4.3 Exceptions to Recognition, Measurement, and Designation or Classification of Assets or Liabilities

For indemnification assets recognized at fair value, no separate valuation allowance is recognized for concerns about collectibility before the adoption of ASU 2016-13. Entities should take into account collectibility concerns when measuring fair value since such concerns could result in a measurement of the indemnification asset that differs from that of the indemnified item. For indemnification assets measured at other than fair value, entities can establish a separate valuation allowance for collectibility concerns. Such an allowance would only affect presentation. We believe that after adoption of ASU 2016-13, if the indemnified item is a financial asset measured at amortized cost, the associated indemnification asset is within the scope of ASC 326-20 because ASC 805-20-25-27 requires indemnification assets to be “measured on the same basis as the indemnified item, subject to the need for a valuation allowance for uncollectible amounts.” See Deloitte’s Roadmap Current Expected Credit Losses for more information.

Acquisition agreements often include indemnification arrangements, but the parties to the business combination may instead establish such arrangements separately. In such cases, we believe that entities should consider analogizing to the factors in ASC 810-10-40-6 in determining whether to account for the acquisition agreement and the separate indemnification agreement as a single arrangement. Typically, we would expect that the application of those factors would lead an entity to conclude that the indemnification arrangement is part of the business combination agreement, in which case the acquirer would recognize, measure, and subsequently account for the indemnification assets by using the guidance in ASC 805.

When measuring an indemnification asset that was initially recognized as part of the accounting for a business combination, an entity should use assumptions that are consistent with those used to measure the indemnified item after the acquisition date, subject to any contractual limitations and considerations about the indemnifying party’s credit risk. If a change in the amount recognized for the indemnification asset is not the result of a qualifying measurement-period adjustment, the entity should recognize the change in earnings. An entity should use judgment in determining whether the changes to the indemnified item and the indemnification asset should be recognized in the same income statement line item so that they effectively offset one another.

If an indemnification asset only becomes recognizable after the measurement period for the indemnified item is closed, the recognition of the asset is subject to other GAAP rather than the guidance in ASC 805. In some cases, it may be appropriate to apply a loss recovery model to the recognition of the indemnification asset. The accounting framework underlying such a model is based on an analogy to the guidance on recognition of potential loss recoveries in ASC 410. Specifically, ASC 410-30-35-8, which provides subsequent measurement guidance related to environmental obligations, states, in part:

The recognition criteria for a loss recovery is different from that for a gain contingency. Provided that its collection is probable, a loss recovery is recognized in the period in which the loss is incurred (or the period in which collection becomes probable). However, a gain contingency is recognized on the earlier of when the gain is realized or is realizable. While not codified, paragraph 16 of EITF Issue 01-10 provides the EITF’s understanding of the distinction between a loss recovery and a gain contingency: a loss recovery represents the recovery of a loss already recognized in the financial statements, whereas a gain contingency represents the recovery of a loss not yet recognized in the financial statements or recovery of an amount that is greater than the loss recognized in the financial statements.

ASC 805-20-40-3 states that an acquirer only derecognizes an indemnification asset “when it collects the asset, sells it, or otherwise loses the right to it.” If there were no changes in the values of the recorded liability and associated indemnification asset after the acquisition date, both the asset and liability would be reversed upon derecognition, with no net effect on the income statement.

ASC 805 requires entities to perform two steps in determining whether an asset or liability arising from a contingency qualifies for recognition in a business combination. The first step is to evaluate whether the “fair value of the asset or liability arising from a contingency can be determined [at the acquisition date or] during the measurement period.” If so, the asset or liability is recognized as of its acquisition-date fair value as part of the accounting for the business combination.

Although ASC 805 does not provide specific guidance on whether the fair value of a contingency is determinable, it does state that “the acquisition-date fair value of a warranty obligation often can be determined.” However, in practice, the acquisition-date fair value of many contingencies, such as contingencies related to litigation, may not be determinable.

If an acquirer cannot determine the acquisition-date fair value of a contingency during the measurement period, it proceeds to the second step and recognizes the contingency at its estimated amount if (1) “it is probable that an asset existed or that a liability had been incurred at the acquisition date” and (2) “[t]he amount of the asset or liability can be reasonably estimated.” These requirements are similar to those in ASC 450 related to loss contingencies. However, in a business combination, both assets and liabilities arising from contingencies have the same recognition criteria, whereas under ASC 450 a gain contingency is not recognized until the earlier of when it is realized or it is realizable.

