On the Radar
The Current Macroeconomic Environment
The current macroeconomic environment has created ongoing
challenges and uncertainty in various areas of accounting, including the
accounting for leases. For example, the U.S. 30-year fixed mortgage rate has
nearly doubled since 2016, the year in which ASC 842 was issued.1
Many commercial real estate entities have encountered increased
costs of capital and tightening lending standards while also dealing with higher
levels of maturing debt; reductions in the volume of real estate transactions;
and evolving real estate demands and preferences related to the way people work,
live, and shop. The actual impact of the current macroeconomic environment on
commercial real estate assets will differ on the basis of various factors,
including geographic location, tenant-specific operations, and in-place lease
terms. Commercial real estate entities, including real estate owners, operators,
and developers, should continually monitor, evaluate, and update their
lease-related accounting and reporting.
Evolution of Technology Use and the Need for More Power
More and more companies are leveraging artificial intelligence
(AI) to enhance internal productivity or are incorporating generative AI into
their revenue-generating products. Advancements in technology have led to rising
demand for computing power.2 To fulfill this demand, many technology companies have significantly
expanded their data center footprints, leading to a rise in leasing transactions
both for data center space and the hardware housed within it. Some of these
transactions may also be contracted as service arrangements in which a supplier
agrees to provide a specified level of computing capacity to its customer. In
such cases, companies should carefully evaluate a service arrangement that
involves the use of PP&E to determine whether the arrangement contains a
lease.
Demand for electricity to power the surge in AI hardware investments has
similarly led to a high volume of transaction activity in the power and
utilities sector, including the development of new power generation facilities
across the United States to meet regional demand. Given the current
macroeconomic environment, many companies in the sector have entered into
complex transactions to finance these projects, including sale-and-leaseback
transactions, build-to-suit arrangements, and synthetic leases (e.g., a lease
arrangement in which a significant portion of the lease payments is structured
as a residual value guarantee, typically resulting in lower ROU asset and lease
liability balances compared with leases with fixed rental payments). Because the
accounting for such arrangements can be challenging, companies involved in these
types of transactions should consider consulting with their accounting advisers
and should continue to monitor developments related to these topics.
Lease Accounting Hot Topics
Real Estate Rationalization
Entities in almost every industry sector continue to
reevaluate how they are doing business as well as the impact of their
ever-evolving business strategies on their brick-and-mortar real estate
needs. For instance, certain entities in the retail sector have shifted from
brick-and-mortar stores to online shopping. Moreover, such entities have
been considering where their employees conduct their required business
activities and to what extent brick-and-mortar real estate assets will be
needed for such activities on a go-forward basis. Specifically, many
entities continue to undertake real estate rationalization programs to
determine their appropriate organization-wide real estate footprint. The
goal of initiating such programs may be for entities to right-size their
real estate portfolios to manage costs while adequately supporting their
business needs.
In addition to adjusting to the evolving macroeconomic
environment, entities continue to refine their hybrid-work approaches. While
vacancy rates for office properties in certain areas may have been higher a
couple of years ago because more professionals were allowed to spend a
greater percentage of their time working from home, many entities are now
expecting their employees to work more days in the office, emphasizing the
importance of collaboration.
Entities continue to reassess their real estate footprint and adjust their
real estate portfolios. Some entities are moving to different-sized spaces
in the same geographical area, while others are changing the amount of space
they are leasing in their current location. As a result, such entities are
often abandoning properties, subleasing space they are no longer using, or
modifying existing leases to change the amount of space or the lease term.
Further, as a financing method to improve their liquidity, entities are
increasingly entering into sale-and-leaseback transactions involving real
estate. As a result of these real estate rationalization efforts, companies
are also more frequently evaluating leases for impairment. Each of these
topics is addressed below and within this publication.
See Deloitte’s March 30, 2021,
Accounting Spotlight and May
22, 2023, Financial Reporting
Alert for further details on the
impact of real estate rationalization and commercial
real estate macroeconomic trends, respectively, on
an entity’s lease accounting.
Impairment and Abandonment
The right-of-use (ROU) assets recorded on a lessee’s
balance sheet under ASC 842 are subject to the ASC 360-10 impairment
guidance applicable to long-lived assets. When events or changes in
circumstances indicate that the carrying amount of the asset group may
not be recoverable (i.e., impairment indicators exist), the asset group
should be tested to determine whether an impairment exists. The decision
to change the use of a property subject to a lease could be an
impairment indicator. See Section 8.4.4 for more information
about the two-step impairment process.
