Chapter 4 — Recognizing and Measuring the Identifiable Assets Acquired and Liabilities Assumed

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.

Right-of-use (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 4.3.11.1.4.) 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 4.3.11.1.8) 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 4.3.11.1.9).
• 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 4.3.11.1.10).

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 4.3.11.1.7), including favorable or unfavorable renewal or termination options (see Section 4.3.11.1.8).
• Leasehold improvements owned by the acquiree (see Section 4.3.11.1.9).
• 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 4.3.11.1.10).
• An intangible asset for the value of the existing customer relationship between the acquiree and its lessee (see Section 4.3.11.1.11).

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 4.3.11.1.10).
• An intangible asset for the value of the existing customer relationship between the acquiree and its lessees (see Section 4.3.11.1.11).

 

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 4.3.11.1.3 and 4.3.11.1.6, 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 4.3.11.1.7 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 4.3.11.1.1, 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 4.3.11.1.1 through 4.3.11.1.14.

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).

As indicated in ASC 805-20-25-6, if a lease is modified as part of a business combination, the acquirer reconsiders the acquiree’s classification of the lease. Otherwise, the acquiree’s classification generally carries over to the acquirer. See Section 4.2 for more information.

If the terms of a lease are modified as part of the business combination and the lease qualifies as a new lease in accordance with ASC 840-10-35-4, the acquirer classifies the lease as of the acquisition date on the basis of the modified lease terms.

Alternatively, a lease might be changed as part of a business combination 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.

For acquired operating leases in which the acquiree is the lessee, ASC 840 and ASC 805 prohibit recognition of a separate asset for the right to use the underlying asset or a separate liability for the remaining minimum lease payments.

However, an acquirer may recognize other assets or liabilities, such as:

• Any leasehold improvements owned by the acquiree (see Section 4.3.11.2.7).
• An intangible asset or a liability if the terms of the lease (including renewal or purchase options) are favorable or unfavorable relative to current market terms for similar leases (see Section 4.3.11.2.8).
• An intangible asset for the value associated with an in-place lease, including a lease at current market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.2.9).

Before measuring a capital lease asset, the acquirer must determine whether it expects to obtain ownership of the leased property at the end of the lease term. It must consider all facts and circumstances, including the terms of the contract, whether it contains a bargain purchase option, and entity-specific factors. If the acquirer expects to obtain ownership of the property subject to the capital lease, it measures the lease asset at the fair value of the underlying property. If the acquirer does not expect to obtain ownership of the property subject to the capital lease, it measures the lease asset at the fair value of the leasehold interest, which is the fair value of the right to use the property until the end of the lease term.

The acquirer also recognizes a liability at fair value for the remaining minimum lease payments. The assumptions used in measuring the liability should be consistent with those used in measuring the asset (e.g., the same lease term should be used in measuring both the asset and the liability).

In addition, when the acquiree is the lessee in a capital lease, the acquirer may recognize other assets or liabilities, such as:

• Any leasehold improvements owned by the acquiree (see Section 4.3.11.2.7).
• An intangible asset for the value associated with an in-place lease, including a lease at current market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.2.9).

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 or conditions 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 property subject to the lease, an acquirer may recognize the following separately when the acquiree is the lessor in an operating lease:

• Any leasehold improvements owned by the acquiree (see Section 4.3.11.2.7).
• An intangible asset or a liability if the terms of the lease (including renewal or purchase options) are favorable or unfavorable relative to current market terms for similar leases (see Section 4.3.11.2.8).
• An intangible asset for the value associated with an in-place lease, including a lease at current market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.2.9).
• An intangible asset for the value of the existing customer relationship between the acquiree and its lessees (see Section 4.3.11.2.10).

In addition to the net investment in the lease, the 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 at current market terms if market participants would place value on an at-the-money contract (see Section 4.3.11.2.9).
• An intangible asset for the value of the existing customer relationship between the acquiree and its lessees (see Section 4.3.11.2.10).

Acquired leasehold improvements that are owned by the acquiree are measured at their acquisition-date fair values. ASC 805-20-35-6 requires that acquirers amortize leasehold improvements “over the shorter of the useful life of the assets or a term that includes required lease periods and renewals that are deemed to be reasonably assured.” Therefore, to determine the amortization period of leasehold improvements acquired in a business combination, acquirers must evaluate as of the acquisition date both the useful life of those improvements and the required lease periods and renewals that are deemed to be reasonably assured.