In some cases, an acquirer may not have identified the contingency either before or on the acquisition date. Although the contingency must have existed as of the acquisition date (i.e., it resulted from prior events), the acquirer is not limited to only recognizing items that were known at the time of acquisition. Contingencies identified during the measurement period that existed as of the acquisition date still qualify for recognition as part of the business combination accounting.

The fair value measurement of a contingent liability takes into account the time value of money. However, for contingent liabilities recognized at their estimated amounts, discounting is permitted, but not required, only if both the timing and amounts of future cash flows are fixed or reliably determinable on the basis of objective and verifiable information. Although ASC 410-30 specifically addresses environmental remediation liabilities, an entity may also find the guidance useful for evaluating whether discounting is appropriate for other contingencies arising from liabilities. ASC 410-30-35-12 states, in part, that the “measurement of the liability, or of a component of the liability, may be discounted to reflect the time value of money if the aggregate amount of the liability or component and the amount and timing of cash payments for the liability or component are fixed or reliably determinable.” However, because the timing and amounts of future cash flows of many contingencies are inherently subjective, it is often difficult for an entity to meet the criteria for discounting (e.g., in the early phases of litigation and environmental remediation efforts). In addition, if the timing and amounts of future cash flows are fixed or reliably determinable, the acquirer would likely be able to measure the contingency at fair value.

ASC 805 does not provide specific subsequent measurement guidance for contingencies recognized in a business combination, except to say that “[a]n acquirer shall develop a systematic and rational basis for subsequently measuring and accounting for assets and liabilities arising from contingencies depending on their nature.” The subsequent accounting depends on whether the contingency was measured at fair value or at its estimated amount.

For contingencies initially recognized at fair value, the acquirer must develop a “systematic and rational” subsequent measurement approach that is consistent with the nature of the asset or liability. In paragraph B20 of the Basis for Conclusions of FSP FAS 141(R)-1, the FASB suggested that the methods used to subsequently account for guarantees initially recognized at fair value under ASC 460-10 (formerly FASB Interpretation 45) could be applied to warranty obligations initially recognized at fair value. We believe that the guidance in ASC 460-10 for the subsequent accounting of guarantees would also be an acceptable approach to accounting for other contingencies recognized at fair value, not just warranty obligations. Another systematic and rational approach would be for entities to subsequently account for contingencies by applying the methods used for AROs under ASC 410. Entities should use judgment in assessing whether the subsequent accounting method they select is consistent with the nature of the asset or liability. Entities should also apply the same method to similar assets and liabilities.

However, we do not believe that the application of ASC 450 to contingencies recognized at fair value would be a systematic or rational approach. This is because it would not be appropriate for an entity to recognize a contingency at fair value on the acquisition date and then immediately recognize a gain or loss upon measuring the contingency at its estimated amount under ASC 450. In addition, subsequently measuring a contingency at fair value is not a systematic or rational approach unless fair value measurement is required by other GAAP.

For contingencies initially recognized in accordance with ASC 805-20-30-23 at the amount that can be reasonably estimated, acquirers should apply other GAAP, including ASC 450, in periods after the acquisition date. However, assets arising from contingencies should not be derecognized after the acquisition date because they do not meet the gain contingency recognition threshold in ASC 450.

Adjustments to the amounts recognized for a contingency should be accounted for as measurement-period adjustments (see Section 6.1) if they are (1) made within the measurement period and (2) based on the facts and circumstances that existed as of the acquisition date. If the adjustments resulted from facts or circumstances that did not exist as of the acquisition date, they should be recognized in the income statement. It can be particularly challenging for entities to determine whether adjustments to contingencies result from changes in facts or are related to facts that existed as of the acquisition date, especially in the case of litigation-related contingencies.

If a contingency does not qualify for recognition as part of the accounting for a business combination, the acquirer should recognize the asset or liability when it meets the recognition criteria in the applicable GAAP, such as ASC 450 for contingencies or ASC 410 for loss recoveries (see discussion in Section 4.3.4.2 for more information). Under ASC 450, gain contingencies are not recognized until the earlier of when they are realized or are realizable. Because an acquirer cannot adjust the acquisition accounting for the recognition of a contingency after the end of the measurement period, contingencies that qualify for recognition outside of the business combination accounting are recognized in the income statement. Also, contingencies for which the obligating event did not exist on the acquisition date, even those that arose before the end of the measurement period, do not qualify as measurement-period adjustments since they are not related to facts and circumstances that existed as of the acquisition date.

