BLOG SERIES: Sale and lease back as an alternative financing method and IFRS 16 implications
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 this type of deals.
Sale and leaseback definition
In the context of the shipping industry, a sale-and-leaseback is a transaction in which a shipping company (lessee) sells its vessel to another company (lessor) and immediately leases it back. There are various standardised contracts issued by various bodies to facilitate this process. Each contract is tailored to cover the specific needs of each client.
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. It allows shipping companies 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 this type of contracts.
IFRS 16 implications
Historically companies could structure a deal as an operating lease to have an asset and its associated liability off the balance sheet. However, with the adoption of IFRS 16 from 1 January 2019, all leases should be included on the statement of financial position and all companies that charter-in a vessel recognise 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 IFRS 16 may have a substantial impact on gearing ratios, profitability and operating cash flows which should be carefully considered to tackle the challenges of any covenant constraints.
Based on IFRS 16 guidance, 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 or the incremental borrowing rate of the company, if the implicit interest rate cannot be readily determined.
IFRS 16 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. If it meets the definition of a sale, the lessee will measure the right –of –use vessel arising at the retained portion of the previous carrying amount and any gains or losses limited to the amount relating to the rights transferred. If the transfer does not meet the definition of a sale, the lessee will continue to recognise the transferred vessel and will recognise a financial liability equal to the transfer proceeds by applying IFRS 9. What this actually means is that the seller-lessee has a re-purchase option on the underlying asset, then a sale has not occurred.