On the Radar
Leases
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 Section 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. Stay tuned for future refinements in
accounting standard setting as a result of these
initiatives.
For a comprehensive discussion of the
lease accounting guidance in ASC 842, see Deloitte’s
Roadmap Leases.
Contacts
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Kristin Bauer
Audit &
Assurance
Partner
Deloitte &
Touche LLP
+1 312 486
3877
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If you are interested in Deloitte’s goodwill accounting service offerings, please
contact:
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Tim Kolber
Audit &
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Managing Director
Deloitte &
Touche LLP
+1 203 563
2693
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Audit & Assurance
Advisory Partner
Deloitte & Touche LLP
+1 615 313 4365
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Footnotes
1
Source for graphic: Mortgage Rates —
Freddie Mac.