Sale-and-leaseback: the accounting lowdown

Central government last week decided to allow Northamptonshire County Council to use capital receipts from the sale of its headquarters to balance its revenue budget. Stephen Sheen investigates the accounting implications of sale-and-leaseback deals.

The recent news that communities secretary James Brokenshire is to give Northamptonshire County Council a capitalisation direction that will allow the proceeds of a sale-and-leaseback of its headquarters to support the revenue budget will be stirring excitement in finance departments across the country.

Could sale-and-leaseback be the next property craze for local government?

There will plenty of difficult decisions to be taken before a deal is concluded.

The purpose of this article is to show how just considering the financial implications requires a lot more than dreaming of big piles of cash.

There are two main types of sale-and-leaseback:

• Finance leaseback – one which effectively uses the property as security for a loan – the freehold is sold for cash, but the capacity of the property is leased back in its entirety. In substance, the authority is taken to have borrowed the “sale” proceeds, which it will repay via future lease rentals.  It will make no gain on the disposal of the freehold.
• Operating leaseback – one which liquidates surplus capacity in a property – perhaps you own a four-storey building but only need to occupy two storeys yourself; or the building currently has a 40 year economic life but the authority will not need to use it for more than the next 10 years. In this case, you could sell the freehold, lease back the capacity that you need, and take a gain for the capacity disposed of.

Finance leasebacks should be rare in local government, because they would require the purchaser to be able to offer an interest rate implicit in the lease rentals that would be more attractive than PWLB borrowing rates.

If a finance leaseback does not offer access to cheaper cash than an authority could otherwise get, there is no substantial point to it.

Operating leasebacks should be more common.

Once an authority is assured that a freehold building has surplus capacity, then it would be sensible to consider the options for disposing of that surplus.

Perhaps, looking to hold on to the freehold and rent the space out yourselves might be a more cautious plan, but conditions might be favourable for a remunerative sale.

However, all control over the surplus capacity needs to be given up in order to meet the criteria for this type of transaction.

One of the key considerations will be to see beyond the cash flows to determine the extent to which a sale-and-leaseback will increase the resources of an authority and bring spending power.

This a crucial issue, because the more simplistic approach for identifying capital receipts under the local government financing rules might tell a very different tale from the proper accounting practices that will identify the real substance of a transaction.

Proper accounting practices will particularly take into account the extent to which the original acquisition and subsequent capital expenditure on a property has been financed before identifying new spending power.

The accounting processes for the two types of lease will be:

Finance leaseback

• the property remains on the balance sheet;
• the receipt of cash is matched with a liability to repay the cash in the form of lease rentals;
• any additional resources will largely only come from the savings made from lease payments compared with the interest that would otherwise have been payable on money borrowed.

Operating leaseback

• the sale is accounted for by writing the property out of the balance sheet against the sale proceeds to give a gain/loss on disposal that is credited/debited against revenues;
• the first call on the sale proceeds is thus to cover the unfinanced cost of the property – resources are only increased by the surplus;
• lease rentals will be charged against revenues as they arise, resulting in additional resources if these are less than the costs of the property would have been for the year.

The accounting arrangements are due to change with the imminent implementation of IFRS 16, but the basic resourcing arithmetic will stay the same, with gains only being recognisable to the extent that the value of the capacity permanently disposed of exceeds the unfinanced cost of that capacity.

The difficulty with all this is that, in both cases, the receipt of cash may trigger recognition of a capital receipt for the full sale proceeds under section 9 of the Local Government Act 2003, causing pulses to quicken.

A capital receipt will be problematic in that its use will be restricted to incurring new capital expenditure, unless it can be used to fund revenue expenditure under the flexible use of capital receipts initiative.

Or a kindly secretary of state can be found who will feel bound by previous decisions to give a capitalisation direction.

A bigger conceptual problem is that the capital receipt might heavily overstate the new resources generated for an authority by the sale-and-leaseback.

This will obviously be the case for a financing leaseback, as no income will be recognised in the accounting process that could result in a credit to the capital receipts reserve.

A capital receipt could only be created by an accounting sleight of hand that would need to be reversed as soon as it is effected.

For an operating leaseback, it will be easier to work a credit into the capital receipts reserve.

But this does not mean that it would be prudent to plan how to spend the balance.

If there is capital financing outstanding on the property, then the capital receipt should prudently be applied to clear the outstanding amount.

Otherwise, revenues in future years will be debited with both an MRP charge for the original cost of the property and the price for renting the property back – a double burden that it would not be prudent to place on future council tax payers.

A cool head will therefore be required when the promise of oodles of cash is made to work out precisely how much the transaction will (or will not) add to the authority’s spending power, and plan to restrict new spending to that amount.

Basically, if you are going to start paying for the building again, you should make sure that you have finished paying for it the first time around.

In summary, sale-and-leaseback can be a fantastic idea if the conditions are right.

But the financial implications are more complicated than just counting the sale proceeds.

Stephen Sheen is the managing director of Ichabod’s Industries, a consultancy providing technical accounting support to local government

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