8.4 Recognition and Measurement

ASC 842 introduces a lessee model under which all leases except those subject to the short-term lease exemption are recognized on the balance sheet.

This section addresses phases 1 through 4 of the lease “life cycle.” That is, it provides an overview of the guidance that a lessee would evaluate when determining (1) the lease inception and commencement dates, (2) how to initially recognize and measure a lease, (3) how to subsequently measure a lease, and (4) how to account for the impairment of an ROU asset (when applicable).

8.4.1 Lease Inception and Lease Commencement

8.4.1.1 Lease Inception

Lease inception is the date on which the terms of the contract are agreed to and the agreement creates enforceable rights and obligations. At lease inception, an entity must evaluate whether a contract is or contains a lease. See Chapter 3 for additional information on identifying a lease.

8.4.1.2 Lease Commencement Date

ASC 842-10

55-19 In some lease arrangements, the lessor may make the underlying asset available for use by the lessee (for example, the lessee may take possession of or be given control over the use of the underlying asset) before it begins operations or makes lease payments under the terms of the lease. During this period, the lessee has the right to use the underlying asset and does so for the purpose of constructing a lessee asset (for example, leasehold improvements).

55-20 The contract may require the lessee to make lease payments only after construction is completed and the lessee begins operations. Alternatively, some contracts require the lessee to make lease payments when it takes possession of or is given control over the use of the underlying asset. The timing of when lease payments begin under the contract does not affect the commencement date of the lease.

55-21 Lease costs (or income) associated with building and ground leases incurred (earned) during and after a construction period are for the right to use the underlying asset during and after construction of a lessee asset. There is no distinction between the right to use an underlying asset during a construction period and the right to use that asset after the construction period. Therefore, lease costs (or income) associated with ground or building leases that are incurred (earned) during a construction period should be recognized by the lessee (or lessor) in accordance with the guidance in Subtopics 842-20 and 842-30, respectively. That guidance does not address whether a lessee that accounts for the sale or rental of real estate projects under Topic 970 should capitalize rental costs associated with ground and building leases.

The ASC master glossary defines the commencement date of the lease as the “date on which a lessor makes an underlying asset available for use by a lessee.” Although a contract may explicitly define a date that meets the legal definition of the “lease commencement date” with respect to identifying when rent will need to be paid, that date may not necessarily meet the accounting definition of the commencement date of the lease. This is because, from an accounting perspective, the lease commencement date is linked to when the underlying asset is made available for use by the lessee and this date may sometimes differ from the explicit contract commencement date and is not always aligned with the date on which payment commences.

Example 8-9

Determining the Lease Commencement Date

Retailer enters into an arrangement to lease retail space from Landlord for a period of 10 years. According to the legal contract terms, the commencement date of the lease will be June 30, 20X2. At that point, Retailer is expected to commence its retail operations and will begin making the contractually required lease payments. Landlord has agreed to give Retailer access to the property starting on March 1, 20X2, so that Retailer can make the necessary leasehold improvements to the space before commencing commercial operations.

In this scenario, although the contract explicitly defines the legal lease commencement as June 30, 20X2, the lease commencement date for accounting purposes would be March 1, 20X2, since Landlord has made the underlying asset available for Retailer’s use as of that date.

Connecting the Dots

Recognition and Disclosure Requirements Before Lease Commencement

Although there is no recognition or measurement of leases before lease commencement, ASC 842-20-50-3(b) requires the disclosure of “[i]nformation about leases that have not yet commenced but that create significant rights and obligations for the lessee.” See Section 15.2.2 for more information.

In addition, as indicated in paragraph BC182 of ASU 2016-02, “if the costs of meeting an obligation under the lease exceed the economic benefits expected from the lease, an entity should consider the guidance in Topic 450 on contingencies.” As a result, the lessee may be required to recognize a liability after lease inception but before the lease commencement date.

Changing Lanes

Initial Measurement of a Lease

A lease is initially recognized at lease commencement under ASC 840 and ASC 842. However, the inputs used to initially measure the lease under ASC 840 and ASC 842 are determined at different times. For example, under ASC 840, inputs such as discount rate and fair value, as well as the lease classification itself, were determined at lease inception; however, under ASC 842, the inputs and lease classification are determined at lease commencement. As a result, there could be differences between the initial recognition of a lease under ASC 842 and that under ASC 840.

8.4.2 Initial Recognition and Measurement of the Lease

ASC 842-20

25-1 At the commencement date, a lessee shall recognize a right-of-use asset and a lease liability.

30-1 At the commencement date, a lessee shall measure both of the following:

The lease liability at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement (as described in paragraphs 842-20-30-2 through 30-4)
The right-of-use asset as described in paragraph 842-20-30-5.

30-2 The discount rate for the lease initially used to determine the present value of the lease payments for a lessee is calculated on the basis of information available at the commencement date.

30-3 A lessee should use the rate implicit in the lease whenever that rate is readily determinable. If the rate implicit in the lease is not readily determinable, a lessee uses its incremental borrowing rate. A lessee that is not a public business entity is permitted to use a risk-free discount rate for the lease, determined using a period comparable with that of the lease term, as an accounting policy election for all leases.

30-4 See Example 2 (paragraphs 842-20-55-17 through 55-20) for an illustration of the requirements on the discount rate.

30-5 At the commencement date, the cost of the right-of-use asset shall consist of all of the following:

The amount of the initial measurement of the lease liability
Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received
Any initial direct costs incurred by the lessee (as described in paragraphs 842-10-30-9 through 30-10).

30-6 See Example 3 (paragraphs 842-20-55-21 through 55-39) for an illustration of the requirements on lessee measurement of the lease term.

All leases (finance and operating leases), other than those that qualify for (and for which an entity elected to apply) the short-term recognition exemption, must be recognized as of the lease commencement date on the lessee’s balance sheet. Accordingly, at this time, a lessee will recognize a liability for its obligation related to the lease and a corresponding asset representing its right to use the underlying asset over the period of use. In addition to the below discussion of the initial determination of the lease liability and ROU asset, Example 3 in ASC 842 (reproduced in Section 8.9.1.1) illustrates the initial measurement of the lease liability and ROU asset for both finance and operating leases. Further, Example 4 in ASC 842 (reproduced in Section 8.9.1.2) comprehensively illustrates the initial measurement and subsequent measurement of the lease liability and ROU asset for an operating lease.

8.4.2.1 Initial Determination of the Lease Liability

Irrespective of whether a lease is classified as an operating lease or a finance lease, a lessee must recognize a lease liability and measure this liability at the present value of lease payments not yet paid (see Chapter 6 for additional discussion of lease payments). This value should be discounted by using an appropriate discount rate. When calculating the discount rate used to initially measure the lease liability, the lessee must use information that is available as of the lease commencement date (see Chapter 7 for more information about the discount rate).

8.4.2.2 Initial Determination of the ROU Asset

In addition to recognizing the lease liability, a lessee will recognize a corresponding asset representing its right to use the underlying asset over the lease term. The ROU asset is initially measured as follows:

ROU Asset Components	Description	Roadmap Section
Lease liability	Present value of lease payments not yet paid	8.4.2.1
Plus: Initial direct costs	Costs that are directly attributable to negotiating and arranging the lease that would not have been incurred had the lease not been executed (e.g., commissions paid, payments made to an existing tenant to incentivize that tenant to terminate its lease)	6.11
Plus: Prepaid lease payments	Any lease payments made to the lessor before or at the commencement of the lease	N/A
Less: Lease incentives received	Include both payments made by the lessor to or on behalf of the lessee and any losses incurred by the lessor as a result of assuming a lessee’s preexisting lease with a third party	6.2.2

Changing Lanes

Consideration of Asset’s Fair Value

ASC 840 explicitly prohibited the recognition of a capital lease asset in an amount greater than the fair value of the underlying asset. By contrast, lease measurement under ASC 842 may result in the recognition of an ROU asset whose carrying amount is greater than the fair value of the underlying asset. When the carrying amount of the ROU asset is greater than the fair value of the asset, a lessee should challenge the inputs and assumptions used to determine the right of use, such as the discount rate used, the identification of lease and nonlease components, and the associated allocation of consideration to those components. When the carrying value of the ROU asset exceeds the fair value of the underlying asset, insofar as a triggering event occurs that would cause a lessee to test the underlying asset for recoverability under ASC 360, the underlying asset or related asset group could be impaired. See Section 8.4.4 for a discussion of the requirements related to testing the ROU asset for impairment. Also see Q&A 16-4A in Section 16.3.1.1.2 for considerations related to the impact of “hidden” impairments upon adoption of ASC 842.

Example 8-10

Initial Measurement of the Lease Liability and ROU Asset

Lessee enters into a five-year contract with Supplier for the right to use specified machinery over the lease term. The contract meets the definition of a lease and only includes a single lease component. As a result, Lessee needs to determine the lease liability and ROU asset resulting from the lease at lease commencement.

The facts relevant to determining the initial measurement of the lease liability and ROU asset are as follows:

Lease Liability Calculation

At commencement, the initial measurement of the lease liability (regardless of lease classification) is calculated as the present value of the lease payments not yet paid by using the lease term and discount rate determined at lease commencement. As illustrated below, the information relevant to determining the lease liability is the lease term of five years, lease payments that increase by 2.5 percent in each period, and the lessee’s incremental borrowing rate.

ROU Asset Calculation

At commencement, the initial measurement of the ROU asset (regardless of lease classification) is calculated as the lease liability, increased by any initial direct costs and prepaid lease payments, reduced by any lease incentives received before commencement.