Although the existence of an impairment indicator would
not itself be a reason for a lessee to reevaluate the lease term for
accounting purposes, an entity should consider whether any of the
reassessment events in ASC 842-10-35-1 have occurred simultaneously with
the impairment indicator. See Section 5.4.1.2 for further
discussion of the relationship between these concepts.
The guidance in ASC 360-10 on accounting for abandoned
long-lived assets also applies to ROU assets. 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 but still has a
contractual obligation under the underlying lease, the lessee needs to
evaluate whether the ROU asset has been or will be abandoned.
Abandonment accounting only applies when the underlying property subject
to a lease is no longer used for any business
purposes, including storage. If the lessee intends to use the space at a
future time or retains the intent and ability to sublease the property, abandonment
accounting would be inappropriate.
Common
Pitfall
We have seen some companies
assert that they are abandoning the property, even
though it is only temporarily idled, or that they
may still be using it for minor operational needs
or may have the intent and ability to sublease it.
Under these circumstances, abandonment accounting
would not be appropriate. An entity may need to
use significant judgment in evaluating whether
abandonment has occurred, and a high bar has been
set for concluding that a property has been
abandoned.
In our experience, establishing management’s intent
regarding subleasing involves judgment and depends on various facts and
circumstances, such as the remaining lease term, the nature of the
property, and the level of demand in the rental market. For example, it
may be reasonable to conclude that an ROU asset is subject to
abandonment accounting when the remaining lease term is shorter and the
rental market is, and is expected to remain, weak. On the other hand, it
may be more challenging to conclude that management has forgone the
opportunity to sublease the property if the remaining lease term is
longer, given the increased uncertainty about the level of demand in the
rental market over a longer time horizon. It may be particularly
difficult to reach such a conclusion in an environment in which there
are significant economic uncertainties that may affect the real estate
strategy of other market participants going forward. There are no bright
lines regarding the duration of the remaining lease term in this
analysis, and the exercise could differ from one rental market to the
next. We would also expect specialized properties to be more difficult
to sublease than more generic properties such as retail shopping units
and office space. Entities should carefully evaluate their specific
facts and circumstances when determining whether the ASC 360 abandonment
accounting applies to the ROU asset.
Subleases
A lessee may enter into a sublease if the lessee no
longer wants to use the underlying asset but has identified a third
party to which the asset will be leased. In a sublease, the original
lease between the lessor and the original lessee (i.e., the head lease)
typically remains in effect and the original lessee becomes the
intermediate lessor. Generally, the lessee/intermediate lessor should
account for the head lease and the sublease as separate contracts and
should consider whether the sublease changes the lease term of the head
lease or its classification. The head lessor’s accounting is unaffected
by the existence of the sublease. See Chapter 12 for additional guidance
on accounting for sublease arrangements.
Modification of Existing Lease Arrangements
In the current environment, tenants may negotiate with
lessors to exit early from a leased space, decrease the amount of leased
space, or terminate the lease in its entirety. Some lessees are
modifying existing lease agreements by (1) eliminating or scaling back
office space as a result of hybrid models, (2) reducing space because of
changes in the current environment to cut or maintain costs, or (3)
expanding space as warranted in response to business needs. The
accounting for a lease modification under ASC 842 depends on whether the
modification is accounted for as a separate contract as well as the
nature of the modification.
Common
Pitfall
Many amended contracts describe
a lease amendment as an early termination. In
evaluating these types of amendments, a lessee
must determine whether the amendment is actually a
modification to reduce the lease term. If a
termination takes effect after a specified period
(even a relatively short period), the lessee still
has the right to use the leased asset for that
period. In such cases, the modification consists
of a reduction in the lease term rather than a
full or partial termination. The guidance on full
or partial terminations only applies when all or
part of the lessee’s right of use ceases
contemporaneously with the execution of the
modification (i.e., the space is immediately
vacated). As a reminder, an immediate charge to
the income statement is only appropriate when the
lease is fully or partially terminated.
