With companies slowly beginning to return to the office, they are most likely re-evaluating their real estate needs. Some companies will not need the same amount of space they used to occupy, as there will presumably be employee capacity limits; others may need to increase space in an effort to spread out employee placement and maintain social distancing norms. Either way, as some companies rationalize their square footage and consider subleasing some of their unused office space, they should consider, amongst other things, if this would trigger an impairment of a right of use (ROU) asset or asset group (asset).
Example: Sublease Triggering Event
Assume that a lessee originally accounts for a 10-year lease of a five-story building as a single ROU asset at the commencement of the lease. As a result of not needing all the floors, the lessee decides to sublease one of the floors in year three. At lease inception, the lessee may have accounted for the building as a single leased asset because all the floors were intended to have the same use, and there was no difference in the accounting. However, the lessee should now consider whether their subsequent decision to sublease the one floor indicates that the lease contains more than the one lease component. Assuming that the lessee determines that it now has two lease components (four floors used in their own operations and one floor subleased to a tenant), the lessee would now allocate the ROU asset and other related assets (e.g., leasehold improvements) and the corresponding lease liability based on relative stand-alone basis to each of the two components.
Furthermore, depending on the significance of this “new” sublease component, a company will need to consider whether they have a “triggering event,” resulting from either a change in the manner that the asset was to be used, or if it is likely to incur a loss on the sublease, in accordance with Accounting Standards Codification 360 Property, Plant, and Equipment (ASC 360).
ASC 360 Considerations in the Event of an Impairment
Assuming that the criteria for a triggering event is met in the example above, what’s next? In accordance with ASC 360, long-lived assets are grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent from cash flows of other assets and liabilities. As a result of executing a sublease, the lessee should now consider reassessing their asset grouping due to the change in facts and circumstances in how they will use the ROU asset (i.e., using less floors and leasing the other floor).
ASC 360 also places emphasis on “identifiable cash flows” that are “largely independent” – since the lessor under the sublease will now receive separate cash flows (rent) and may conclude these cash flows are largely independent of the cash flows of the other assets and liabilities, the lessor should consider whether the subleased portion represents its own asset group for impairment testing purposes.
After determining that an asset impairment may be triggered, a lessee must perform the recoverability test described in ASC 360 to determine whether impairment has occurred.
Test for Recoverability Under ASC 360
ASC 360 provides guidance for evaluating long-lived assets for impairment, but it does not explicitly provide guidance for lessees on how operating lease liabilities and future cash outflows for lease payments should be determined for use in the recoverability test. Under ASC 360, financial liabilities (e.g., long-term debt) are typically excluded from an asset group as they are company-wide costs and cannot normally be tied directly to a specific asset. Alternatively, operating liabilities (e.g., accounts payable and accrued expenses) generally are included in the cash flows used to test recoverability to the extent they can be tied to the specific asset.
An operating lease is typically for a specific asset, and it may be straightforward for a company to link specific cash outflows to the specific asset. In the Basis for Conclusions of Accounting Standards Update (ASU) 2016-02, the Financial Accounting Standards Board (FASB) stated that “while both types of lease liabilities are financial liabilities, finance lease liabilities are the equivalent of debt, and operating lease liabilities are not ’debt like‘ but, rather, operating in nature,” thereby providing some additional guidance on what could be included versus excluded. Once an organization has made the policy election to include or exclude an operating lease liability in the carrying value and undiscounted cash flows of the asset group that includes the ROU asset, they then must apply that policy election in the impairment calculation as described below.
If the undiscounted cash flows from the ROU asset or asset group are less than the carrying amount of the ROU asset or asset group, the ROU asset or asset group is considered to be impaired, and the lessee must determine the impairment loss amount. To calculate the impairment loss, a company should compare the ROU asset’s or asset group’s fair value to the ROU asset’s or asset group’s carrying amount.
Determining Fair Value of an ROU Asset or Asset Group
When determining the fair value of an ROU asset or asset group, a lessee should consider what a market participant would pay in an upfront, onetime payment for the remaining lease term for its highest and best use, even if that use differs from its current or intended use. For example, a tenant that currently leases space for retail use may conclude that the highest and best use of the space by market participants is for non-retail use. This valuation may require significant effort or involve the use of a specialist.
In the wake of a global pandemic, a significant number of companies may explore subleasing to better use their workspaces, considering many have adapted to a remote workforce and many employees may not want to return to an office. This culmination of factors may increase the prevalence of subleasing and may trigger the need to complete an impairment analysis.
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 The exclusion of long-term debt reflects the FASB’s decision not to allow how an entity handles their financing activities to influence an impairment