The information relevant to determining the ROU asset includes the lease liability of $65,328, increased by the initial direct costs of $750 and lease payments made before lease commencement (there are no prepayments in this example), and reduced by lease incentives received of $2,500.

Recognizing the Lease Liability and ROU Asset (Journal Entries)

As a result of the above calculations, at lease commencement the lessee would recognize the following amounts in its general ledger:

8.4.2.3 Accounting for Lease Incentives When Lease Payments Are Highly or Totally Variable

A lessor sometimes provides a lessee with a lease incentive to entice the lessee into leasing the underlying asset (e.g., the lessor may provide the lessee with funding for the construction of certain lessee-specific leasehold improvements). Lease incentives are a component of lease payments, which, as described in ASC 842-10-30-5(a), include “[f]ixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee” (emphasis added). ASC 842 also explicitly indicates that lease incentives that the lessee receives on or before the lease commencement date would be accounted for as a reduction of the ROU asset in accordance with ASC 842-20-30-5, which states:

At the commencement date, the cost of the right-of-use asset shall consist of all of the following:

The amount of the initial measurement of the lease liability
Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received
Any initial direct costs incurred by the lessee (as described in paragraphs 842-10-30-9 through 30-10). [Emphasis added]

In certain arrangements, when the payment structure of the lease is such that the fixed lease payments are minimal or zero (e.g., a retail store lease in which the lessee pays the lessor a percentage of the gross sales as rent), the lease liability and ROU asset balance, as calculated at lease commencement, may not be significant or may equal zero. While ASC 842 clearly stipulates that lease incentives should be accounted for as a reduction of the ROU asset when the ROU asset is initially measured (either directly or through a reduction in the fixed lease payments), ASC 842 is silent on how an entity should account for lease incentives when the lease payments are highly or totally variable in such a way that reducing the ROU asset would result in a negative balance.6

To the extent that lease incentives received from the lessor are greater than the ROU asset balance (before adjusting for the lease incentives), a lessee should reduce the ROU asset down to zero and recognize the difference as a liability, because it would be inappropriate to recognize a negative ROU asset. This liability should be reversed on a straight-line basis over the lease term and should be recognized as a reduction of lease cost.

Example 8-11

Assume the following facts:

Lessee enters into a lease agreement with Lessor for the use of building space for a 10-year term.
According to the agreement, before the lease commencement date, Lessor will provide Lessee with a $1.25 million tenant incentive for Lessee to use in building out the space.
Over the lease term, Lessee is not required to pay any fixed lease payments for use of the property; however, Lessee is required to pay 2 percent of gross sales, which is recognized as variable lease cost in each period.

In this example, because the payment structure is such that there are no fixed lease payments to be paid by Lessee, Lessee would not recognize a lease liability or ROU asset as of the lease commencement date. Rather, Lessee would be required to recognize a variable lease cost in the form of 2 percent of gross sales in each period. Because no ROU asset is recognized at lease commencement, the $1.25 million tenant incentive received would be recognized as a liability rather than as a reduction of the ROU asset. After lease commencement, the incentive liability would be reversed and recognized as a reduction of lease cost on a straight-line basis over the lease term. Lessee would therefore record the following journal entry for each year:

8.4.2.4 Lessee’s Accounting for Costs Related to Shipping, Installation, and Other Similar Items When the Lessor Does Not Provide Such Activities

After lease inception, a lessee may incur certain costs for shipping, installing, and performing other services to ready the leased asset for its intended use (e.g., site preparation). When the lessee pays the lessor to perform activities necessary to ready the leased asset for its intended use, such activities do not represent nonlease components in the contract, because the lessee is not receiving a separate service from the lessor in connection with these activities. Rather, these activities are necessary to fulfill the lease. Because these activities do not represent a nonlease component, any payments made by the lessee to the lessor should be included in the lessee’s lease payments (unless there are nonlease components in the contract to which a portion of the payments should be allocated).

Although ASC 842 provides guidance on how a lessee should account for payments made to a lessor to perform fulfillment activities necessary to ready the leased asset for its intended use,7 ASC 842 is less clear on how a lessee should account for such costs when it pays a third party8 (unrelated to the lessor) to perform these activities after lease inception.

The definition of initial direct costs in ASC 842 focuses on incremental costs that a lessee (or lessor) incurs to negotiate and obtain a lease (this focus is similar to that in the definition of incremental costs to obtain a contract with a customer in ASC 340-40). Because shipping and installation represent activities performed to ready the leased asset for its intended use and are incurred after the lease has been obtained, we generally do not believe that it is appropriate to apply the guidance on initial direct costs in ASC 842 to account for these costs.

On the basis of a technical inquiry with the FASB staff, we understand that, in the absence of explicit cost guidance in U.S. GAAP, including ASC 842, a lessee may elect to use either of the following approaches to account for these costs:

Approach A — Analogize to the measurement guidance in ASC 360 and capitalize the costs as appropriate. ASC 360-10-30-1 states, in part:

Paragraph 835-20-05-1 states that the historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. [Emphasis added]

Because shipping, installation, and other similar activities are necessary to bring the leased asset to the condition and location necessary for its intended use, we believe that it is appropriate for a lessee to analogize to the guidance in ASC 360 when capitalizing costs incurred to compensate a third party for performing these services.
Approach B — Expense the costs as incurred.

In the technical inquiry, the FASB staff indicated that lessees should apply the accounting policy election consistently on an entity-wide basis to all leases and should disclose the accounting policy elected, if material.

The above approaches are consistent with a speech given by Andrew Pidgeon, a professional accounting fellow in the SEC’s Office of the Chief Accountant, at the 2018 AICPA Conference on Current SEC and PCAOB Developments. Mr. Pidgeon stated, in part:

For example, a lessee may pay a party other than the lessor to ship a leased asset to the lessee’s premises. Topic 360 would require capitalization of those costs if the lessee purchased the asset. Since the asset is leased, not purchased, the lessee could determine that the costs are in the scope of other GAAP, or it could determine recognition in current period earnings is appropriate. In lieu of recognizing those costs in current period earnings, the staff did not object to a lessee, as an accounting policy election, analogizing to Topic 360 to capitalize costs incurred to place a leased asset into its intended use. [Footnotes omitted]

We further understand, on the basis of the aforementioned technical inquiry with the FASB staff, that a lessee may elect, as an accounting policy, to present the capitalized costs associated with shipping, installing, and other similar services performed to ready a leased asset for its intended use as either a separate asset within PP&E or as part of the related ROU asset (thereby increasing the ROU asset).

Regardless of the presentation elected by the lessee, we would not expect a difference in the total expense recognition pattern, and the capitalized costs should be included in the same asset group as the ROU asset when impairment testing is performed under ASC 360.

A lessee should also apply its accounting policy on this presentation consistently on an entity-wide basis to all leases and should disclose the accounting policy elected, if material.

8.4.2.5 Leases Entered Into for R&D Activities

ASC 730-10

25-2 Elements of costs shall be identified with research and development activities as follows (see Subtopic 350-50 for guidance related to website development):

Materials, equipment, and facilities. The costs of materials (whether from the entity's normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. The cost of such materials consumed in research and development activities and the depreciation of such equipment or facilities used in those activities are research and development costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred. See Topic 360 for guidance related to property, plant, and equipment; the Impairment or Disposal of Long-Lived Assets Subsections of Subtopic 360-10 for guidance related to impairment and disposal; and paragraphs 360-10-35-2 through 35-6 for guidance related to depreciation. . . .

A lessee may lease an underlying asset (e.g., PP&E) for use in research and development (R&D) activities. The initial accounting for a lease used in R&D activities depends both on whether the leased assets have an alternative future use and on the classification of the lease. For ROU assets related to finance leases for R&D activities, an entity should apply the guidance in ASC 730, which requires an entity to expense PP&E acquired for use in R&D activities if such assets have no alternative future use. Thus, the same accounting should be applied to ROU assets associated with an R&D finance lease since a finance lease is akin to an acquisition of the underlying asset.

We believe that there are two acceptable approaches to accounting for ROU assets associated with R&D operating leases:

View 1 — Underlying assets that have no alternative future use are expensed as of the commencement date in a manner consistent with ASC 730. (This approach is similar to that discussed above for a finance lease.)
View 2 — The R&D operating leases should be accounted for in a manner consistent with the accounting for other non-R&D operating leases, as outlined in Section 8.4.

8.4.3 Subsequent Measurement

ASC 842-20

35-6 See Examples 3 and 4 (paragraphs 842-20-55-21 through 55-46) for an illustration of the requirements on lessee subsequent measurement.

While the requirements for initial recognition and measurement of the lease liability and ROU asset are the same for every lease regardless of whether it is classified as a finance lease or an operating lease, the subsequent measurement and related expense profile differ on the basis of the lease classification. That is, finance leases generally have a front-loaded expense recognition profile (see Section 8.4.3.1 for additional details) and operating leases have a straight-line expense recognition profile (see Section 8.4.3.2 for additional details). The graph below compares these two recognition profiles.

The discussion below describes the accounting requirements related to, and includes examples illustrating, the subsequent measurement of both finance and operating leases. Note that Section 8.9 also includes examples from ASC 842 that illustrate the subsequent measurement of finance and operating leases. Specifically, Example 3 (ASC 842-20-55-22 and ASC 842-20-55-30, reproduced in Section 8.9.1.1) and Example 4 (ASC 842-20-55-41 through 55-46, reproduced in Section 8.9.1.2), depict the initial and subsequent measurement of the lease liability and ROU asset.

