Rather than requiring any gain from a sale to be deferred over the term of a leaseback, the updates now enable
immediate realization of gains from the same transaction. With immediate recognition comes the opportunity to move
such gains through the income statement and into the retained earning portion of the balance sheet, resulting in
common equity, tier-1 (CET1) capital (or core capital). As a bank’s CET1 capital ratio is the core measure of an
institution’s financial strength, the greater the level of CET1 capital, the greater the flexibility, strength, and command
an institution will have over its future.
On February 25th, the Boards finalized the new lease accounting standards, which go into effect in 2018 for most
companies. The new standards now require a lessee to record on its balance sheet both a lease liability and a right-ofuse (ROU) asset for any long-term lease obligations the company executes. This new balance sheet treatment of leases
has garnered significant attention, becoming a focal point of the new standards.
What has been significantly less discussed is how changes to the lease accounting rules apply to entities engaging in
sale-leaseback transactions. This memo, created for the edification of banks, will describe how depreciated branches,
when sold for a gain above the recorded book value in an operating sale-leaseback agreement, can directly enable the
establishment and recognition of newly generated CET1 capital.
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Sale-Leasebacks: Quick Summary
● For a transaction to be recognized as a sale, control of the property must fully transfer from seller
to the buyer (control meaning that the buyer takes on the risk and rewards of owning the property)
● For a sale, any gains generated will be recognized on the income statement and, assuming overall
profitability, can be passed on to the retained earnings portion of the balance sheet.
● Once recorded in the retained earnings portion of the balance sheet, such amounts can be
recognized as non-dilutive CET1 capital
● Depreciated assets are most likely to result in a gain during a sale
● Leases must be recorded as liabilities on the balance sheet
● An ROU asset equivalent to the lease liability must be recorded on the balance sheet
● The new standards go into effect for non-public, for-profit companies the fiscal year starting after
December 15th, 2019
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What did the old standards say?
Sale
Like the new standards, the old standards stated that in order for a transaction to be considered a sale, the seller-lessee
could not have continuing involvement in the property or monetary risk or rewards from ownership. The old standards
were also more rules-based than the new standards; a number of qualifiers needed to be met to successfully
consummate a sale.
Lease treatment
The old accounting standards allowed for off-balance sheet treatment of operating leases, which diminished the
transparency of an entity’s accounting.
Gain treatment: deferred gain
With the old standards, banks could not immediately recognize the full gain on sale related to a sale-leaseback
of their operational real estate. The old standards required a deferral of all gains (up to the present value of
required future lease payments for all leaseback arrangements) across the course of the lease term. Based on
these regulatory metrics, deferred gain treatment had served as a headwind to such transactions and a barrier
to the realization of CET1 capital for banks and financial institutions in the context of a sale-leaseback.
Sample transaction (old accounting regulations)
ABC BANK owns a branch that was purchased for $400,000 several years ago. The branch has a total book value of
$150,000 due to depreciation. Of the $150,000, there is $100,000 booked as land (at cost) and $50,000 booked as the
residual value of the building and structure. ABC Bank has also booked $250,000 in accumulated depreciation. Assuming
that the fair value of the branch in today’s market is $750,000, an embedded, off-balance sheet gain of $600,000 exists
within the branch (fair value minus the current book value). Assuming a 35% tax rate, $390,000 will pass to ABC Bank
after a sale is consummated within the context of an operating sale-leaseback, amortized over the course of the lease
term.
Assuming ABC Bank sells the branch and lease-backs the location under market level terms, the following may
apply:
● Term: 10 years
● Lease rate: $39,000 per year
● Structure: NNN
● Rent Increases: 0%
● Present value of future lease payments (at an 8% discount rate): +/- $262,000
Under the old standards, the maximum amount of gain that would be recognized immediately is limited to what
exceeds the present value of the future lease payments amortized over the course of the lease. In this case, +/$128,000 of gain would be recognized immediately because the present value of the lease ($262,000) is less
than the gain ($390,000). The $128,000 would be deferred and amortized on a straight-line basis for the
duration of the lease term, creating annual gain of +/- $12,800.
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What do the new standards say?