Evaluation of Lease Options
When determining the lease term at lease
commencement, an entity should determine the noncancelable period of
a lease, which includes lessee renewal option periods whose exercise
is believed to be reasonably certain (and includes lessee
termination option periods when exercise is reasonably certain not
to occur). The likelihood of whether a lessee will be economically
compelled to exercise or not exercise an option to renew or
terminate a lease is evaluated at lease commencement. In performing
this assessment, an entity would consider contract-based,
asset-based, entity-based, and market-based factors (e.g., the
market rental rates for comparable assets), which may be affected by
changes in the macroeconomic environment.
A lessor would not reassess the lease term unless
the lease is modified and the modification is not accounted for as a
separate contract.
See Sections 5.2 and 5.4 for
further discussion of the impact of options on lease term.
Sale-and-Leaseback Arrangements
A sale-and-leaseback transaction is a common and
important financing method for many entities and involves the transfer
of a property by the owner (“seller-lessee”) to an acquirer
(“buyer-lessor”) and a transfer of the right to control the use of that
same asset back to the seller-lessee for a certain period.
It is important for an entity to evaluate the provisions
of any sale-and-leaseback arrangement since the contract terms may
significantly affect the accounting. For example, the seller-lessee
would not be able to derecognize the underlying asset (i.e., a failed
sale) or recognize any associated gain or loss on the sale if (1) the
contract includes a provision that grants the original owner (future
tenant) an option to repurchase the property or (2) the leaseback would
be classified as a finance lease. Rather, both parties would account for
the transaction as a financing arrangement. The below graphic outlines
key considerations related to the accounting for a sale-and-leaseback
arrangement. See Chapter 10 for more information.
Lease Collectibility
In addition to the impairment considerations described
above, lessors should be aware that net investments in leases (arising
from sales-type and direct financing leases) are subject to the CECL
impairment model, which is based on expected losses rather than
historical incurred losses. See Section 5.3 of Deloitte’s Roadmap
Current
Expected Credit Losses for further discussion of
the application of the CECL model to the net investment in the lease
(i.e., lease receivables and the unguaranteed residual asset).
Lessors with outstanding operating lease receivables
must apply the collectibility model under ASC 842-30. Entities should
apply this collectibility model in a timely manner in the period in
which amounts under the lease agreement are due. Under the ASC 842-30
collectibility model, an entity continually evaluates whether it is
probable that future operating lease payments will be collected on the
basis of the individual lessee’s credit risk. When collectibility of the
lease payments is probable, the lessor will apply an accrual method of
accounting. When collectibility is not probable, the lessor will limit
lease income to the cash received, as described in ASC 842-30-25-13.
Entities should continue to assess the impact of the current environment
when determining whether to move tenants either to or from this cash
basis of accounting as opposed to the accrual method of accounting.
Ongoing Accounting Standard-Setting Activities
Since the issuance of ASU 2016-02 several years ago, the
FASB has released various ASUs to provide additional transition relief and make
certain technical corrections and improvements to the standard. See Appendix E for details on
these ASUs.
In addition, as part of its agenda consultation process, the
FASB issued an invitation to comment (ITC) on January 3, 2025, to solicit
feedback on the Board’s future standard-setting agenda. Leasing-related items
addressed in the ITC include the following:
- For “transactions that involve (1) transfers of real estate (with a repurchase option) to a legal entity and (2) a sale and leaseback of assets,” the relationship between the variable interest entity (VIE) model in ASC 810-10 and the accounting for sale-and-leaseback transactions in ASC 842-40.
- Accounting for lease arrangements in which the lessee agrees to pay the lessor by transferring noncash consideration in the form of a share-based payment over the lease term.
Comments on the ITC are due by June 30, 2025.
The FASB is
currently performing a postimplementation review of
ASU 2016-02 and continues to evaluate stakeholder
feedback on the adoption of ASC 842. Appendix E discusses ongoing FASB activity,
including the current items on the FASB’s technical
agenda. Stay tuned for future refinements in
accounting standard setting as a result of these
initiatives.
Footnotes
1
Source for graphic: Mortgage
Rates — Freddie Mac.
2
According to Deloitte estimates, the data center
electricity demand could rise fivefold by 2035, reaching 176 GW. For
more information, see Deloitte’s article Nuclear Energy's Role in Powering Data Center
Growth.