8.4.3.1 Subsequent Measurement of a Finance Lease

ASC 842-20

25-5 After the commencement date, a lessee shall recognize in profit or loss, unless the costs are included in the carrying amount of another asset in accordance with other Topics:

Amortization of the right-of-use asset and interest on the lease liability
Variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred (see paragraphs 842-20-55-1 through 55-2)
Any impairment of the right-of-use asset determined in accordance with paragraph 842-20-35-9.

35-1 After the commencement date, for a finance lease, a lessee shall measure both of the following:

The lease liability by increasing the carrying amount to reflect interest on the lease liability and reducing the carrying amount to reflect the lease payments made during the period. The lessee shall determine the interest on the lease liability in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the liability, taking into consideration the reassessment requirements in paragraphs 842-10-35-1 through 35-5.
The right-of-use asset at cost less any accumulated amortization and any accumulated impairment losses, taking into consideration the reassessment requirements in paragraphs 842-10-35-1 through 35-5.

35-2 A lessee shall recognize amortization of the right-of-use asset and interest on the lease liability for a finance lease in accordance with paragraph 842-20-25-5.

35-7 A lessee shall amortize the right-of-use asset on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the right-of-use asset’s future economic benefits. When the lease liability is remeasured and the right-of-use asset is adjusted in accordance with paragraph 842-20-35-4, amortization of the right-of-use asset shall be adjusted prospectively from the date of remeasurement.

35-8 A lessee shall amortize the right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the right-of-use asset to the end of the useful life of the underlying asset.

After lease commencement, a lessee measures its lease liability by using the effective interest rate method. That is, in each period, the liability will be increased to reflect the interest that is accrued on the related liability by using the appropriate discount rate, offset by a decrease in the liability resulting from the periodic lease payments.

The lessee’s recognition of the ROU asset after lease commencement will be similar to that for other nonfinancial assets. That is, the lessee would generally recognize the ROU asset at cost, reduced by any accumulated amortization and accumulated impairment losses.

The ROU asset itself is amortized on a straight-line basis unless another systematic method better reflects how the underlying asset will be used by and benefit the lessee over the lease term. The period over which the underlying asset will be amortized is the shorter of (1) the useful life of the underlying asset or (2) the end of the lease term. Two exceptions to this principle are situations in which the lease agreement includes a provision that either (1) results in the transfer of ownership of the underlying asset to the lessee at the end of the lease term or (2) includes a purchase option whose exercise by the lessee is reasonably certain. In either of these scenarios, the ROU asset should be amortized over the useful life of the underlying asset.

Together, the interest and amortization expense components result in a front-loaded expense profile similar to that of a capital lease arrangement under ASC 840. Lessees would separately present the interest and amortization expenses in the income statement.

The example below illustrates the subsequent measurement of a finance lease. For an additional illustration of such measurement, see Example 3 in ASC 842 (ASC 842-20-55-27 and 55-28, reproduced in Section 8.9.1.1).

Example 8-12

Subsequent Measurement of a Finance Lease

Assume the same facts as in Example 8-10. Further, assume that after evaluating the lease classification on the commencement date, Lessee concludes that the lease should be classified as a finance lease. As a result of this determination, Lessee would subsequently account for the lease liability and ROU asset in the following manner:

Subsequent Measurement of Lease Liability

The lease liability at any given time is accounted for by using the effective-interest method. Under this approach, the liability is adjusted to reflect an increase for the periodic interest expense (calculated by using the discount rate determined at lease commencement), reduced by the lease payment.

In this example, the discount rate used to determine the interest expense for each given period is the lessee’s incremental borrowing rate of 6.5 percent.

Subsequent Measurement of ROU Asset

The ROU asset at the end of any given period is calculated as the ROU asset at the beginning of the period, reduced by the periodic amortization of the ROU asset. In a manner consistent with the amortization approach for other nonfinancial assets, the ROU asset is amortized in each period on a straight-line basis unless another systematic basis is more representative of the pattern in which the lessee expects to consume the ROU asset’s future economic benefits.

Journal Entries

As a result of the above calculations, during the first year of the lease, Lessee would recognize the following amounts in its general ledger (note that only year 1 entries have been included):

8.4.3.2 Subsequent Measurement of an Operating Lease

ASC 842-20

25-6 After the commencement date, a lessee shall recognize all of the following in profit or loss, unless the costs are included in the carrying amount of another asset in accordance with other Topics:

A single lease cost, calculated so that the remaining cost of the lease (as described in paragraph 842-20- 25-8) is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset (see paragraph 842-20-55-3), unless the right-of-use asset has been impaired in accordance with paragraph 842-20-35-9, in which case the single lease cost is calculated in accordance with paragraph 842-20-25-7
Variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred (see paragraphs 842-20-55-1 through 55-2)
Any impairment of the right-of-use asset determined in accordance with paragraph 842-20-35-9.

25-8 Throughout the lease term, the remaining cost of an operating lease for which the right-of-use asset has not been impaired consists of the following:

The total lease payments (including those paid and those not yet paid), reflecting any adjustment to that total amount resulting from either a remeasurement in accordance with paragraphs 842-10-35-4 through 35-5 or a lease modification; plus
The total initial direct costs attributable to the lease; minus
The periodic lease cost recognized in prior periods.

35-3 After the commencement date, for an operating lease, a lessee shall measure both of the following:

The lease liability at the present value of the lease payments not yet paid discounted using the discount rate for the lease established at the commencement date (unless the rate has been updated after the commencement date in accordance with paragraph 842-20-35-5, in which case that updated rate shall be used)
The right-of-use asset at the amount of the lease liability, adjusted for the following, unless the right-of-use asset has been previously impaired, in which case the right-of-use asset is measured in accordance with paragraph 842-20-35-10 after the impairment:
1. Prepaid or accrued lease payments
2. The remaining balance of any lease incentives received, which is the amount of the gross lease incentives received net of amounts recognized previously as part of the single lease cost described in paragraph 842-20-25-6(a)
3. Unamortized initial direct costs
4. Impairment of the right-of-use asset.

55-3 This Subtopic considers the right to control the use of the underlying asset as the equivalent of physical use. If the lessee controls the use of the underlying asset, recognition of lease cost in accordance with paragraph 842-20-25-6(a) or amortization of the right-of-use asset in accordance with paragraph 842-20-35-7 should not be affected by the extent to which the lessee uses the underlying asset.

After lease commencement, a lessee is required to measure its lease liability for each period at the present value of any remaining lease payments, discounted by using the rate determined at lease commencement. Effectively, this approach is consistent with the model used to calculate the liability related to the finance lease (i.e., lease liabilities are subsequently measured the same way regardless of lease classification). That is, in each period, the liability will reflect an increase for interest that is accrued on the related liability by using the appropriate discount rate, offset by a decrease resulting from the periodic lease payments.

For an operating lease, the subsequent measurement of the ROU asset is linked to the amount recognized as the lease liability (unless the ROU asset is impaired). Accordingly, the ROU asset would be measured as the lease liability adjusted by (1) accrued or prepaid rents (i.e., the aggregate difference between the cash payment and straight-line lease cost), (2) remaining unamortized initial direct costs and lease incentives, and (3) impairments of the ROU asset.

After lease commencement and over the lease term, a lessee would recognize, in the income statement, (1) a single lease cost calculated in a manner that results in the allocation of the remaining lease costs over the remaining lease term, either on a straight-line basis or another systematic or rational basis that is more representative of the pattern in which the underlying asset is expected to be used; (2) variable lease payments not recognized in the measurement of the lease liability in the period in which the related obligation has been incurred; and (3) any impairment of the operating lease ROU asset.

Connecting the Dots

Overview of the “Plug” Approach

While the ASU discusses subsequent measurement of the ROU asset arising from an operating lease primarily from a balance sheet perspective, a simpler way to describe it would be from the standpoint of the income statement. Essentially, the goal of operating lease accounting is to achieve a straight-line expense pattern over the term of the lease (provided that there is not a more representative pattern of consumption of the benefit). Accordingly, an entity effectively takes into account the interest on the liability (i.e., the lease obligation consistently reflects the lessee’s obligation on a discounted basis) and adjusts the amortization of the ROU asset to arrive at a constant expense amount. To achieve this, the entity first determines the straight-line expense amount by taking total payments over the life of the lease, net of any lessor incentives, plus initial direct costs, divided by the lease term. Then, the entity calculates the interest on the liability by using the discount rate for the lease and deducts this amount from the required straight-line expense amount for the period. This difference is simply “plugged” as amortization of the ROU asset. By using this method, the entity recognizes a single operating lease expense rather than separate interest and amortization charges, although the effect on the lease liability and ROU asset on the balance sheet reflects a bifurcated view of the expense. Under this method, the amortization of the ROU asset generally increases each year as the liability accretion decreases as a result of a declining lease liability balance.

The example below illustrates the subsequent measurement of an operating lease. For additional illustrations, see Example 3 (ASC 842-20-55-29 and 55-30, reproduced in Section 8.9.1.1) and Example 4 (ASC 842-20-55-41 through 55-46, reproduced in Section 8.9.1.2), which depict the subsequent (Example 3) and initial and subsequent (Example 4) measurement of the lease liability and ROU asset for an operating lease.

Example 8-13

Subsequent Measurement of an Operating Lease

Assume the same facts as in Example 8-10. Further, assume that upon evaluating the lease classification on the commencement date, Lessee concludes that the lease should be classified as an operating lease. As a result of this determination, Lessee would subsequently account for the lease liability and ROU asset by using one of two approaches, each of which results in the same outcome:

Approach A: ROU Asset Balance Derived From Lease Liability

Approach B: Application of the “Plug” Approach

Lease Cost

After lease commencement, a lessee would recognize a single lease cost in the income statement, calculated so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis unless there is another systematic and rational basis that better reflects how the benefits of the underlying asset are consumed over the lease term.

