Sale and leaseback transactions and IFRS 16 implications
The shipping industry has experienced a very challenging decade with suppressed rates and ongoing impact of the 2008 financial crisis including the reform of the banking industry with the implementation of stricter risk management rules. The new Basel III rules have led a lot of the traditional shipping banks to restructure their corporate lending portfolios including shipping. In some cases the banks have decided to drastically reduce their exposure to the shipping industry due to a high perception of risk and concerns regarding its cyclical nature. This has resulted to a significant decrease in funds available for borrowing and has led shipping companies to seek alternative methods of financing for the acquisition of vessels such as sale and leaseback, issuing listed bonds and joint ventures with private equity funds.
In the past few years, we have witnessed an increasing number of sale and leaseback transactions between private and listed ship owning companies with Chinese banks. The Chinese banks have taken advantage of the gap that traditional banks have left and are acting as intermediaries between Chinese shipyards and international ship owners by facilitating these types of deals. But how do the sale and leaseback transactions work?
Sale and leaseback definition
In the context of the shipping industry, a sale-and-leaseback is a transaction in which a shipping company sells its vessel to another company and then leases it back. The shipping company that sells the vessel becomes the lessee, and the company that purchases the vessel becomes the lessor. In this type of transaction, the lessor is typically a leasing company, a private equity fund or an institutional investor.
The sale of the vessel is done with the understanding that the shipping company will immediately leaseback the asset from the buyer. There are various standardized contracts issued by various bodies to facilitate this process. The specific details of the lease agreement are tailored to the needs of each client and are usually arranged for a specific period of time between 7 and 10 years, a set time charter in rate and a purchase option at the end of the contract.
What are the benefits to ship owners from these types of transactions?
A sale and leaseback transaction allows companies to free up cash, improve liquidity and redeploy capital into core shipping activities by benefiting from the usage of the vessel. Since the sale-and-leaseback arrangement is an alternative to borrowing funds, there are shipping companies that choose this method of financing if the lease payments are lower than the interest payments they would have had to pay if they had borrowed money to finance the purchase of the asset. For most companies though, it allows them to operate their vessels in a market that they know quite well and, if market conditions improve to repurchase their vessel back at a lower price by using the purchase option embedded in the contracts.
Other benefits of transactions like these are that liquidity secured can be used to pay off other debts and give more flexibility to the company to tackle with the challenges from minimum liquidity loan covenants and other covenant constraints.
IFRS 16 implications
Historically companies could structure a deal to have an asset and its associated liability off the balance sheet. They structure a deal as an operating lease by viably shifting the ownership risk from the company to special purpose entities to minimize any legal and capital consequences. However with the adoption of IFRS 16 from January 1, 2019 all leases should be included on the statement of financial position and treated in the same way whether the deal was originally structured as an operating or a finance lease. This means that from January 1, 2019 all owners who have a sale and leaseback contract which now is classified as an operating lease will have to recognize their interest in the vessel as an asset in the statement of financial position and at the same time record a liability for the future lease payments under the charter.
The implementation of the new standard may have a substantial impact on gearing ratios of shipping companies that charter in a substantial number of vessels under an operating lease, as the new treatment will increase both gross assets and liabilities. Total debt will be higher and this may have an impact with loan covenants based on total debt levels as it may lead to breaches due to the upcoming accounting changes.
The changes could also impact profitability. Under the current treatment, costs are spread evenly over the period of the operating lease. Under the new standard, there are two elements determinant: 1) the depreciation of the vessel; and 2) the interest charge. The depreciation will be accounted for using the straight line method but the interest charge will be weighted towards the earlier part of the lease. Although the total lease charge will be the same over the charter period, it will be more front-loaded, with higher charges in the earlier years and lower charges in the later years.
The new standard will have a potentially positive effect on operating cash flows, since some of the cash flows currently shown as operating outflows will be categorized as financing outflows. This will largely depend on how the company accounted interest costs previously in the statement of cash flows.
Based on the new standard, all leases will broadly follow the old methodology used to determine the value of a finance lease. The value of the vessel and the relevant liability will be based on the present value of the lease payments discounted using the interest rate implicit in the lease, if that rate can be readily determined. If the rate cannot be readily determined, the lessees shall use their incremental borrowing rate.
The new standard also requires an entity to determine whether the transfer of a vessel is accounted for as a sale based on the satisfaction of IFRS 15 requirements on performance obligations. In the case the transfer meets the definition of a sale, the lessee will measure right –of –use vessel arising from the leaseback proportion of the previous carrying amount of the vessel that relates to the right of use retained by the lessee. Accordingly, the lessee will recognize only the amount of any gain or loss that relates to the vessel transferred to the lessor. In cases where the consideration for the sale of the vessel does not equal the fair value of the vessel or if the rate set is not the market rate, the seller-lessee shall account for any below market terms as a prepayment of lease payments and any above market terms shall be accounted for as additional financing provided by the lessor to the lessee.
In the case that the transfer of the vessel by the seller- lessee does not satisfy the requirements of IFRS 15 as a sale, the lessee will continue to recognize the transferred vessel and will recognize a financial liability equal to the transfer proceeds by applying IFRS 9. The opposite will apply for the lessor who will recognize a financial asset equal to the transfer proceeds by applying IFRS 9.