Editor’s note: For impairment considerations related to transition, please see this previous edition: Can prior impairments or exit cost accruals impact lease transition?
Under prior lease guidance, only capital leases were recognized on balance sheet and therefore subject to the impairment guidance in ASC 360, Property, Plant, and Equipment. Operating leases were not recognized on balance sheet and therefore did not have recognized assets that would be subject to ASC 360.
Under new guidance, however, lessees will recognize virtually all leases on balance sheet. As a result, operating lease assets will also be subject to the same impairment guidance applied to finance lease assets and other property, plant, and equipment.
The inclusion of operating lease assets in asset group impairment tests can result in incremental impairment charges. In addition, companies may need to retool processes to properly apply the guidance.
Companies with smaller asset groups that experienced declines in expected cash flows may be significantly impacted by this guidance. Retailers with stores that meet the asset group definition are one example. Below we highlight some of the issues companies may need to consider.
If a company determines that an asset group is impaired, the long-lived assets, including the leased asset, should be written down to reflect the impairment. However, individual assets should not be written down below their fair value if fair value is readily determinable without undue cost and effort.
Fair value is predicated on market participant assumptions, which may differ from the company specific assumptions that were used to determine if the asset group was impaired. For example, when determining the fair value of a space used by a retail tenant, it is possible that the highest and best use of that space would be for a non-retail tenant. Lessees should also determine whether it is appropriate to consider renewal options it had not planned on exercising in its calculation of fair value.
Additionally, because the asset group includes leased assets that were not previously subject to the impairment guidance, companies may also need to consider implementing incremental processes and controls around determining fair value for those assets. To gain a better perspective, they may want to involve other business functions in this assessment, such as real estate, procurement, finance, or treasury.
The leasing standard requires that a lessee remeasure a lease liability in certain situations. While an impairment trigger will not necessarily constitute a trigger to reassess lease term and consequently remeasure the lease liability, the two are not mutually exclusive. A lessee would, for example, need to remeasure the lease liability if there was a significant event, or change in circumstance, that is within the control of the lessee that directly affects whether the company is reasonably certain to exercise a renewal option. Changes to a lease liability upon remeasurement are generally reflected in the lease asset. Therefore, separate from any potential impairment, a company may need to adjust a lease asset for a remeasurement event.
The useful life of the leased asset might need to be considered when the leased asset is impaired, as well as when there are changes to how the asset will be used. Notwithstanding, a company that plans to exit a leased space which it does not intend to sublet should not presume that the lease asset has no future value.
Specifically, the company should reconsider the useful life of the asset based on its expected use, and also determine what the expected fair value of the asset at the date of exit would be from the perspective of a market participant. Depreciation for the remaining useful life should take into account the expected fair value of the asset at the time of exit.
When considering the useful life of leasehold improvements a company should take into account its assumptions for the associated leased asset, as well as any intent to exit and/or sublease the space.
The asset impairment test requires comparing (a) the carrying amount of the asset group to (b) its expected undiscounted future cash flows, commonly known as the recoverability test. When performing the test, we believe companies may elect to either include or exclude the lease liability from the asset group.
Companies that exclude the liability, should also exclude the associated rent expense from the expected future cash outflows. Conversely, those that include the liability in the asset group, should also include the associated rent expense.
We believe companies that choose to include the associated rent expense could elect to either include the entire rent expense in the expected cash flows, or only the portion associated with repayment of the principal.
Regardless of whether a company elects to include or exclude the lease liability and associated rent expense, we believe that election is only applicable to the fixed principal payments. Variable payments which are not reflected in the lease liability should always be included in the expected future cash outflows.
While a company may initially view a leased building as a single lease component (i.e., a single lease asset), each of the floors may meet the definition of a separate lease component under the leases guidance. Accordingly, if a company exits a floor, it may be appropriate to reevaluate whether there is more than one lease component, and view the exited floor (or floors) as a separate lease component.
Further, as companies may track the cash flows associated with the exited floor, they may be required to consider the exited floor (or floors) a distinct asset group, which would be separately evaluated for impairment.
The new leases standard allows companies to account for leased assets that have similar characteristics as a portfolio, provided that the result will not be materially different.
Although the guidance allows for the portfolio approach for purposes of lease classification and initial measurement, the lease assets should not necessarily be combined for the purpose of impairment testing. Rather a company should consider which asset groups the individual lease assets should be included in.
Once a lease is impaired, the company may no longer recognize lease expense on a straight-line basis, but rather must calculate the lease expense in a manner similar to a finance lease.
Recognition of a lease asset, and its interaction with impairment guidance, creates unique application considerations.
To learn more about this topic and other emerging issues, please contact your PwC advisor. Additional information on the new leasing standard can also be found on the CFO direct lease accounting page.
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Partner, Accounting Advisory, PwC US
Partner, Valuation, PwC US
Director, National Professional Services Group, PwC US