In this example, the total remaining lease cost on the commencement date would be $77,094, which is calculated as the total lease payments (including those that have been paid and those that have not yet been paid) increased by initial direct costs and reduced by any incentives paid or payable to the lessee (fixed payments of $78,844 plus the $750 in initial direct costs less the $2,500 incentive). Generally, the total lease payments would be adjusted by the prior-period lease costs (which are zero in this example).

The resulting remaining lease cost is recognized on a straight-line basis over the remainder of the lease term (i.e., Lessee would recognize $15,4199 in each period, which is calculated as $77,094 ÷ 5).

Subsequent Measurement of Lease Liability

The lease liability for an operating lease at any given time is calculated as the present value of the lease payments not yet paid, discounted by using the rate that was established on the lease commencement date (unless the rate was adjusted as a result of a liability remeasurement event).

In this example, Lessee will measure the remaining lease payments at present value at the end of any given period by using the incremental borrowing rate of 6.5 percent, which was established at lease commencement.

Subsequent Measurement of ROU Asset (Approach A)

The ROU asset, at any given time, is measured as the amount of the lease liability, adjusted by (1) prepaid or accrued rents, (2) any unamortized initial direct costs, and (3) the remaining balance of any lease incentives received (gross amount received net of amount already recognized as part of the single lease costs).

In this example, Lessee will measure its ROU asset at the end of each period as the lease liability, adjusted by the prepaid/accrued rent, any unamortized initial direct costs, and any unamortized incentives received by the lessee.

Subsequent Measurement of ROU Asset (Approach B)

The ROU asset, at any given time, is measured as the ROU asset balance at the beginning of the period, adjusted by the current-period ROU asset amortization, which is calculated as the current-period lease cost adjusted by the lease liability accretion to the then outstanding lease balance (i.e., the increase in the liability as a result of applying the commencement-date discount rate).

In this example, which illustrates the accounting for period 1, Lessee will calculate the ROU balance of $52,405 at the end of period 1 in the following manner:

Journal Entries

As a result of the above calculations, during the first year of the lease, Lessee would recognize the following amounts in its general ledger (note that only period 1 entries have been included):

8.4.3.2.1 Subsequent Measurement of an Operating Lease When the ROU Asset Would Be Reduced Below Zero Because of Accrued Rent10

At lease commencement, the ROU asset is measured as the lease liability adjusted by (1) accrued or prepaid rents, (2) initial direct costs, and (3) lease incentives received. In subsequently measuring an operating lease, an entity must use an amortization method that achieves a straight-line expense profile. An accrued rent balance is established when escalating lease payments are present for a portion of the lease term (e.g., fixed lease payments in early years are lower than those in later years). In a long-term lease with escalating lease payments (e.g., a 40-year ground lease), the adjusting amount for accrued rent can be greater than the lease liability balance. Accordingly, a question arises about how to subsequently measure the ROU asset, since it would be reduced below zero. That is, the cumulative lease payments less the cumulative straight-line expense recognized (i.e., accrued rent) can be greater than the lease liability balance; as a result, the ROU asset is reduced below zero.

We believe that, in the subsequent measurement of an operating lease, when the ROU asset would be reduced below zero because the cumulative lease payments less the cumulative straight-line expense recognized (i.e., accrued rent) are greater than the lease liability, the ROU asset should be reclassified and presented as a liability and the straight-line expense should not be disrupted. Thereafter, when the balance of the ROU asset returns to a positive amount, the balance should be reverted to its original classification (i.e., should be presented again as an ROU asset). We think that this approach is appropriate because we do not believe that it is appropriate to present a negative ROU asset, thereby offsetting other positive ROU assets. Similarly, we do not believe that it would be appropriate to adjust the discount rate (i.e., impute a lower discount rate) in these situations to “solve” for this problem (i.e., disallow the ROU asset from becoming negative).

Example 8-1411

Lessee’s Accounting for an Operating Lease When the ROU Asset Would Be Reduced Below Zero Because of Accrued Rent

Retail Co. enters into a 20-year agreement to lease land from Land Owner. According to the terms of the agreement, Retail Co. will pay $1,000 in year 1 and the lease payment will double in each subsequent year (i.e., increase by 100 percent compared with the prior year’s lease payment, so in year 2 a payment of $2,000 is due; in year 3, $4,000; in year 4, $8,000; etc.). Retail Co.’s incremental borrowing rate at lease commencement is 8 percent. (Note that Retail Co. cannot readily determine the rate implicit in the lease.) Assume that none of the criteria in ASC 842-10-25-2 are met and that Retail Co. classifies its lease as an operating lease.

At lease commencement, Retail Co. will recognize a lease liability and an ROU asset of $244,531,632, which is calculated as the present value of the remaining lease payments by using the incremental borrowing rate at commencement. In this scenario, the total lease payments over the lease term are $1,048,575,000 ($1,000 in year 1, with a 100 percent escalator each year). The recognition of the total lease payments evenly over the 20 years results in a straight-line rent expense of $52,428,750 per year.

At the end of year 11, the lease liability is equal to $567,935,936 while the embedded accrued rent balance is $574,669,250 ($2,047,000 cumulative lease payments less $576,716,250 cumulative straight-line expense recognized). As a result, at the end of year 11, without adjustment, the ROU asset would be negative $6,733,314 ($567,935,936 lease liability less $574,669,250 of embedded accrued rent). Therefore, in accordance with this section, we believe that at the end of year 11, an adjustment to presentation is necessary. Accordingly, the ROU asset is presented as $0 and a liability of $6,733,314 is presented. See the illustration in the table below.

In the above illustration, it can be observed that at the end of year 13, the liability will reach its highest point of $17,250,114. Thereafter, the balance of the liability will begin to deplete. At the end of year 17, the lease liability will once again exceed the embedded accrued rent, thereby reinstating a positive ROU asset. That is, the lease liability is equal to $762,305,909, while the embedded accrued rent is $760,217,750. At this point, the liability will have a zero balance and the ROU asset is equal to $2,088,159. By the end of year 20 (i.e., the end of the lease term), the lease liability and ROU asset will appropriately reduce to zero. The total lease expense recognized over the lease term is $1,048,575,000, which is equal to the total lease payments over the term; further, the straight-line expense of $52,428,750 remained consistent each period.

8.4.3.3 Variable Payments Based on the Achievement of a Specified Target

ASC 842-20

55-1 A lessee should recognize costs from variable lease payments (in annual periods as well as in interim periods) before the achievement of the specified target that triggers the variable lease payments, provided the achievement of that target is considered probable.

55-2 Variable lease costs recognized in accordance with paragraph 842-20-55-1 should be reversed at such time that it is probable that the specified target will not be met.

A lessee should recognize variable payments before achieving a specified target when the achievement of the target is deemed probable. Variable payments recognized in accordance with ASC 842-20-55-1 would be reversed when achievement of the specified target is no longer deemed probable. As illustrated in the next section, we believe that this guidance applies when targets are based on cumulative performance during the lease term.

8.4.3.3.1 Lessee’s Timing of Variable Payments

Many lease arrangements contain variable payments based on the use or performance of the underlying asset. Examples include (1) a retail store lease that requires the lessee to pay a percentage of store sales each month, (2) a car lease that requires the driver to pay for each mile driven, and (3) a PPA that requires the lessee (the off-taker) to buy all electricity produced by a weather-dependent generating plant such as a wind farm.

Under ASC 842, variable payments that do not depend on an index or rate are excluded from the initial measurement of the lease liability and ROU asset.

ASC 842-20-25-5(b) (for finance leases) and ASC 842-20-25-6(b) (for operating leases) both state that variable lease payments not included in the initial measurement of the lease should be recognized in profit or loss “in the period in which the obligation for those payments is incurred” (emphasis added). In addition, the implementation guidance in ASC 842-20-55-1 states that a “lessee should recognize costs from variable lease payments (in annual periods as well as in interim periods) before the achievement of the specified target that triggers the variable lease payments, provided the achievement of that target is considered probable” (emphasis added).

In lease arrangements in which the lessee pays a variable amount based on usage or performance, questions have arisen about whether the lessee is required to assess the probability of future performance throughout the lease term and record a charge (and a corresponding liability) for the variable lease payment amount assessed as probable.12

We believe that the guidance in ASC 842-20-55-1 on the probable achievement of variable lease payment targets is meant to be narrowly applied to scenarios involving discrete performance targets or milestones that will be achieved over time (e.g., a specified level of cumulative store sales) and, in those limited scenarios, is meant to require recognition in each period over the lease term at an amount that reflects an appropriate apportionment of the expected total lease cost. This guidance ensures that the cost of the lease is appropriately allocated to both the periods of use that contribute to the variable payment requirement and the periods of use in which the variable payment requirement has been met. Such allocation is necessary when performance targets are cumulative and have the potential to cross reporting periods.

We do not believe that the guidance on the probable achievement of variable lease payment targets is meant to otherwise require an assessment of a probable level of performance over the lease term and require a charge in advance of actual performance when the variability arises and is resolved within a reporting period. For example, in a vehicle lease, a variable charge per mile driven that starts with the first mile and continues throughout the lease term can be discretely measured and expensed in the reporting period in which the charge is incurred. That is, it is unnecessary to assess the probability of future mileage to ensure proper period attribution of the variable charges. Applying a probability model to this type of variable payment structure could lead to an inappropriate acceleration of variable expense attributable to future use.