For more information, see Deloitte’s Roadmap Contingencies, Loss Recoveries, and Guarantees.

A reacquired right is an identifiable intangible asset that an acquirer recognizes separately from goodwill because it arises from contractual rights. However, reacquired rights are an exception to ASC 805’s measurement principle because ASC 805 requires entities to measure them on the basis of the related contract’s remaining term, regardless of whether market participants would consider potential contract renewals in determining the rights’ fair value. While market participants would generally reflect expected renewals of the term of a contractual right in their fair value estimate of a right traded in the market, the FASB has observed that an acquirer that controls a reacquired right could assume indefinite renewals of its contractual term, effectively making the reacquired right an indefinite-lived intangible asset. The Board has therefore concluded that a right reacquired from an acquiree is no longer a contract with a third party and, in substance, has a finite life. Accordingly, reacquired rights are measured only on the basis of the remaining contractual term.

However, complexities can arise when a contract has no stated term or is perpetual. In making reacquired rights an exception to the measurement principle, the FASB intended to limit the value attributed to a reacquired right by restricting the measurement to only the remaining contractual term. In this way, an acquirer could not assume that there would be unlimited renewals (since the reacquired right becomes a contract between the acquirer and itself as a result of the acquisition), classify the reacquired right as indefinite-lived, and measure it consistently with its classification. Accordingly, we would expect it to be unusual for a reacquired right to be classified as indefinite-lived. Before classifying a reacquired right as indefinite-lived and measuring it consistently with its classification, entities should consider consulting with experts, and SEC registrants should consider consulting with the SEC staff on a prefiling basis.

At the 2005 AICPA Conference on Current SEC and PCAOB Developments, then SEC OCA Professional Accounting Fellow Brian Roberson stated the following regarding the valuation of reacquired rights:

While a reacquired right is the result of a preexisting contractual relationship with the acquiree, not all preexisting relationships with an acquiree will result in the recognition of a reacquired right because not all preexisting relationships (e.g., a lawsuit) lead to the reacquisition of a right previously granted to the acquiree. If the terms of the preexisting contractual relationship giving rise to a reacquired right are favorable or unfavorable relative to the terms of current market transactions for the same or similar items, the acquirer must recognize a settlement gain or loss related to the preexisting contractual relationship separately from the accounting for the business combination. ASC 805-10-55-21 provides guidance on measuring that settlement gain or loss (see Section 6.2.2 for more information).

ASC 805-20-35-2 states that an entity amortizes a reacquired right “over the remaining contractual period of the contract in which the right was granted.” If an acquirer subsequently sells a reacquired right to a third party, the carrying amount of the intangible asset is included in the determination of the gain or loss on the sale. If the acquirer subsequently sells only a portion of the reacquired right to the third party, the acquirer will need to develop a reasonable allocation method for measuring the portion of the intangible asset’s carrying amount that it will include in determining the gain or loss on the sale. Such an allocation method would be necessary if, for example, an acquirer reacquires a franchise right to a specific geographic area and then subsequently subdivides that geographic area and sells only a portion of it to a third party.

Under ASC 805-20-30-15, when measuring the funded status of pension and other postretirement plans, an acquirer must exclude the effects of an entity’s planned but not executed amendments, terminations, and curtailments. Planned or expected amendments, terminations, and curtailments are not considered part of the liability assumed on the acquisition date. Such actions are recognized in the postcombination financial statements in accordance with ASC 715.

Upon an acquisition or a change in control, an acquirer may be obligated to modify an existing plan. The acquirer should assess the modification to determine whether it is part of the business combination or whether it should be accounted for outside of the business combination in accordance with ASC 805-10-55-18. If the modification is determined to be part of the business combination, the acquirer should include the effect of the modification on the existing plan in measuring the plan’s funded status.

The measurement of the projected benefit obligation for pensions or accumulated postretirement benefit obligation for other postretirement benefits and the fair value of the plan assets on the acquisition date should reflect any other necessary changes in discount rates or other assumptions that are based on the acquirer’s assessment of relevant future events.

In addition, ASC 805-20-55-51 addresses the accounting for contractual termination benefits and curtailment losses in an acquiree’s preacquisition financial statements. It states that “[t]he liability for the contractual termination benefits and the curtailment losses under employee benefit plans that will be triggered by the consummation of the business combination shall not be recognized when it is probable that the business combination will be consummated; rather it shall be recognized when the business combination is consummated.”

