Adopting Accounting Standards Codification (ASC) 842, Leases, introduces new considerations for companies with leases. One such complex consideration is accounting for the potential impairment of right-of-use (ROU) assets, particularly in scenarios involving subleases.
While offices have reopened since the pandemic forced tens of millions of people to work from home in 2020 and 2021, many employees continue to work remotely, and vast amounts of office space are left unused. Companies may reevaluate their real estate needs and decide they don't need the same amount of space they used to occupy.
Companies that sublease some or all of their unused space must consider whether this change triggers the need to reevaluate the asset group related to the ROU asset and an impairment of the ROU asset.
Understanding ROU assets
ROU assets represent a lessee's right to use an underlying asset for the lease term. In other words, the lessee has the right to obtain economic benefit from using an asset owned by another entity (the lessor).
This accounting concept, introduced by ASC 842, has significantly changed how entities account for leases. When a lessee subleases a part or all of a leased asset, it introduces another layer of complexity to the accounting process.
Subleases and their impact on asset groups and impairment analysis
Let's consider an example of how subleases can complicate lease accounting and the impact on the impairment analysis.
Say a company signs a 10-year lease for a three-story building. They initially accounted for the lease as a single ROU asset, as there was no perceived accounting effect at the time. The company determines it doesn't need all three floors three years into the lease and decides to sublease one floor.
The company should now consider whether deciding to sublease one floor indicates that the lease contains more than one component—two floors used in its operations and one sublet to a tenant—and the proper asset grouping for any separated ROU assets.
In addition, depending on the significance of the new sublease component, the company will need to consider whether they have a "triggering event" resulting from either:
- A change in the way the ROU asset will be used, or
- The likelihood of incurring a loss on the sublease.
When a triggering event for impairment occurs, ASC 360-10, Impairment or Disposal of Long-Lived Assets, requires the ROU asset to be tested for impairment.
In isolation, a decision to sublease or a plan to abandon may not require a reassessment of an asset grouping, particularly if the lessee continues to use the underlying asset substantially in the same manner for a period after the decision. In other words, if the level of identifiable cash flows has not yet materially changed, they may not need to reassess the asset grouping at the time they decide to sublease. However, if the sublease is loss-making, it may indicate that impairment exists and would need to be calculated and recorded on the decision date.
Test for recoverability
If a triggering event has occurred, ASC 360 requires long-lived assets to be grouped with other assets and liabilities based on identifiable and largely independent cash flows. In sublease scenarios, lessees should reassess their asset grouping, considering changes in the usage of the ROU asset. Cash flows from subleases are considered largely independent, prompting a reassessment of whether the subleased portion constitutes its own asset group for impairment testing.
While ASC 360 guides the evaluation of long-lived assets for impairment, it does not explicitly direct lessees on handling operating lease liabilities in the recoverability test. Financial liabilities are typically excluded from an asset group, whereas operating liabilities linked to a specific asset are included.
Operating lease liabilities, being more operational in nature, may be included in the cash flows used for the recoverability test based on the organization's policy election, which must consistently apply in impairment calculations.
Calculating Impairment
If the undiscounted cash flows are less than the carrying amount, it signifies impairment, and the lessee must determine the impairment loss. Calculating this loss involves comparing the ROU asset or asset group's fair value to the carrying amount.
Fair value is what a market participant would pay in an upfront, one-time payment for the remaining lease term for its highest and best use (even if that use differs from its current or intended use). Determining fair value and highest and best use often requires input from a specialist.
Go-forward Accounting
Once the ROU asset for an operating lease is impaired, lease expense will no longer be recognized on a straight-line basis. The company should continue to amortize the lease liability using the same effective interest method as before the impairment charge. The ROU asset, however, should be subsequently amortized on a straight-line basis for the remainder of the lease.
The CBIZ ARC Advantage
Accounting for subleases and the impairment of ROU assets is a critical aspect of financial reporting, ensuring that an entity's financial statements accurately reflect its financial position. This requires a meticulous approach in sublease scenarios, considering the intricate interplay between the head lease and the sublease. By understanding the mechanics of impairment analysis and employing best practices, entities can confidently navigate this complex terrain.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