The scenarios in the example below illustrate the difference between the treatment of variability when discrete cumulative targets exist and the treatment when the variability is resolved within the reporting period.

Example 8-15

Scenario A

Retailer X is a lessee in an arrangement in which it is required to pay $500 plus 3 percent of store sales each month over a five-year lease term. Retailer X is not required to forecast its sales over the lease term and accrue for a level of sales that is deemed probable to occur. Rather, each month, X will recognize variable lease expense equal to 3 percent of sales.

Scenario B

Utility Y is a lessee in a PPA in which it purchases all of the output from a wind farm owned by an independent power producer (IPP) at a fixed price per MWh. Since the wind farm is 100 percent weather-dependent, Y’s lease payments are 100 percent variable (Y pays only for electricity produced). Studies performed before the wind farm was constructed indicate that there is a 95 percent likelihood that electrical output will equal or exceed 25,000 MWh per month. Despite the very high likelihood (95 percent is well above the “probable” threshold) of a minimum performance level, Y is not required to accrue for a corresponding amount of lease payments (i.e., an expectation of variable lease payments based on future production). Rather, Y will recognize variable lease expense each month as electricity is delivered and billed by the IPP.

Scenario C

Retailer Z is a lessee in a five-year operating lease that requires it to pay base rent of $500 per month plus an additional $100 per month beginning when cumulative store sales exceed $100,000. Retailer Z believes that it is probable that this sales target will be achieved by the end of year 2 (i.e., rent will become $600 per month after the target is met).

Retailer Z should quantify the amount that it is probable for the entity to incur on the basis of its achievement of the target ($3,600, or $100 per month for 36 months) and should apportion that amount to each period beginning at commencement. That is, since eventual achievement of the cumulative sales target is deemed probable at commencement, the $3,600 should be recognized ratably over the five-year term (i.e., $500 per month for 24 months plus $600 per month for 36 months, resulting in an expense of $560 per month) even though the target has not yet been achieved. This is an appropriate accounting outcome because sales in years 1 and 2 contribute to the achievement of the target. Accordingly, years 1 and 2 should be burdened by an appropriate amount of the incremental lease expense.

On the basis of the above fact pattern, Z would recognize an incremental lease expense of $60 per month beginning at lease commencement (i.e., $3,600 divided by the 60 months of the lease term) to reflect the expected additional rent associated with the anticipated achievement of the sales target.

In addition, once the target is actually achieved, Z would remeasure the ROU asset and corresponding liability in accordance with ASC 842-10-35-4(b), since it would conclude that a “contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based is resolved such that those payments now meet the definition of lease payments.”

Provided that Z achieves the sales target as planned at the end of year 2 (assume a 0 percent discount rate for simplicity), Z would recognize the following amounts in its financial statements:

Bridging the GAAP

Target Achievement Under U.S. GAAP Versus That Under IFRS Accounting Standards

Under U.S. GAAP, a lessee is required to recognize costs from variable lease payments in annual and interim periods before the achievement of the specified target if the target is considered probable; however, this guidance does not exist under IFRS 16. Therefore, in such circumstances, the accounting outcome under U.S. GAAP could differ from that under IFRS Accounting Standards.

8.4.3.4 Subsequent Measurement for Leases That Include a Term Consisting of Nonconsecutive Periods of Use

The ASC master glossary defines “period of use” as “[t]he total period of time that an asset is used to fulfill a contract with a customer (including the sum of any nonconsecutive periods of time).” Insofar as the lessee concludes that the contract is or contains a lease over the “period of use,” the lease liability and corresponding ROU asset initially would be measured on the basis of the present value of the remaining lease payments that will be received over that nonconsecutive period, discounted by using the appropriate rate at lease commencement (see Section 5.2.4.5 for additional information).

A lessee must also determine how it will subsequently measure the lease. ASC 842-20-25-6(a) states that after the commencement date, the lessee would recognize in profit or loss “[a] single lease cost, calculated so that the remaining cost of the lease (as described in paragraph 842-20-25-8) is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset” (emphasis added).

If a lease grants a lessee the right to use an asset over nonconsecutive periods and is determined to be an operating lease, the lessee should limit the recognition of lease costs to the periods in which it has the right to use the underlying asset.

The benefit that is expected to be derived from the lessee’s use of the underlying asset is linked directly to the “period of use” associated with the asset. When the period of use includes nonconsecutive periods, the benefit expected to be derived from the lessee’s use of the underlying asset would be recognized only in the periods in which it has the right to use the underlying asset. Therefore, in a manner consistent with the guidance in ASC 842-20-25-6(a), the lessee would recognize a single lease cost in the income statement, calculated so that the remaining cost of the lease is allocated on a straight-line basis over the lease term, which would include the sum of the nonconsecutive periods.

Example 8-16

Lessee’s Accounting for an Operating Lease With Nonconsecutive Periods

Retail Co. enters into a two-year lease agreement with Mall Owner under which Retail Co. will lease a specific store front in the mall from October through December for the holiday seasons ending December 31, 2019, and December 31, 2020.

According to the terms of the agreement, Retail Co. will pay $10,000 per month in each of the three months during those periods. Retail Co.’s incremental borrowing rate at lease commencement is 6 percent. (Note that Retail Co. cannot readily determine the rate implicit in the lease.)

At lease commencement, Retail Co. will recognize a lease liability and ROU asset of $57,679, which is calculated as the present value of the remaining lease payments by using the incremental borrowing rate at commencement (i.e., the $10,000 payments made during the months of October, November, and December for each of the two years ending on December 31, 2019, and December 31, 2020).

Since the underlying asset only benefits the lessee during the months of October, November, and December, it would be appropriate to only recognize a lease cost over these nonconsecutive periods. In this scenario, the total lease payments over the term of the lease term are $60,000 ($10,000 per month × 6 months). The recognition of the $60,000 evenly over the six, nonconsecutive periods of use (i.e., a lease cost of $10,000) results in a lease cost recognition pattern that is representative of the pattern in which the benefit is expected to be derived from the right to use the underlying asset.

See Section 5.2.4.5 for additional information on accounting for an operating lease with nonconsecutive periods and evaluating whether such a lease qualifies as a short-term lease.

Lease Cost

In accordance with ASC 842, after lease commencement, a lessee would recognize a single lease cost in the income statement, calculated so that the remaining cost of the lease is allocated over the remaining lease term (but only those periods for which the right to use the asset exists) on a straight-line basis unless there is another systematic and rational basis that better reflects how the benefits of the underlying asset are consumed over the lease term.

Retail Co. recognizes the remaining lease cost equally over each of the six periods, since the sum of the nonconsecutive periods of use represents the lease term (i.e., Retail Co. recognizes $10,000 in each period, which is calculated as $60,000 ÷ 6).

Subsequent Measurement of Lease Liability

The lease liability for an operating lease in any given period is calculated as the present value of the lease payments not yet paid, discounted by using the rate that was established on the lease commencement date (unless the rate was adjusted as a result of a liability remeasurement event).

In this example, Retail Co. measures the six lease payments at present value by using the commencement-date incremental borrowing rate of 6 percent on the basis of when the payments are paid. For each period, the liability is adjusted to reflect the effect of this discount rate on the outstanding liability. (Note that the liability is accreted each month.) Over the lease term, the lease payments are only applied to the lease liability, and this liability is only reduced, when payments are made (October, November, and December of each year).

Subsequent Measurement of ROU Asset

The ROU asset for an operating lease in any given period is calculated as the lease liability, adjusted for certain discrete amounts, when applicable. In this example, there are no required adjustments; therefore, the ROU asset balance will be exactly the same as the lease liability balance at the end of any given period. Because the payments and related lease costs are limited to six discrete periods over the lease term, the ROU asset will increase in the intervening periods to reflect this fact.

8.4.4 Impairment of an ROU Asset

ASC 842-20

25-7 After a right-of-use asset has been impaired in accordance with paragraph 842-20-35-9, the single lease cost described in paragraph 842-20-25-6(a) shall be calculated as the sum of the following:

Amortization of the remaining balance of the right-of-use asset after the impairment on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the remaining economic benefits from its right to use the underlying asset
Accretion of the lease liability, determined for each remaining period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the liability.

35-9 A lessee shall determine whether a right-of-use asset is impaired and shall recognize any impairment loss in accordance with Section 360-10-35 on impairment or disposal of long-lived assets.

35-10 If a right-of-use asset is impaired in accordance with paragraph 842-20-35-9, after the impairment, it shall be measured at its carrying amount immediately after the impairment less any accumulated amortization. A lessee shall amortize, in accordance with paragraph 842-20-25-7 (for an operating lease) or paragraph 842-20-35-7 (for a finance lease), the right-of-use asset from the date of the impairment to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term.

35-11 See Example 5 (paragraphs 842-20-55-47 through 55-51) for an illustration of the requirements for impairment of a right-of-use asset.

A lessee must test an ROU asset for impairment in a manner consistent with its treatment of other long-lived assets (i.e., in accordance with ASC 360). The impairment test is a two-step process as follows:

Step 1 — An entity compares the carrying value of the asset group with the undiscounted cash flows expected to be generated as a result of the asset group’s use and disposal to determine whether the asset group is recoverable (i.e., “the recoverability test”). If the recoverability test fails because the undiscounted cash flows are less than the carrying value of the asset group, the entity must perform step 2. Conversely, when the undiscounted cash flows exceed the carrying value of the asset group, the asset group is recoverable (i.e., there is no impairment) and therefore there is no need to determine whether the carrying value of the asset group exceeds its fair value.
Step 2 — An entity determines the fair value of the asset group and recognizes an impairment loss equal to the amount by which the carrying amount of an asset group exceeds its fair value (see ASC 360-10-35-17). However, the impairment loss recorded is limited to the carrying value of the long-lived assets in the asset group, and individual long-lived assets within the asset group cannot be written down below their individual fair values. An entity should determine the fair value in accordance with ASC 820-10 and use the perspective of a market participant.

