The most significant impact of the new leases standard (ASC 842) is that lessees will recognize both a lease liability and a related asset on their balance sheet for virtually all leases. This right-of-use asset is subject to the same asset impairment guidance in ASC 360, Property, Plant, and Equipment, that is applied to other property, plant, and equipment.
Additionally, upon adoption of the new standard, companies will cease applying ASC 420, Exit and Disposal costs, to lease arrangements. Any liabilities previously recognized under that guidance in connection with leases, should be eliminated at transition by offsetting the preexisting liability against the newly recognized right-of-use asset.
As companies prepare to report for the first time under the new leases standard, they may find that legacy asset group impairments and lease exit costs can impact transition to the new standard. Below we highlight three scenarios that companies may need to consider.
Lease assets recognized under the new standard are subject to ASC 360 only at, or after, the time they are recognized on the Company’s balance sheet. That is, these lease assets should generally not attract any impairment associated with an asset group impairment that occurred in a period prior to recognition of the asset.
In some cases, however, prior to the recognition of the asset, a company may have been required to recognize an impairment under ASC 360 that exceeded the carrying value of the long-lived assets within that particular asset group. In such situations, the company would not have recognized the entire calculated impairment.
Upon transition, if the triggering event is still present, a previously unrecognized portion of the impairment should be recorded to the extent that the right-of-use asset exceeds its fair value. The offset could be recognized in either equity or as a loss.
Additionally, if an entity reduces the right-of-use asset through the recognition of an ASC 360 impairment at adoption, and the right-of-use asset is for an operating lease, then the expense profile of the lease will change after transition. Specifically, a company should no longer recognize lease expense on a straight-line basis for this lease, but should rather calculate the expense in a manner similar to a finance lease. This would result in a front-loaded pattern of expense recognition.
The Company would still present and disclose the lease as an operating lease.
Companies may for various reasons decide to cease using a particular leased asset. Prior to adoption of the new lease standard, if certain criteria were met, ASC 420 required a company to recognize a liability for the fair value of the remaining above-market lease payments.
As noted in the background section, at transition a company would derecognize any remaining ASC 420 liability through an offset to the newly recognized right-of-use asset.
If at adoption an entity reduces the right-of-use asset through the derecognition of a ASC 420 liability for an operating lease, then subsequent to adoption, the company should no longer recognize lease expense on a straight-line basis. Similar to the impact noted above, expense would be front-loaded.
As previously explained, prior to adoption of the new standard, companies that ceased use of a leased asset would recognize a liability under ASC 420. This would have been measured using the fair value of the remaining lease payments, and accordingly may include an estimate for variable costs that are subject to change, such as contingent rent.
For some companies, this variable component can be significant.
Under the new lease standard, however, variable payments are not reflected in the measurement of the right-of-use asset. Therefore, it is possible that the carrying amount of a lessee’s ASC 420 liability immediately prior to adopting the new lease standard may be greater than the amount of the lease asset that would be otherwise recognized under the new standard.
In such situations, netting the full ASC 420 liability against the right of use asset would result in a negative lease asset. Instead, we believe a company should reduce the carrying amount of the lease asset to zero, and then elect to either:
Recognition of a lease asset, and the interaction with impairment and legacy exit cost guidance, creates unique application considerations at transition. A forthcoming edition of Observations from the front lines will address additional impairment related considerations that are relevant after transition to the new standard.
Observations from the front lines provides PwC’s insight on current economic issues, our perspective regarding the financial reporting complexities, and what companies should be thinking about to effectively address those issues.
Partner, Risk Assurance - ESG, PwC US
Director, National Professional Services Group, PwC US