On the Radar
On the Radar
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.
Lease Accounting Hot Topics for Entities That Have Adopted ASC 842
Real Estate Rationalization
The COVID-19 pandemic ignited a shift in how entities in
almost every industry sector are doing business. Many entities are
reevaluating where their employees conduct their required business
activities and to what extent they will rely on the use of brick-and-mortar
real estate assets on a go-forward basis. Specifically, many entities have
initiated a real estate rationalization program to reevaluate their
organization-wide real estate footprint. The goal of initiating such
programs may be for entities to rightsize their real estate portfolios to
manage costs while adequately supporting their evolving business needs. In
addition to the macroeconomic challenges and uncertainty mentioned above,
expectations related to hybrid-work approaches have led to increased vacancy
rates for office properties in certain locales.
We have also observed an increase in entities 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. Note that the accounting
considerations below apply to entities that have already adopted ASC
842.
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 the current environment given the uncertainties related to
the duration of the COVID-19 pandemic and its impact on 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 in a post-pandemic working
environment and (2) reducing space because of changes in the current
environment to cut or maintain costs. 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 lease receivables.
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 Chapter 17 for details on
these ASUs and current FASB projects.
Most recently, in March 2023, the FASB issued ASU 2023-01, which amends certain provisions of ASC 842
that apply to arrangements between related parties under common control. ASU
2023-01 allows non-PBEs, as well as not-for-profit entities that are not conduit
bond obligors, to make an accounting policy election of using the written terms
and conditions of a common-control arrangement when determining whether a lease
exists, as well as the accounting for the lease (including lease
classification), on an arrangement-by-arrangement basis. Accordingly, a non-PBE,
as well as a not-for-profit entity that is not a conduit bond obligor, that
makes this election may not be required to consider the legal enforceability of
such written terms and conditions, as described above.
ASU 2023-01 also amends the accounting for leasehold improvements in
common-control arrangements for all entities.
See Section 17.3.1.10 for more
information.
The FASB continues
to evaluate stakeholder feedback on the adoption of
ASC 842. Chapter 17
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.