See Deloitte’s Roadmap Impairments and Disposals of Long-Lived Assets and Discontinued Operations for more information about the ASC 360 impairment model.

If the ROU asset related to an operating lease is impaired, the lessee would amortize the remaining ROU asset in accordance with the subsequent-measurement guidance that applies to finance leases — typically, on a straight-line basis over the remaining lease term (see Section 8.4.3.1). This accounting continues to apply even if the ROU asset is remeasured after the impairment. Thus, the operating lease would no longer qualify for the straight-line treatment of total lease expense. However, in periods after the impairment, a lessee would continue to present the ROU asset reduction and interest accretion related to the lease liability as a single line item in the income statement (see Section 14.2.2.2.1).

Connecting the Dots

Undiscounted Cash Flows

The determination of the undiscounted cash flows expected to be generated by an asset group is based on guidance in ASC 360. That is, cash flows included in the impairment test are not limited to cash flows that would be included in the measurement of ROU assets and lease liabilities in accordance with ASC 842. For example, although variable lease payments that do not depend on an index or rate are not included in the measurement of a lease liability and ROU asset, such amounts would be included in cash flows for impairment test purposes.

8.4.4.1 Abandonment Accounting

ASC 360-10

Long-Lived Assets to Be Abandoned

35-47 For purposes of this Subtopic, a long-lived asset to be abandoned is disposed of when it ceases to be used. If an entity commits to a plan to abandon a long-lived asset before the end of its previously estimated useful life, depreciation estimates shall be revised in accordance with paragraphs 250-10-45-17 through 45-20 and 250-10-50-4 to reflect the use of the asset over its shortened useful life (see paragraph 360-10-35-22).

35-48 Because the continued use of a long-lived asset demonstrates the presence of service potential, only in unusual situations would the fair value of a long-lived asset to be abandoned be zero while it is being used. When a long-lived asset ceases to be used, the carrying amount of the asset should equal its salvage value, if any. The salvage value of the asset shall not be reduced to an amount less than zero.

In addition to being subject to the ASC 360 impairment requirements, ROU assets are subject to its abandonment guidance as well. Unlike the impairment requirements, which are applied at the asset group level as discussed in Example 8-17, the abandonment requirements are applied to individual lease components (regardless of whether the lease components were accounted for separately at lease commencement).

In the context of a real estate lease, when a lessee decides that it will no longer need a property to support its business requirements (i.e., the lessee will cease using the property immediately or at some designated future date) but is still contractually obligated under the underlying lease, it needs to evaluate whether the ROU asset has been or will be abandoned, as a result of which such assets would be subject to abandonment accounting. Abandonment accounting only applies when the underlying property subject to a lease is no longer used for any business purposes, including storage. By contrast, even if an entity has fully vacated the space, the asset would not be considered abandoned if the lessee expects to continue to obtain the economic benefits from using the underlying asset (i.e., the underlying asset is viewed as temporarily idled, as contemplated in ASC 360-10-35-49). This would be the case if the lessee intends to use the space at a future time or when it has the intent and ability to sublease the property. This guidance is consistent with ASC 842-10-15-17, which states, in part:

A customer can obtain economic benefits from use of an asset directly or indirectly in many ways, such as by using, holding, or subleasing the asset. The economic benefits from use of an asset include its primary output and by-products (including potential cash flows derived from these items) and other economic benefits from using the asset that could be realized from a commercial transaction with a third party. [Emphasis added]

Accordingly, if a lessee can obtain economic benefit from using the asset, it would continue to record lease expense for an operating lease and ROU amortization for a finance lease.

In applying the abandonment model in ASC 360, a lessee would shorten the remaining useful life of the ROU asset to equal the amount of time remaining before the planned abandonment date. While the ROU asset is affected by the entity’s decision to abandon an asset, the corresponding lease liability is not affected because the lessee is not relieved of its obligations under the lease. The example below illustrates a scenario in which a lessee shortens the remaining useful life of an ROU asset.

Example 8-17

Impact of a Plan to Abandon the Underlying Leased Asset Before the End of the Lease Term

On January 1, 2020, Company S, a lessee, enters into a lease arrangement with a noncancelable lease term of 10 years and no renewal options. The lease is appropriately classified as an operating lease and therefore will have an overall straight-line expense profile (i.e., the amortization of the ROU asset will be “plugged” in each period to achieve an overall straight-line expense pattern, when combined with interest expense on the lease liability, over the 10-year term). At the end of year 1 (i.e., on January 1, 2021), S decides that it will abandon the leased asset on January 1, 2027, before the end of the lease term. Company S considers that the asset will be abandoned since it will no longer use the asset and does not have the intent and ability to sublease the leased asset (see Q&A 16-5A). We do not believe that it is appropriate to continue to recognize an ROU asset after abandonment because S is no longer obtaining economic benefits from the use of the underlying asset through use or sublease. However, S would still be required to recognize a lease liability equal to the present value of the remaining lease payments under the contract. Further, the ROU asset is part of a larger asset group that is not impaired.

In this scenario, at the beginning of the second year, S should shorten the remaining useful life of the ROU asset to equal the amount of time remaining before the planned abandonment date. The SEC staff has indicated that an entity should revisit a long-lived asset’s useful life to determine whether it should be adjusted (i.e., shortened to reflect the expected abandonment date). Specifically, ASC 360-10-S99-2 states, in part:

If an entity commits to a plan to abandon a long-lived asset before the end of its previously estimated useful life, depreciation estimates shall be revised in accordance with FASB ASC Topic 250, Accounting Changes and Error Corrections, to reflect the use of the asset over its shortened useful life.

While ASC 360-10-S99-2 was issued in the context of owned assets, we believe that it applies equally to ROU assets. In addition, paragraph BC255 of ASU 2016-02 contains language indicating that the ROU asset should be zero as of the abandonment date. Paragraph BC255 states, in part:

In the Board’s view, it would be inappropriate to continue to recognize a right-of-use asset from which the lessee does not expect to derive future economic benefits (for example, a right to use a building that the lessee has abandoned) or to recognize that asset at an amount the lessee does not expect to recover. [Emphasis added]

While the guidance is clear on the impact of impairments on the prospective amortization of operating lease ROU assets (see above), we do not believe that it is clear on how an entity should amortize the ROU asset over the shortened remaining useful life in the event of an abandonment plan. Some may view this scenario as akin to an impairment, in which case the remaining balance of the ROU asset on January 1, 2021, would be fully amortized on a straight-line basis over the remaining six years (i.e., the shortened useful life). This amortization profile for the ROU asset, when coupled with the interest expense on the liability (which, in the absence of an early termination of the lease, continues to be recognized by using an effective interest method throughout the entire remaining lease term), will result in a front-loaded expense profile in a manner similar to that for a finance lease. Others believe that, in the absence of an impairment, S should be allowed to retain an overall straight-line expense profile for the period between the (1) date on which a decision is made regarding the abandonment and (2) actual abandonment date. This would be accomplished by “plugging” the ROU asset amortization amount in each period to achieve an overall straight-line expense recognition profile from January 1, 2021, through January 1, 2027, while ensuring that the ROU asset is fully amortized by that date.

We generally believe that a lessee in an operating lease should only be forced to lose overall straight-line expense recognition in the case of an impairment based on ASC 842-20-25-6. While neither of the approaches described above retains a straight-line expense profile over the full remaining term of the lease, the second approach allows the continuation of straight-line treatment (albeit at a higher amount than that in year 1) through the remaining useful life of the ROU asset. However, given the lack of explicit guidance addressing a planned abandonment scenario, we would accept either of the amortization approaches described in the preceding paragraph.

We are aware that, in practice, there are different views on the accounting implications of a planned abandonment; we therefore encourage affected entities to consult with their auditors and accounting advisers regarding this matter. Geoff Griffin, then a professional accounting fellow in the SEC’s Office of the Chief Accountant, addressed this topic in a speech at the 2020 AICPA Conference on Current SEC and PCAOB Developments. Mr. Griffin stated, in part:

Consider a fact pattern where the registrant identified leases for abandonment, but expected there to be an extended period of time between the identification of abandonment and the actual abandonment date. The registrant noted that the leases standard requires a lessee to recognize any impairment loss for a right-of-use asset in accordance with existing guidance on impairment or disposal of long-lived assets; however, upon performing an impairment assessment of the asset group, the registrant concluded there was no impairment. In this fact pattern, the registrant’s identification of specific leases for abandonment did not result in a change to the asset group (i.e., the lowest level of identifiable cash flows) for which it assessed impairment.

The registrant noted that the leases standard did not provide explicit guidance to address its unique circumstances. The registrant identified a number of alternatives that it believed could be acceptable but ultimately concluded that it would be appropriate to adjust the amortization period of the right of use assets associated with the leases identified for abandonment. Given its plans to abandon these leases, and in the absence of any impairment, the registrant re-evaluated the economic life of the associated right-of-use assets and determined that the remaining right-of-use assets should be amortized ratably over the period between identification of abandonment and the actual abandonment date.

The staff did not object to the registrant’s conclusion. [Footnote omitted]

We assume that in the consultation discussed above, it is appropriate for the lessee to consider the lease abandoned. As discussed above, we generally believe that a lessee can conclude that a lease will be abandoned when it will no longer use the asset and does not have the intent and ability to sublease it.