As indicated in ASC 842-10-55-11, an acquirer in a business combination should retain the acquiree’s classification of its leases unless “there is a lease modification and that modification is not accounted for as a separate contract.”

The ASC master glossary defines a lease modification as:

As part of a business combination, a lease might also be changed in ways that do not qualify as a lease modification. For example, a lease may be changed to reflect the new owner of the acquiree. Such a change in the name of one of the parties identified in the contract would not qualify as a lease modification without a change in the scope of or consideration for the lease.

If the terms of a lease are modified as part of a business combination such that there is a lease modification, the acquirer should use the guidance in ASC 842 to determine whether to account for that modification as a separate contract. ASC 842-10-25-8 states that a lease modification should be considered a separate contract (i.e., “separate from the original contract”) if both of the following conditions exist:

Therefore, a lease modification that meets the conditions in ASC 842-10-25-8 effectively results in two separate contracts: (1) the original unmodified contract and (2) a separate contract for the additional right of use. Accordingly, if the lease modification is considered a separate contract, the classification of the original lease is not reconsidered as part of the business combination and the additional right of use added in the lease modification is accounted for, and classified as, a separate “new” lease in accordance with ASC 842 when that lease commences.

However, if the modification does not meet the conditions to be accounted for as a separate contract, the acquirer reconsiders the classification of the lease on the basis of modified terms and conditions that exist as of the acquisition date (i.e., the effective date of the modification) in accordance with ASC 842-10-25-9 and ASC 842-10-25-11 through 25-18.

ROU assets and lease liabilities arising from an acquiree’s operating or finance leases are exceptions to ASC 805’s recognition and fair value measurement principles. Instead, ROU assets and lease liabilities are recognized and measured in accordance with ASC 842. However, an acquirer should recognize and measure at fair value certain lease-related intangible assets or liabilities previously recognized by the acquiree (e.g., in-place lease intangible assets).

For acquired operating or finance leases in which the acquiree is the lessee, the acquirer measures the lease liability and ROU asset in accordance with the principles in ASC 842, and thus their measurement is an exception to ASC 805’s fair value measurement principle. (The acquirer may elect, as an accounting policy, not to recognize assets or liabilities as of the acquisition date for leases that, on the acquisition date, have a remaining lease term of 12 months or less; see Section 4.3.11.4.) The FASB considered whether to require an acquirer to apply the general measurement principle in ASC 805 and measure the acquiree’s ROU assets and lease liabilities at fair value as of the acquisition date but decided against it, as described in paragraph BC416 of ASU 2016-02:

Accordingly, ASC 805-20-30-24 requires an acquirer to measure “the lease liability at the present value of the remaining lease payments, as if the acquired lease were a new lease of the acquirer at the acquisition date.” The remaining lease payments are those expected to be received over the balance of the lease term and should be determined in accordance with the guidance in ASC 842-10-30-5, except that the commencement date for an acquired lease is the acquisition date. Paragraph BC415 of ASU 2016-02 clarifies that “[m]easuring the acquired lease as if it were a new lease at the date of acquisition includes undertaking a reassessment of all of the following:

1. The lease term
2. Any lessee options to purchase the underlying asset
3. Lease payments (for example, amounts probable of being owed by the lessee under a residual value guarantee)
4. The discount rate for the lease.”

We believe that the lease term should be assessed from the acquirer’s perspective. The acquirer should take into account any renewal or purchase options it expects to exercise (see Section 4.3.11.8) and use the discount rate that is implicit in the lease, if readily determinable; otherwise, the acquirer should use its incremental borrowing rate. In a manner consistent with how an entity would determine the incremental borrowing rate for a new lease, the acquirer should evaluate whether the incremental borrowing rate at the parent level (i.e., acquirer level) or the subsidiary level (i.e., acquiree level) would be appropriate on the basis of the terms and conditions of the lease arrangement. Regardless of this determination, the incremental borrowing rate used should be the rate determined as of the acquisition date. However, the acquirer would not reassess the acquiree’s lease classification solely on the basis of differences between the acquirer’s and acquiree’s assessment of the lease term or likelihood of purchase option exercise by the lessee. In other words, the acquirer will retain the lease classification of the acquiree’s leases, regardless of whether the acquirer’s and acquiree’s conclusions differ regarding lease term or purchase options, as long as the acquisition does not result in a lease modification that is not accounted for as a separate contract. (See Chapter 7 of Deloitte’s Roadmap Leases for additional information about the determination of the discount rate and measurement of a new lease under ASC 842 and Section 8.3.5.1.2 of Deloitte’s Roadmap Leases for subsequent accounting considerations for an acquirer that is reasonably certain to exercise a purchase option in an acquired operating lease.