When determining the required lease periods and renewals that are deemed to be reasonably assured, entities should consider the definition of lease term in the ASC master glossary, which states that the term should include “[a]ll periods, if any, for which failure to renew the lease imposes a penalty on the lessee in such amount that a renewal appears, at lease inception, to be reasonably assured.” Acquirers should assess whether the renewal options are bargain renewal options or whether failure to renew would impose a significant penalty, and, on the basis of that assessment, use judgment to determine whether the renewal options are reasonably assured. If, as of the acquisition date, the acquiree has significant leasehold improvements, the acquirer may assume that it is reasonably assured that the acquiree will exercise its renewal options because the loss of the improvements that would result from the failure to renew the lease would impose a significant penalty.

One or more of an acquiree’s lease contracts may be favorable or unfavorable (i.e., off-market) as of the acquisition date relative to current market terms. ASC 805-20-25-12 applies to all operating leases regardless of whether the acquiree was the lessee or the lessor.

From the perspective of the acquirer, a favorable lease represents an asset, while an unfavorable lease represents a liability (balance sheet credit). Some lease contracts may result in the recognition of an intangible asset and others may result in the recognition of a liability. Entities should present intangible assets and liabilities separately on the balance sheet.

The acquirer must consider any renewal options or purchase options in the valuation of an intangible asset or liability as follows:

• If the acquiree is the lessee in an operating lease and the exercise of options is within the acquiree/lessee’s control:

  • Renewal or purchase options that are favorable to the acquiree/lessee are generally considered in the valuation of the intangible asset or liability.
  • Renewal or purchase options that are unfavorable to the acquiree/lessee are generally not considered in the valuation of the intangible asset or liability since the acquirer would not be expected to exercise an unfavorable option.
• If the acquiree is the lessor in an operating lease and the exercise of options is within the lessee’s control:

  • Renewal or purchase options that are unfavorable to the acquiree/lessor are generally considered in the valuation of the intangible asset or liability.
  • Renewal or purchase options that are favorable to the acquiree/lessor are generally not considered in the valuation of the intangible asset or liability since the lessee would not be expected to exercise an unfavorable option.

The value of an in-place lease represents the price that a market participant would be willing to pay for an at-market lease. An intangible asset for the value associated with an in-place lease may exist regardless of (1) the lease classification and (2) whether the acquiree is the lessor or the lessee.

A lease that is in place on the acquisition date may provide value to the lessee because it gives the lessee access to property that is unique or scarce and may permit future contract renewals or extensions.

An in-place lease may also provide value to the lessor by allowing it to avoid certain cash outflows to originate the lease (such as marketing, sales commissions, legal costs, and lease incentives) and lost cash flows during an otherwise required lease-up period. Accordingly, measurement of in-place lease intangible assets should reflect both of these benefits to the acquirer (net of service costs to tenants, such as security and maintenance).

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.

In a business combination, the acquirer does not recognize the acquiree’s deferred rent balance because it does not meet the definition of an asset or liability. The impact of any previously recognized asset or liability of the acquiree for deferred rent would be captured in the fair value measurement of an intangible asset or liability for favorable or unfavorable terms (see Section 4.3.11.2.8). After a business combination, the acquirer accounts for any acquired leases in accordance with ASC 840. Accordingly, the acquirer recognizes any deferred rent starting from the acquisition date in the postcombination period on the basis of the terms of the assumed lease.

If the initial transfer of the asset is determined to be a sale, the transaction is accounted for as a sale-leaseback under ASC 840-40. If the sale-leaseback does not meet the criteria for a sale (i.e., it is a “failed” sale-leaseback), the seller’s/lessee’s accounting for the transaction depends on the type of underlying asset. If the underlying asset is equipment, the seller/lessee accounts for the transaction as a financing transaction — that is, it continues to recognize the asset on its balance sheet as if it were its owner and recognizes a liability. If the underlying asset is real estate, the seller/lessee accounts for the transaction either as a financing transaction or by using the deposit method, depending on the facts and circumstances.

If the seller/lessee is subsequently acquired in a business combination, the acquirer should not reassess the transaction. For example, the acquirer should continue with the acquiree’s accounting for a failed sale-leaseback transaction until the transaction meets the requirements in ASC 840-40 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, 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).

An assembled workforce is an example of an intangible asset that is not identifiable and therefore not separately recognizable in a business combination. In paragraph B178 of the Basis for Conclusions of Statement 141(R), the FASB explains why an assembled workforce is not an identifiable intangible asset to be recognized separately from goodwill in a business combination:

By contrast, an assembled workforce meets the recognition criteria if it is acquired in an asset acquisition, as discussed in Section C.3.4.1.