Sale
The new sales guidance no longer uses industry-specific guidelines. Now, the sales guidance is more streamlined and
philosophy-based. Transfer of control is one of the main new philosophical standards by which to determine if a sale is
has truly been consummated under the new accounting regulations. The guidance outlines certain indicators of the
transfer of control, such as transfer of legal title and the buyer taking on the significant risk and rewards of ownership. A
successful transfer of control means that the seller-lessee will have no “continuing involvement” in the property, which
means the seller-lessee will have no continued fiduciary risks nor rewards derived from the property.
Lease treatment
For operating lease accounting, a seller-lessee shall recognize an ROU asset and a lease liability, initially measured at the
present value of the lease payments, on the balance sheet. The seller-lessee shall also depreciate the single lease cost,
calculated as an average lease payment over the term of the lease, on a straight-line basis.
Gain treatment: immediate gain
Under the new revenue recognition standards, there is no requirement to defer recognition of a resulting gain. Only
differences resulting from “off-market lease/purchase terms,” continued involvement, or other violations of an
operating lease would be subject to deferral and amortization over the lifetime of the leaseback. The seller-lessee shall
recognize the transaction price for the sale at the point in time the buyer-lessor gains control of the asset.
Sample transaction (new accounting regulations)
ABC Bank owns a branch that was purchased for $400,000 several years ago. The branch has a total book value of
$150,000 due to depreciation. Of the $150,000, there is $100,000 booked as land (at cost) and $50,000 booked as the
residual value of the building and structure. ABC Bank has also booked $250,000 in accumulated depreciation. Assuming
that the fair value of the branch in today’s market is $750,000, an embedded, off-balance sheet gain of $600,000 exists
within the branch (fair value minus the current book value). Assuming a 35% tax rate, $390,000 will pass to ABC Bank
after a sale is consummated within the context of an operating sale-leaseback.
Assuming ABC Bank sells the branch and lease-backs the location under market level terms, the following may
apply:
● Term: 10 years
● Lease rate: $39,000 per year
● Structure: NNN
● Rent Increases: 0%
● Present value of future lease payments (at an 8% discount rate): +/- $262,000
After a 35% income tax, ABC Bank is able to recognize a book value gain of $390,000 [($750,000 - $150,000)*(1-.35)].
This dormant resource is unlocked as an income gain for that fiscal year, resulting in $390,000 in new non-dilutive, CET1
equity capital for ABC Bank. On the commencement of the lease date, ABC Bank records a +/- $274,000 ROU asset and
lease liability; this is equal to the total value of the lease ($39,000*10) discounted at a rate of 7% over the ten-year lease
term.
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Final note
Every real estate transaction is different, and different transactions may be consummated for different reasons (such as
increasing operational efficiency instead of generating CET1 capital). The accounting principles should be applied
accordingly.
Brookline Branch is a real estate development company that focuses on helping branches optimize branch networks,
modernize branch real estate, and improve efficiency ratios through a variety of real estate solutions, including saleleasebacks, downsizing branches, and multi-tenant buildouts. For more information, contact [email protected]
or visit our website at BrooklineBranch.com.
FAQ
When is a sale-leaseback recognized?
A sale is recognized when an entity legally transfers control and ownership of an asset for a fair value. That
determination will drive when revenue is recorded. The leaseback portion of a sale-leaseback is recognized on the start
date of the lease term.
Can a bank finance the buyer-lessor in a sale-leaseback?
Financing the sale-leaseback would, in many cases, be considered continuing involvement. For example, if the
seller-lessee provides non-recourse financing to the buyer-lessor for any portion of the sales proceeds or
provides recourse financing in which the only recourse is to the leased asset, the seller-lessee would have
continuing involvement with the property. In a real estate sale-leaseback transaction, if the seller-lessee has
continuing involvement with the property, the seller-lessee would be precluded from accounting for the
transaction as a sale and realizing upfront gains from the sale. Instead, the transaction would be accounted for
either as a financing transaction or by using the deposit method.
When do the new rules go into effect?
For public business entities, the new sale-leaseback standards are effective for fiscal years beginning after
December 15, 2018. For non-public bank entities, the changes are effective for fiscal years beginning after December 15,
2019, and interim periods within fiscal years beginning after December 15, 2020. Early application of the accounting
rules is permitted for all entities.
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