ASC 805-20-30-24 also requires the acquirer to measure the “right-of-use asset at the same amount as the lease liability as adjusted to reflect favorable or unfavorable terms of the lease when compared with market terms.” Accordingly, an acquirer would not recognize a separate intangible asset or liability if an acquired lease in which the acquiree is a lessee is favorable or unfavorable relative to market terms as of the acquisition date. Thus, the acquirer will first measure the ROU asset in accordance with ASC 842 and then adjust the ROU asset for any off-market terms in accordance with ASC 805.

 

Connecting the Dots

ASC 842-10-55-12 states, in part, that “[l]eases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease.” In addition, ASC 842-10-15-3A, which was added by ASU 2023-01, states, in part, that "as a practical expedient, an entity that is not a public business entity . . . may use the written terms and conditions of a related party arrangement between entities under common control to determine whether that arrangement is or contains a lease.” Therefore, under ASC 842, there are no circumstances in which entities would adjust the accounting for related-party leases for off-market terms or conditions. However, an ROU asset acquired in a business combination is adjusted for any off-market terms. We believe that even though it is not explicitly required to do so, an acquirer should, in a manner consistent with the measurement guidance in ASC 805 for all acquired ROU assets, adjust the carrying amount of an ROU asset acquired in a business combination for any off-market terms in a related-party lease. Otherwise, the off-market portion would be captured in goodwill (or possibly a bargain purchase gain) rather than through the amortization of the ROU asset.

In addition to the ROU asset and lease liability, when the acquiree is the lessee, an acquirer should recognize separately:

• Leasehold improvements owned by the acquiree (see Section 4.3.11.9).
• An intangible asset for the value associated with an in-place lease even if the lease is at market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.10).

The ASC master glossary defines a short-term lease as “[a] lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.” Lessees may elect an accounting policy (by class of underlying asset to which the right of use relates) to not recognize on the balance sheet lease liabilities or ROU assets of short-term leases (i.e., the “short-term lease exemption”). Rather, a lessee that makes this accounting policy election recognizes (1) fixed lease payments as an expense on a straight-line basis over the lease term and (2) variable lease payments that do not depend on an index or rate as an expense in the period in which achieving the specified target that triggers the variable lease payments becomes probable. See Deloitte’s Roadmap Leases for further discussion.

ASC 842 amended ASC 805 to allow a similar exemption for leases acquired in a business combination on the basis of a remaining lease term of 12 months or less on the acquisition date. ASC 805-20-25-28B states, in part:

ASC 805-20-25-28B clarifies that the recognition exemption, when elected, also applies to intangible assets or liabilities for favorable or unfavorable terms of acquired operating leases. We also believe that this exception may be applied to in-place lease intangible assets.

The lessor in an operating lease continues to report the assets subject to the lease on its balance sheet. In a business combination in which the acquiree is a lessor, the assets subject to the lease are recognized by the acquirer and measured at their acquisition-date fair values. The fair value measurement of the assets does not take into consideration the terms of the lease arrangement. That is, ASC 805-20-30-5 clarifies that “the fair value of the asset shall be the same regardless of whether it is subject to an operating lease.”

In addition to the asset subject to the lease, an acquirer may recognize the following separately when the acquiree is the lessor in an operating lease:

• An intangible asset or a liability if the terms of the lease are favorable or unfavorable compared with the market terms of leases of the same or similar items as of the acquisition date (see Section 4.3.11.7), including favorable or unfavorable renewal or termination options (see Section 4.3.11.8).
• Leasehold improvements owned by the acquiree (see Section 4.3.11.9).
• An intangible asset for the value associated with an in-place lease, including a lease that is at current market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.10).
• An intangible asset for the value of the existing customer relationship between the acquiree and its lessee (see Section 4.3.11.11).