We believe that, as illustrated in Mr. Griffin’s speech and Example 8-17, the remaining life of the ROU asset should be revised (i.e., shortened) in such circumstances. We would accept different approaches to amortizing the ROU asset over the shortened useful life, including the ratable approach described in Mr. Griffin’s speech. Example 8-17 describes what we believe is another acceptable approach that allows for retention of an overall straight-line expense profile for the remaining life of the ROU asset.

8.4.4.2 Considerations Related to the Impairment of an ROU Asset

Under ASC 842, since operating and finance leases are both recorded on a lessee’s balance sheet, the ROU assets associated with both types of leases are subject to the impairment guidance in ASC 360-10-35. That is, when events or changes in circumstances indicate that an ROU asset’s carrying amount may not be recoverable (i.e., impairment indicators exist), an ROU asset (or asset group that includes the ROU asset, referred to interchangeably throughout as an “ROU asset”) should be tested to determine whether there is an impairment.

As discussed above, the impairment test is a two-step process. Because a lessee is required to (1) recognize lease liabilities and ROU assets related to finance leases and operating leases under ASC 842 and (2) subject ROU assets related to both finance leases and operating leases to impairment testing under ASC 360-10, questions have arisen regarding how a lessee should consider the respective lease liability in determining the carrying value and undiscounted expected future cash flows of the asset group when testing ROU assets for impairment.

8.4.4.2.1 Unit of Account for Impairment Testing — Asset Group/Lease Component Considerations Related to Subleasing a Portion of a Larger ROU Asset

As described above, an impairment loss is evaluated, recognized, and measured at the asset group level. A lessee must reassess its identified asset group when there are significant changes in the facts and circumstances associated with how the asset or assets in the asset group are used (as opposed to when management decides to change how they are used). Changes in facts or circumstances that may result in the need to reevaluate an asset group include:

The lessee changes how it is using the underlying asset within its business.
The lessee executes a sublease of the underlying asset.

In this respect, a lessee must carefully consider the impact of executing a sublease of a property or a portion of a property in the context of the asset group determination. Specifically, when a head lessee/intermediate lessor subleases a property or a portion of a property, the determination of the asset group for ROU asset impairment testing could be affected (i.e., the sublease of the property or a portion of the property may now meet the definition of an asset group).

In addition to asset group considerations, a head lessee’s/intermediate lessor’s sublease of a portion of a larger asset (e.g., one floor of a 10-floor office building) may indicate that the subleased portion of the larger asset should be treated as a separate lease component in the head lease. This would be the case irrespective of whether the various lease components in the contract were formally identified and separated into separate lease components at the inception of the lease. For example, assume that the head lessee/intermediate lessor initially accounted for the 10-floor building lease as a single lease component or unit of account and, accordingly, recorded one ROU asset and lease liability for the arrangement. We believe that the head lessee in a sublease arrangement should generally reconsider whether the subleased asset should be deemed a separate lease component under the head lease upon the execution of the sublease. As a result, to apply the appropriate accounting, an entity may need to allocate the ROU asset and lease liability to two or more separate lease components (e.g., the ROU asset and lease liability may need to be bifurcated between the subleased asset and the remaining portion of the initial ROU asset).

If, after revisiting the asset group or reevaluating the lease components in a contract, an entity determines that the property (or a portion of the property subject to a sublease) represents a separate asset group, it may then be subject to an ASC 360 impairment assessment since, in accordance with ASC 360-10-35-21, such a change could represent “[a] significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used.” In this scenario, the impairment analysis may need to be performed at the level of the individual ROU asset (if the underlying property is subleased or ceases to be used).

When a lessee subleases a discrete portion of a larger asset, the lessee’s reconsideration (as the head lessee/intermediate lessor) of the following may be warranted under the head lease: (1) the asset group for purposes of testing the ROU asset for impairment under ASC 360 and (2) whether there should be a separate ROU asset for the subleased portion of the larger asset (i.e., whether there is more than one lease component in the head lease).

Example 8-18

A lessee has an existing lease for 10 floors in an office building, which was classified as an operating lease. The lessee subsequently subleases one of the 10 floors to a third party. The sublease is also classified as an operating lease, and the head lessee/intermediate lessor is not relieved of its primary obligation under the head lease with respect to the subleased floor. Upon entering into the head lease, the lessee assumed that the unit of account for recognition of the lease liability and ROU asset was one asset encompassing all 10 floors in the office building. That is, the lessee accounted for the leased asset as one lease component but did not specifically evaluate whether there were one or more lease components, because accounting for the lease would not have differed in this case if multiple lease components had been identified. (See Section 4.2 for additional information related to the identification of lease components.) Because the unit of account is critical to determining an impairment under ASC 360 and allocating consideration under ASC 842, a head lessee/intermediate lessor that subleases a portion of a larger asset should consider whether (1) the subleased asset (one floor) would qualify as its own asset group for impairment testing and (2) the subleased asset should be treated as a separate lease component.

The criteria for assessing asset groups for the ASC 360 impairment test differ from those for identifying separate lease components under ASC 842. The identification of an asset group focuses on separately identifiable cash flows that are largely independent of the cash flows of other groups of assets and liabilities. The identification of separate lease components is based on whether an entity meets the two criteria in ASC 842-10-15-28 related to (1) economically benefitting from the right of use on its own or together with other, readily available, resources and (2) whether the right of use is separately identifiable (see Section 4.2.1).

Changing Lanes

Lease Impairment Considerations

The requirements in ASC 842 for the impairment assessment of finance lease ROU assets are consistent with those for capital leases under ASC 840. However, the amounts that will ultimately be factored into the determination of the ROU asset may differ under ASC 842 since the guidance on this topic in ASC 842 differs from that in ASC 840 in certain respects (e.g., the ROU asset may be greater under ASC 842 because of the allocation between lease and nonlease components/executory costs). The difference between the carrying amount of the ROU asset under ASC 842 and that of the capital lease asset under ASC 840 may therefore have an impact on the overall carrying amount of the asset group as a whole and, in turn, may affect an impairment analysis.

In addition, ASC 842 introduces the concept of an operating lease ROU asset. Under ASC 840, operating leases were accounted for off the balance sheet in a manner similar to executory contracts and therefore were subject to the guidance in ASC 420. Specifically, rather than applying an ASC 360 impairment model, an entity recognized any costs related to terminating an operating lease, if certain criteria were met, in accordance with ASC 420 (i.e., the costs and a related liability were recognized as the difference between the remaining lease costs to be paid by the lessee, offset by the anticipated sublease income).

ASC 842 has eliminated the operating-lease-related guidance in ASC 420, instead requiring that a lessee use the ASC 360 impairment model to evaluate its ROU assets for impairment. This is a notable difference from the ASC 840 requirements in that rather than recognizing an operating lease termination cost on a lease-by-lease basis (when necessary), a lessee is required to apply the ASC 360 long-lived asset impairment guidance at an asset group level. Therefore, an impairment charge could potentially be recognized for an ROU asset even if there are no impairment indicators at the ROU asset level (as would be the case when an impairment is allocated to all assets in the asset group).

Connecting the Dots

Applicability of ASC 420 to Nonlease Components

As discussed above, after the adoption of ASC 842, operating leases are no longer within the scope of ASC 420 on exit or disposal cost obligations; rather, lessees must use the ASC 360 impairment model to evaluate their ROU assets for impairment. ASC 420-10-15-3, as amended, states that the scope of ASC 420 includes “[c]osts to terminate a contract that is not a lease.” Therefore, questions have arisen regarding whether nonlease components within a contract that also contains one or more lease components should continue to be evaluated under ASC 420 after the adoption of ASC 842. Since ROU assets subject to the guidance in ASC 360 are related only to the lease component(s) in a contract, we believe that the amended scope of ASC 420 is only intended to exclude the lease component(s) and that lessees should therefore continue to evaluate any nonlease components under ASC 420 if they have not elected the practical expedient described in ASC 842-10-15-37. See Section 4.3.3.1 for a detailed discussion of this practical expedient offered to lessees. For entities that have elected this practical expedient not to separate lease and nonlease components and instead account for both lease and nonlease components as a single lease component, all costs associated with the contract would be considered outside the scope of ASC 420 as outlined in ASC 420-10-15-3.

The example below from ASC 842-20-55-48 through 55-51 illustrates the impairment of an ROU asset in an operating lease.

ASC 842-20

55-47 Example 5 illustrates impairment of a right-of-use asset.

Example 5 — Impairment of a Right-of-Use Asset in an Operating Lease

55-48 Lessee enters into a 10-year lease of a nonspecialized asset. Lease payments are $10,000 per year, payable in arrears. The lease does not transfer ownership of the underlying asset or grant Lessee an option to purchase the underlying asset. At lease commencement, the remaining economic life of the underlying asset is 50 years, and the fair value of the underlying asset is $600,000. Lessee does not incur any initial direct costs as a result of the lease. Lessee’s incremental borrowing rate is 7 percent, which reflects the fixed rate at which Lessee could borrow the amount of the lease payments in the same currency, for the same term, and with similar collateral as in the lease at commencement. The lease is classified as an operating lease.

55-49 At the commencement date, Lessee recognizes the lease liability of $70,236 (the present value of the 10 lease payments of $10,000, discounted at the rate of 7 percent). Lessee also recognizes a right-of-use asset of $70,236 (the initial measurement of the lease liability). Lessee determines the cost of the lease to be $100,000 (the total lease payments for the lease term). The annual lease expense to be recognized is therefore $10,000 ($100,000 ÷ 10 years).