The acquirer and the acquiree may also enter into noncompete agreements at the time of the business combination. There are differing views regarding whether such agreements should be accounted for as part of the business combination or whether they represent transactions that are separate from the acquisition (see Section 6.2). These differing views are discussed in paragraph BC19 of ASU 2014-18, which is based on a consensus of the PCC. It states, in part:

At the 2003 AICPA Conference on Current SEC Developments, then SEC OCA Professional Accounting Fellow Chad Kokenge stated the following in prepared remarks:

In addition, in a statement at the 2006 AICPA Conference on Current SEC and PCAOB Developments, then SEC OCA Professional Accounting Fellow Joseph Ucuzoglu also addressed the valuation of customer-relationship intangible assets in a business combination:

There is often an active market for customer information, referred to as customer lists, which an entity may receive regarding the acquiree’s customers. Such information is generally deemed to be separable if there are no terms of confidentiality or restrictions on selling, leasing, or otherwise exchanging it, even if the entity has no intention of doing so.

However, if the terms of confidentiality or restrictions on the sale or transfer of customer lists prohibit a company from selling, leasing, or otherwise exchanging a noncontractual customer list, the separability criterion would not be met and an intangible asset would not be recognized apart from goodwill. While most entities will possess some information about their customers, thereby establishing the presence of a customer-list intangible asset, the specific information possessed and the resulting value of this asset will vary.

An order or production backlog acquired in a business combination meets the contractual-legal criterion even if the purchase or sales orders are cancelable. However, the fact that a contract is cancelable may affect the fair value measurement of the associated intangible asset.

Customer relationships (both contractual and noncontractual) are recognized separately from goodwill only if they exist as of the acquisition date. If the acquiree routinely signs contracts with its customers (e.g., sales and purchase orders), the acquirer would recognize separate intangible assets for the following:

• Customer contracts that exist as of the acquisition date.
• Customer relationships that exist as of the acquisition date, regardless of whether a contract exists on that date.

Although ASC 805 does not define the term “contractual,” it indicates that both of the above items would satisfy the contractual-legal criterion. Therefore, the absence of enforceable rights by the parties to a particular arrangement does not preclude recognition. The SEC staff has historically agreed with this view.

In addition, while a noncontractual customer relationship may not be separable by itself, it may be separable along with another identifiable asset, liability, or contract — such as a sales representative’s contract or a brand, trademark, or product line — even if management has no intention of separating it. In that case, the customer relationship would meet the separability criterion. ASC 805-20-55-25 provides the following three criteria that may indicate that a relationship exists between an entity and its customer:

• The acquired entity maintains current customer information.
• The acquired entity contacts its customers regularly.
• Customers can directly contact the acquired entity.

ASC 805 nullified EITF Issue 02-17 but carried forward the EITF’s prior decisions about customer contracts and related customer relationships. Issue 02-17 offered the following illustration, which is still considered relevant under the guidance in ASC 805:

The following cases from ASC 805-20-55-53 through 55-57 illustrate the recognition of customer-contract and customer-relationship intangible assets acquired in a business combination:

Despite the absence of enforceable rights between the parties regarding future purchases or the fulfillment of accrued benefits, such loyalty program arrangements are deemed to meet the contractual-legal criterion because the parties have agreed to certain terms and conditions or had a previous contractual relationship, or both. Any liability accruals, or revenue deferrals, by the operator would also indicate that the arrangement is “contractual.” In addition to evaluating the recognition and measurement of an acquired customer-related intangible asset, an acquirer must separately evaluate the recognition and measurement of assumed liabilities related to the acquiree’s customer loyalty program as of the acquisition date.

In prepared remarks at the 2005 AICPA Conference on SEC and PCAOB Developments, then SEC OCA Professional Accounting Fellow Pamela Schlosser offered the following example, which discussed a scenario in which overlapping customers would provide value to the acquirer:

In the SEC staff’s view, an acquired customer relationship that overlaps an existing customer relationship has value because it gives the acquirer the ability to generate incremental cash flows; for example, an acquirer can sell new products to the customer or increase its “shelf space” with the customer. That value may also be reflected in the recognition of other intangible assets, such as trade names, that drive customer loyalty. The SEC staff also indicated that the most appropriate approach to valuing the intangible asset would generally be an income approach based on the benefits of incremental sales to those customers.

Another unit of account issue can occur if numerous customer-related intangible assets with different customers are acquired. In practice, customer-related intangible assets with different customers but with similar characteristics are frequently aggregated into pools for recognition and measurement. Entities must apply judgment in determining which characteristics make the customers similar.