ASC 805-20-30-25 requires that when the acquiree is a lessor in a sales-type or direct financing lease, the acquirer must recognize the net investment in the lease — measured as the sum of the present value of the lease receivable and the unguaranteed residual asset — which should approximate fair value. The ASC master glossary defines a lease receivable as “[a] lessor’s right to receive lease payments arising from a sales-type lease or a direct financing lease plus any amount that a lessor expects to derive from the underlying asset following the end of the lease term to the extent that it is guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis.” In the measurement of a lease receivable, it is assumed that the acquirer entered into the lease on the acquisition date under the terms in effect on that date. The measurement should include assessment of the lease term, any lessee options to purchase the underlying asset, lease payments, and the discount rate for the lease as described in paragraph BC415 of ASU 2016-02. See Deloitte’s Roadmap Leases for discussion about the measurement of a new lease under ASC 842.

The ASC master glossary defines an unguaranteed residual asset as “[t]he amount that a lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis.” Such an asset is measured as “the difference between the fair value of the underlying asset at the acquisition date and the carrying amount of the lease receivable, as determined in accordance with [ASC 805-20-30-25(a)], at that date.” Because the measurement of the acquisition-date fair value of the underlying asset takes into account the terms and conditions of the existing lease arrangement, including any favorable or unfavorable terms, the acquirer does not recognize a separate intangible asset or liability for such off-market terms.

As described in paragraph BC417 of ASU 2016-02, the Board considered requiring an acquirer to apply the general principle in ASC 805 and measure the acquiree’s lease receivable and unguaranteed residual asset at fair value as of the acquisition date but ultimately decided against such an approach:

The net investment in the lease is subsequently accounted for in accordance with ASC 842. See Deloitte’s Roadmap Leases for more information on the subsequent accounting for the net investment in a sales-type or direct financing lease.

In addition to the net investment in the lease, an acquirer may recognize the following separately when the acquiree is the lessor in a sales-type or direct financing lease:

• An intangible asset for the value associated with an in-place lease, including a lease that is at current market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.10).
• An intangible asset for the value of the existing customer relationship between the acquiree and its lessees (see Section 4.3.11.11).

 

Connecting the Dots

The above guidance on the recognition of favorable or unfavorable terms in a lease arrangement also applies to sublease transaction scenarios in which the lessee (i.e., intermediate lessor) is not relieved of its primary obligation under the head lease arrangement. For example, if the acquiree is the lessee in a sublease transaction, it would adjust the measurement of its ROU asset for any off-market terms as if it were the lessee in a normal lease arrangement. Likewise, if the acquirer is the intermediate lessor in a sublease transaction, it would account for the off-market terms as if it were the lessor in a normal lease arrangement. Thus, it would either recognize a separate intangible asset or liability or recognize an adjustment to the measurement of the underlying asset, depending on the classification of the sublease as either an operating lease or a sales-type or direct financing lease. See Deloitte’s Roadmap Leases for more information about sublease arrangements.

Acquired leasehold improvements that are owned by the acquiree are measured at their acquisition-date fair values. ASC 805-20-35-6 requires such improvements, once recognized, to be amortized over the shorter of the remaining lease term or the useful life of those assets, as determined by the acquirer, unless (1) “the lease transfers ownership of the underlying asset to the lessee” or (2) “the lessee is reasonably certain to exercise an option to purchase the underlying asset,” in which case the acquirer is required to amortize the leasehold improvements to the end of their useful life.

The existence of leasehold improvements owned by the acquiree can affect the acquirer’s determination of the lease term (and thus of the acquirer’s measurement of lease assets and lease liabilities). As discussed in Sections 4.3.11.3 and 4.3.11.6, the acquirer measures the acquired lease as if it were a new lease on the acquisition date, which includes undertaking a reassessment of the lease term (and other inputs). For example, if, as of the acquisition date, the acquiree/lessee has significant leasehold improvements, the acquirer may be likely to exercise a renewal option if failing to do so would result in the loss of those improvements with a remaining useful life.

For additional information about the accounting for leasehold improvements (including the importance of determining which party owns the improvements and the issuance of ASU 2023-01 related to the accounting for leasehold improvements in common-control arrangements), see Deloitte’s Roadmap Leases.

An in-place lease intangible asset represents the price that a market participant would be willing to pay for an at-market lease. The value associated with an in-place lease reflects, for example, the value associated with avoiding (1) the costs of originating an acquired lease (such as the costs to execute the lease, including marketing costs, sales or leasing commissions, and legal and other related costs) and (2) costs that would be incurred if an asset that was intended to be leased was acquired without a lessee.