55-50 At the end of Year 3, when the carrying amount of the lease liability and the right-of-use asset are both $53,893, Lessee determines that the right-of-use asset is impaired in accordance with Section 360-10-35 and recognizes an impairment loss of $35,000. The right-of-use asset is part of an asset group that Lessee tested for recoverability because of a significant adverse change in the business climate that affects Lessee’s ability to derive benefit from the assets within the asset group. The portion of the total impairment loss for the asset group allocated to the right-of-use asset in accordance with paragraph 360-10-35-28 is $35,000. After the impairment charge, the carrying amount of the right-of-use asset at the end of Year 3 is $18,893 ($53,893 – $35,000). Because of the impairment, the total expense recognized in Year 3 is $45,000 ($10,000 in lease expense + the $35,000 impairment charge). Beginning in Year 4, and for the remainder of the lease term, the single lease cost recognized by Lessee in accordance with paragraphs 842-20-25-6(a) and 842-20-25-7 will equal the sum of the following:

Amortization of the right-of-use asset remaining after the impairment ($18,893 ÷ 7 years = $2,699 per year)
Accretion of the lease liability. For example, in Year 4, the accretion is $3,773 ($53,893 × 7%) and, in Year 5, the accretion is $3,337 ($47,665 × 7%).

55-51 Consequently, at the end of Year 4, the carrying amount of the lease liability is $47,665 (that is, calculated as either the present value of the remaining lease payments, discounted at 7 percent, or the previous balance of $53,893 – $10,000 Year 4 lease payment + the $3,773 accretion of the lease liability). The carrying amount of the right-of-use asset is $16,194 (the previous balance of $18,893 – $2,699 amortization). Lessee measures the lease liability and the right-of-use asset in this manner throughout the remainder of the lease term.

The amortization schedule and related journal entries below have been calculated on the basis of the facts in the example above.

8.4.4.2.1.1 Asset Group Considerations

When a head lessee/intermediate lessor subleases a portion of a larger asset, the determination of the asset group for ROU asset impairment testing could be affected. If events or changes in circumstances indicate that the carrying amount of an ROU asset may not be recoverable (see ASC 360-10-35-21), a head lessee/intermediate lessor will assess the head lease ROU asset for impairment. A lessee is required to apply the guidance in ASC 360 on impairment of long-lived assets at an asset group level. The ASC master glossary defines an “asset group” as follows:

[T]he unit of accounting for a long-lived asset or assets to be held and used, which represents the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities.

The guidance in ASC 360 on impairment focuses on “identifiable cash flows” that are “largely independent,” including both cash inflows and cash outflows. Since a head lessee (lessor under the sublease) will receive separate cash flows under the sublease, the head lessee should consider whether the subleased portion of the larger asset represents its own asset group for impairment testing purposes. In doing so the head lessee will also need to consider whether the cash outflows due under the head lease (e.g., rent, CAM, taxes) are separately identifiable for the subleased portion of the larger asset. Therefore, when the sublease is executed, the determination of the original asset group should be revisited. In determining whether cash outflows are separately identifiable, an entity should use judgment and consult with its accounting advisers.

The assessment of whether the asset group is the subleased portion of the leased asset or the larger asset is important because a conclusion that the asset group is the subleased portion may be more likely to result in an impairment. Further, once an ROU asset related to an operating lease is impaired, a lessee can no longer recognize lease expense on a straight-line basis in its income statement in accordance with ASC 842-20-25-7. Rather, the single lease expense profile for the impaired ROU asset will become “front-loaded” in a manner similar to the treatment of a finance lease. For further discussion of ROU asset impairment, see Deloitte’s Roadmap Impairments and Disposals of Long-Lived Assets and Discontinued Operations.

8.4.4.2.1.2 Considerations Related to the Lease Component

A head lessee’s/intermediate lessor’s sublease of a portion of a larger asset (e.g., one floor of a 10-floor office building from the example above) may indicate that the subleased portion of the larger asset should be treated as a separate lease component in the head lease. Assume that the head lessee/intermediate lessor in the above example initially accounted for the 10-floor building lease as a single lease component or unit of account and, accordingly, recorded one ROU asset and lease liability for the arrangement. We believe that the head lessee in a sublease arrangement should generally reconsider whether the subleased asset should be deemed a separate lease component under the head lease. As a result, there could be two separate lease components and corresponding ROU assets and liabilities (i.e., for both the subleased asset and the remaining portion of the initial ROU asset). It is important for an entity to determine the appropriate unit of account when applying the lessee or lessor accounting model in ASC 842, since implications include, but are not limited to, the allocation of consideration to the components in the contract. See Chapter 4 for additional information on components of a contract.

8.4.4.3 ROU Assets That Are Held for Sale

A disposal group includes all long-lived assets, including ROU assets, expected to be disposed of as a group through a sale. An ROU asset would be considered held for sale when the disposal group meets the held-for-sale criteria in ASC 360-10-45-9. That is, an ROU asset can be considered “held for sale” if (1) the lease is part of a disposal group for which it is expected that the purchaser will assume the lease as part of the purchase of the group or (2) the entity has initiated a “plan” under which it is identifying a third party to assume (acquire) the related lease so that the entity can be relieved of being the primary obligor under the lease. An ROU asset is not considered held for sale when the entity intends to sublease the underlying property.

8.4.4.3.1 Amortization Considerations

A lessee should not continue to amortize an ROU asset that is characterized as “held for sale.” ASC 842 amended ASC 360-10-15-4 to clarify that ROU assets of lessees are within the scope of the guidance pertaining to the impairment or disposal of long-lived assets, including the accounting for assets held for sale. Therefore, when a long-lived asset (or disposal group) is characterized as held for sale, the amortization of the ROU asset should cease in accordance with ASC 360-10-35-43, which states:

A long-lived asset (disposal group) classified as held for sale shall be measured at the lower of its carrying amount or fair value less cost to sell. If the asset (disposal group) is newly acquired, the carrying amount of the asset (disposal group) shall be established based on its fair value less cost to sell at the acquisition date. A long-lived asset shall not be depreciated (amortized) while it is classified as held for sale. Interest and other expenses attributable to the liabilities of a disposal group classified as held for sale shall continue to be accrued. [Emphasis added]

Further, this conclusion is not affected by the lease’s classification as either operating or finance. That is, for both types of leases, a lessee should stop amortizing the ROU asset at the point when the ROU asset is classified as held for sale. With respect to operating leases, this conclusion applies even though the lessee recognizes a single lease cost within operating expenses, since ROU asset amortization is a component of the single lease cost.

The resulting accounting impact on finance and operating lease ROU assets, respectively, would be that (1) the amortization of the finance lease ROU asset would cease and only the interest cost would be recognized going forward and (2) the amortization of the operating lease ROU asset would cease and only the liability accretion (interest cost) would be recognized as the single lease cost. For operating leases, the straight-line lease expense profile is no longer applicable; rather, the expense profile related to the interest cost while the ROU asset is held for sale would be similar to that of an impaired ROU asset as discussed above.

ASC 360-10-45-6 indicates that if circumstances change and an entity no longer plans to dispose of a long-lived asset (or disposal group), the asset would be reclassified from “held for sale” back to “held and used.” Further, ASC 360-10-35-44 states:

If circumstances arise that previously were considered unlikely and, as a result, an entity decides not to sell a long-lived asset (disposal group) previously classified as held for sale, the asset (disposal group) shall be reclassified as held and used. A long-lived asset that is reclassified shall be measured individually at the lower of the following:

Its carrying amount before the asset (disposal group) was classified as held for sale, adjusted for any depreciation (amortization) expense that would have been recognized had the asset (disposal group) been continuously classified as held and used
Its fair value at the date of the subsequent decision not to sell.

Accordingly, ASC 360-10-35-44 requires the entity to adjust the carrying amount of the long-lived asset that is reclassified as “held and used” to the lower of (1) the asset’s fair value or (2) the asset’s carrying amount before it was classified as held for sale, adjusted for any depreciation that would have been recorded while the asset was classified as held for sale. For this adjustment to be made, there must be a catch-up of the depreciation that would have been recognized had the asset remained classified as held and used.

For both finance and operating lease ROU assets, the depreciation referred to above would equate to the ROU asset amortization not recorded while the asset was held for sale. The catch-up entry to record forgone amortization would align the ROU asset balance with what would have been recorded had the ROU asset remained classified as held and used. A normal amortization profile would then be reestablished for the ROU asset (e.g., for operating leases, a straight-line, single lease cost for the remaining lease term, provided that the ROU asset continues to be classified as held and used and has not been impaired, as discussed above).

Footnotes

The guidance in ASC 842-20-30-5(b) is applicable regardless of whether the lease incentive is paid or payable at commencement or is contingent on a future event. See Section 8.5.4.3 for our views on acceptable approaches to estimating and accounting for contingent lease incentives. To the extent that the initial recognition of a contingent lease incentive would result in a negative ROU asset, the guidance in this section would be applicable.

See ASC 842-10-15-30(b).

Although this section focuses on the accounting for a lessee’s costs incurred to compensate a third party to perform these services, we believe that the same considerations would apply to internal costs incurred by a lessee to perform these activities on its own.

Answer is rounded.

See Q&A 16-3A for a discussion of operating leases that would result in a negative ROU asset as of the date of initial application because of a large accrued rent balance.

This example contains an extreme rent escalation to highlight the issue. While we would not expect such extreme rent escalations to be common in practice, this issue does arise with certain leases, particularly leases of land with long durations (e.g., 100 years).

“Probable” is defined as the “future event or events are likely to occur,” in a manner consistent with the term’s meaning in ASC 450 on contingencies.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.