Subsequent useful life determinations and methods of amortization might differ among pools. ASC 350-30 provides additional guidance on subsequently measuring and accounting for assets acquired in a business combination (see Section 4.10.5).

The ASC master glossary defines a servicing asset as “[a] contract to service financial assets under which the benefits of servicing are expected to more than adequately compensate the servicer for performing the servicing. A servicing contract is either: [(a)] [u]ndertaken in conjunction with selling or securitizing the financial assets being serviced [or (b)] [p]urchased or assumed separately.” Further, ASC 860-50-05-3 states that contracts to service financial assets may include the following:

Although servicing is inherent in all financial assets, it is not recognized as a separate intangible asset unless (1) the underlying financial assets (e.g., receivables) are sold or securitized and the servicing contract is retained by the seller or (2) the servicing contract is separately purchased or assumed.

Employment contracts, including collective bargaining agreements, meet the contractual-legal criterion for recognition apart from goodwill as intangible assets (or, in some circumstances, liabilities). When valuing an employment contract, an entity should consider whether there are any favorable or unfavorable contract elements and any inherent fair value related to the price that a market participant would pay for an at-market employment contract. In practice, little value is often attributed to at-market employment contracts because employees often give relatively short notice of their intention to leave their job and the employment contracts are often not enforced. In addition, while an employment contract may be perceived to be above or below market from the employer’s perspective (i.e., the pricing of the contract is favorable or unfavorable relative to market terms), an entity may find it challenging to measure such an asset or liability because of the difficulty of substantiating market compensation for specific employees. Therefore, it is unusual for an acquirer to recognize an asset or liability for an off-market employment contract. The value of an employment contract should be recognized separately from the value of a noncompete agreement (see Section 4.10.4.1.3).

Use rights are contract-based intangible assets. Certain use rights are tangible, rather than intangible, assets. An acquirer should account for use rights on the basis of their nature. For example, mineral rights, which are legal rights to explore, extract, and retain all or a portion of mineral deposits, are tangible assets (see Section 4.8.2).

ASC 805-20-55-40 states that “[c]omputer software and program formats acquired in a business combination that are protected legally, such as by patent or copyright, meet the contractual-legal criterion for identification as intangible assets.” However, even software and program formats not protected by patent or copyright may meet the separability criterion if they can be separated or divided from the acquiree (individually or combined with a related identifiable asset, liability, or contract) and sold, transferred, licensed, rented, or exchanged.

While a database acquired in a business combination that is protected by copyright would meet the contractual-legal criterion, databases that are not protected by copyright can be, and often are, exchanged, licensed, or leased to others in their entirety or in part. Such databases acquired in a business combination meet the separability criterion even if they do not arise from contractual rights unless there is a restriction on their transfer or exchange.

ASC 805-20-55-43 defines title plant as “[a] historical record of all matters affecting title to parcels of land in a particular geographical area.” The number of years covered by a title plant varies depending on regulatory requirements and the minimum information period considered necessary to issue title insurance policies efficiently. Because title plant assets are bought and sold (either in whole or in part) in exchange transactions or are licensed, they meet the separability criterion unless there is a restriction on their transfer or exchange.

Antipiracy laws or regulations frequently exist to protect trade secrets and other intellectual property. Even a trade secret that is not protected by laws or regulations would generally be recognized as an intangible asset apart from goodwill if the separability criterion was met, which is likely to be the case. However, the value of such a trade secret might be adversely affected by the lack of legal or regulatory protection.

The guidance on the subsequent accounting for defensive intangible assets was developed in EITF Issue 08-7, which was codified in ASC 350-30. In Issue 08-7, the EITF concluded that intangible assets that an acquirer intends to use as defensive assets are a unit of account that is separate from any of the acquirer’s existing assets. The EITF also indicated that an acquirer should assign a useful life to a defensive intangible asset that reflects the period over which the entity consumes the asset’s expected benefits — that is, the direct and indirect cash flows resulting from the entity’s preventing others from realizing any value from the asset (defensively or otherwise). An acquirer should determine a defensive intangible asset’s useful life by estimating the period over which the asset will diminish in value, which is a proxy for the period over which the acquirer expects a defensive intangible asset to contribute directly or indirectly to its future cash flows.

While that Issue did not preclude an acquirer from assigning an indefinite life to a defensive intangible asset, the EITF concluded that it would be rare for an acquirer to do so. The fair value of a defensive intangible asset is generally expected to diminish over time as a result of a lack of market exposure, investment, competitive, and other factors. In addition, the EITF indicated that if an acquired intangible asset meets the definition of a defensive intangible asset, it cannot be considered immediately abandoned and written off.