An intangible asset for an in-place lease should be recognized separately in the financial statements and not combined with other lease-related assets or liabilities (e.g., not combined with lessee ROU assets, lessor net investments in leases, intangible assets for favorable lease terms, or liabilities for unfavorable lease terms).

The interrelationship of various types of intangible assets associated with the same lessee can pose challenges in the recognition and measurement of a customer-related intangible asset. The values assigned to other assets and liabilities — such as lease receivables, off-market contracts, and in-place lease intangible assets — may also affect the valuation of customer-related intangible assets.

When an entity enters into a lease, the terms of the lease are presumed to be at market even if the arrangement includes up-front or deferred payments (i.e., the total amount of the payments is presumed to reflect the market rate). However, if a lease with prepaid or deferred payments is acquired in a business combination, the remaining lease payments may be more or less than they would be for a new lease of the property with the same remaining term. As a result, the lease may be above or below market as of the acquisition date. See Section 4.3.11.7 for the accounting for off-market terms, which depend on whether the acquiree is the lessee or the lessor and the classification of the lease.

On the adoption date of ASC 842, leases that were previously classified as leveraged leases under ASC 840 are subject to the guidance in ASC 842-50, which is generally consistent with the accounting requirements for leveraged leases in ASC 840 and effectively carries forward that guidance. However, if a leveraged lease is modified after the entity adopts ASC 842, it is accounted for as a new lease in accordance with ASC 842 (i.e., classification is reassessed and leveraged lease accounting would no longer be available). Entities are not permitted to account for any new lease arrangements as leveraged leases after the adoption of ASC 842.

If a leveraged lease is acquired in a business combination after the adoption of ASC 842, the acquirer does not reassess the lease’s classification (unless it is modified on or after the date of acquisition) and must apply the recognition, measurement, presentation, and disclosure guidance for leveraged leases in ASC 842-50. If the acquired leveraged lease is modified as part of the business combination, it should be reclassified in accordance with the lease classification guidance in ASC 842. As discussed in Section 4.3.11.1, a modification is a change in the scope of or consideration for a lease. Changing the parties identified in a lease contract would not change the classification of a leveraged lease because such a change does not alter the scope of or consideration for the lease.

If the acquiree is a lessor in a leveraged lease that is not modified as part of the business combination, the acquirer measures the net investment on the basis of the remaining net future cash flows and gives appropriate recognition to the estimated future tax effects of such cash flows. The net investment is then broken down into its component parts (i.e., net rentals receivable, estimated residual value, and unearned income, including the discount to adjust the other components to present value), which are recognized as of the acquisition date. After the acquisition, the acquirer accounts for the investment in the leveraged lease in accordance with ASC 842-50.

Example 4 in ASC 842-50-55-27 through 55-33 illustrates the accounting for a leveraged lease acquired in a business combination. Also, see Deloitte’s Roadmap Leases for more information about the accounting for leveraged leases.

If the initial transfer of the asset is determined to be a sale in accordance with ASC 842-40 and ASC 606, the transaction is accounted for as a sale and leaseback under ASC 842-40. The seller/lessee derecognizes the underlying asset, recognizes any gain or loss on the sale, and accounts for the leaseback as it would any other operating lease. The buyer/lessor recognizes the underlying asset and accounts for the lease as it would any other operating or direct financing lease. If the seller/lessee or buyer/lessor in a sale-and-leaseback transaction is subsequently acquired in a business combination, the acquirer should account for the leaseback as described in Sections 4.3.11.1 through 4.3.11.14.

If the initial transfer does not meet the criteria to be a sale in accordance with ASC 842-40 and ASC 606 (i.e., it is a “failed” sale and leaseback), the seller/lessee and the buyer/lessor account for the transaction as a financing transaction. The seller/lessee continues to report the property on its balance sheet as if it were its owner and recognizes a financial liability (i.e., debt). The buyer/lessor does not recognize the property on its balance sheet and instead recognizes a financial asset (i.e., a loan receivable). If the seller/lessee or buyer/lessor in a failed sale-and-leaseback transaction is subsequently acquired in a business combination, the acquirer should not reassess the transaction. For example, the acquirer may continue to use the acquiree’s accounting for the failed sale-and-leaseback transaction until the transaction meets the requirements in ASC 842-40 and ASC 606 for the transfer to be accounted for as a sale. The assets and liabilities related to the arrangement should be measured at their acquisition-date fair values.

In addition, there may be situations in which a third party acquires an asset directly from the acquiree before or concurrently with the business combination and subsequently leases the asset back to the acquirer after the acquisition. In substance, such arrangements may represent sale-and-leaseback transactions if it is determined that the acquirer or future lessee controls the asset before or concurrently with the acquisition. See Chapter 10 of Deloitte’s Roadmap Leases for more information.

In addition, the acquirer should consider whether it has recognized any assets or liabilities related to the lease that should be derecognized as part of the effective settlement of the arrangement. The carrying amounts of the recognized assets or liabilities, if any, would adjust the amount of the gain or loss recognized for the settlement of the preexisting relationship, as illustrated in Example 3 in ASC 805-10- 55-33 (reproduced in Section 6.2.2.3).

ASC 805-20-25-8(b) requires an acquirer to carry forward the classification of an acquired contract as an insurance or a reinsurance contract (rather than a deposit) that the acquiree made at the inception of the contract on the basis of its terms and any related contracts or agreements. If the terms of those contracts or agreements were modified in a way that would change their classification, the acquirer determines the classification of the contract on the basis of its terms and other pertinent factors on the modification date, which may be the acquisition date. When assessing whether a contract qualifies as insurance or reinsurance, an entity must consider related contracts and arrangements because they can significantly affect the amount of risk transferred.

The assets and liabilities arising from the rights and obligations of insurance and reinsurance contracts acquired in a business combination are recognized on the acquisition date and measured at their acquisition-date fair values. That recognition and measurement might include a reinsurance recoverable, a liability to pay future contractual claims and claim expenses on the unexpired portions of the acquired contracts, and a liability to pay incurred contractual claims and claim expenses. However, those assets acquired and liabilities assumed would not include the acquiree’s insurance and reinsurance contract accounts, such as deferred acquisition costs and unearned premiums that do not represent future cash flows.

Although insurance and reinsurance contracts are measured at fair value, the FASB noted in paragraph B192 of Statement 141(R) that an acquirer should be able to subsequently report the acquired business on the same basis as its written business. However, rights and obligations related to insurance and reinsurance contracts are not measured at fair value under existing GAAP. Thus, in ASC 944-805, the Board provided specific measurement and recognition guidance that requires an acquirer to separate the fair value of the insurance and reinsurance contracts it acquires into (1) insurance and reinsurance GAAP accounting balances, in keeping with the acquirer’s accounting policies, and (2) an intangible asset (or, infrequently, another liability) for the difference between the fair value of the insurance and reinsurance contracts and the amount recognized in accordance with the acquirer’s existing accounting policies. As a result, the acquirer is permitted to subsequently report the acquired business on the same basis as its written business since the intangible asset is amortized separately. However, while the total value of an insurance contract represents its fair value, the elements of a contract do not (i.e., the rights and obligations related to insurance and reinsurance contracts are measured under existing GAAP, and the intangible asset (or liability) is calculated as a residual).

Other contracts that provide third-party contingent commissions are accounted for in the same manner as other contingencies, and contracts that provide guarantees of the adequacy of claims liabilities are accounted for as indemnifications.

ASC 805 refers to the subsequent measurement guidance for insurance contracts in ASC 944. Under that guidance, the insurance contract intangible asset (or liability) is measured on a basis consistent with the related insurance or reinsurance liability. Specifically, ASC 944-805-35-1 through 35-3 provide the following guidance:

As explained in paragraph BC35 of the ASU, the first expedient “provides relief for contracts that have been previously modified before the acquisition date” by allowing an acquirer to reflect the aggregate effect of all modifications as of the acquisition date. The second expedient provides “relief for situations in which the acquirer does not have the appropriate data or expertise to analyze the historical periods in which the contract was entered into” by allowing an acquirer to determine the stand-alone selling price as of the acquisition date. Under ASC 805-20-30-30, any practical expedients used by the acquirer should be applied (1) “on an acquisition-by-acquisition basis” and (2) “consistently to all contracts acquired in the same business combination.” Entities are also required to provide certain disclosures if they elect to use any of the practical expedients. See Section 7.3.6 for more information.

While we do not believe that the acquirer should recognize a separate asset for those up-front payments in its postcombination financial statements, we do believe that the up-front payments to customers could affect the value of another asset, such as a customer relationship intangible asset or an off-market component of a customer contract.