Action Plan for Lease Impairments During COVID
The new lease accounting standard ASC842 is effective for public companies beginning January 1st, 2019 with private companies scheduled to adopt one year later in 2020. Due to the pandemic, this adoption date was delayed by one year pushing it to December 31, 2021. Lease Impairment on ROU Assets and ASC842 Compliance is one of the challenges that are giving lease accounting departments an added workload to process, while creating new compliance issues to resolve, as part of the lease accounting transformation. Whether you are a lessee or a lessor, your compliance objectives remain the same – to accurately capture the lease liability calculator for each corresponding asset, so that ROU asset amortization can be accurately reported.
The primary purpose of the standard was to address the fact that most operating leases are deemed off-balance sheet financing arrangements and currently are only disclosed via a company’s financial footnotes in the “Commitments and Contingencies” footnote.
Therefore, for every identified lease, companies will be required to create a lease liability calculated as the present value of the future fixed payments and a corresponding asset (“right of use” asset). The right of use asset will be amortized over the life of the lease.
The income statement will be impacted by a straight-line lease expense item that would essentially contain an interest component with the amortization of the asset being the plug-in order to achieve straight-line lease expense over the life of the lease.
Impairment under ASC842
An asset impairment arises when there is a sudden drop in the fair value of an asset below its recorded cost. The accounting for asset impairment is to write off the difference between the fair value and the recorded cost. Some impairments can be so large that they cause a significant decline in the reported asset base and profitability of a business.
Impairment only occurs when the amount is not recoverable. This happens when the carrying amount exceeds the sum of the undiscounted cash flows expected to result from the use of the asset over its remaining useful life and the final disposition of the asset. The bulk of these cash flows are usually derived from the subsequent use of the asset, since the disposition price may below.
A lessee’s right-of-use asset is subject to the same asset impairment guidance in ASC 360 applied to other elements of property, plant, and equipment. There are two types of impairment from the lessee scenarios: finance and operating leases.
Impairment-finance leases (lessee)
If a lessee records an impairment charge on a right-of-use asset associated with a finance lease, it should revise the amortization expense by calculating a new straight-line amortization based on the revised asset value.
Impairment — operating lease (lessee)
The amortization of an operating lease right-of-use asset generally increases over the lease term. As a result, throughout the lease term, the net book value of a right-of-use asset resulting from an operating lease is typically greater than it would have been having the lease been classified as a finance lease.
Because of this higher value, a right-of-use asset arising from an operating lease may have a higher risk of impairment.
If there is an impairment charge for a right-of-use asset associated with an operating lease, it would not impact the value of the recorded lease liability absent a modification to the lease terms or a reassessment of options to renew.
An impairment resulting from market-based factors that are not within the lessee’s control is not, in itself, a trigger for the lessee to reassess the lease term or an option to purchase the underlying asset.
Once the right-of-use asset for an operating lease is impaired, lease expense will no longer be recognized on a straight-line basis. A lessee should continue to amortize the lease liability using the same effective interest method as before the impairment charge. The right-of-use asset, however, should be subsequently amortized on a straight-line basis. The resulting accounting is similar to the accounting a lessee would apply to a finance lease, however, the lease is still classified as an operating lease, and a lessee should continue to follow operating lease presentation and disclosure guidance.
Tips for assessing your ROU assets for impairment
1) Determine a schedule for assessment. Many companies perform fixed assets impairment every two years or at a minimum, every five years. It may be necessary to do more regular assessments based on market factors or industry-specific factors.
2) It is necessary to test assets for impairment at the lowest level at which there are identifiable cash flows that are largely independent of the cash flows of other assets. In cases where there are no identifiable cash flows at all (as is common with corporate-level assets), place these assets in an asset group that encompasses the entire entity, and test for impairment at the entity level.
3) If there is an impairment at the level of an asset group, allocate the impairment among the assets in the group on a pro-rata basis, based on the carrying amounts of the assets in the group. However, the impairment loss cannot reduce the carrying amount of an asset below its fair value.
4) Under no circumstances is it allowable to reverse an impairment loss under US GAAP.
Lease Impairment on ROU assets and ASC842 Compliance
The Service Funnel test, helps us to identify risk, as well as to understand where lease impairment interpretation may require further guidance, requiring technical accounting expertise.
Why?
The Covid-19 impact on impairment is significant, given the changes to fair market value (FMV) on both Real Estate leases as well as high-end Equipment leases, requiring an in-depth analysis on determining if the impairment assessment schedule is still valid during covid. Depending upon asset value differentiation, companies may be looking to re-assess asset valuations in part due to Covid impact – specifically commercial real estate leases, which have experienced massive declines in valuation during the pandemic. If you look at the service funnel, it is comprised of 7 unique service requirements, which in unison make up a compliant ROU asset.
Lease Impairment considerations:
- Immediate Lease Compliance: Is the present value of the asset in line with FMV? Has the asset been recently assessed to accurately reflect lease liability over the life of the lease? Is the straight-line expense, based on current interest and amortization, relevant?
- Critical Date Notifications: When was the asset valuation last assessed? Has the difference between the recorded coast and FMV been calculated?
- Lease Administration: Are your leas(es), finance, or operating? Is your lease impairment recoverable? Do you know your asset assessment date? Knowing these dates is critical to achieving lease compliance and not overpaying for either your interest or amortization costs. Having the proper controls, based on a service with a firm like Leaseology, is critical to staying on top of your lease administration needs.
- Disclosures Reporting: Are your expenses current and accurately captured and reflective in your compliance reporting? – Onboarding onto a Lease Management solution includes a deep technical accounting review, to ensure that assets are currently in their valuations and that your straight line expenses over the life of the lease will survive an audit.
- Technical Accounting: To stay on top of your enterprise lease accounting requirements, you must understand the EBITDA impact of your compliance reporting initiative as well as ensure that you are properly accounting for your lease in the most financially effective manner. Technical accountants are rare, but worth their weight in gold. Ensure that you have a technical accountant reviewing your leases and disclosure statements.
- Lease Negotiation: Are your leased assets at FMV? Have you reassessed your assets during the pandemic? The purpose of lease accounting is to protect your assets, validate costs/expenses and achieve compliance.
- Document Management: It is critical to the compliance effort to know your FMV of your leased assets as well as to have accuracy on your income statement. Having a centralized document management platform is a key benefit for tracking and executing your organization’s lease compliance objectives. A true repository for your business will help uncover evergreen leases, undervalued assets and provide reporting accuracy. Evergreen leases are where companies continue with automated payments, long after an asset has expired/been paid off – simply out of lack of asset visibility, commonly due to lack of a centralized document management platform. Having a service to provide this is one of the many benefits of a managed service, such as Leaseology.
In response to the ASC842/IFRS16/GASB87 compliance mandate, due at the end of 2021, customers do not have the time to develop RFP’s, research solution
The bulk of the post compliant lease accounting work effort lies in the ongoing maintenance of disclosure reporting. To quote a 10B global accounting firm on Disclosure Statement objectives:
FASB Accounting Standards Codification (ASC) 842-20-50-1 and 842-30-50-1 provide that “the objective of the disclosure requirements is to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases.” The standard further indicates that “a lessee [lessor] shall consider the level of detail necessary to satisfy the disclosure objective and how much emphasis to place on each of the various requirements. A lessee [lessor] shall aggregate or disaggregate disclosures so that useful information is not obscured by either the inclusion of a large amount of insignificant detail or by aggregating items that have different characteristics.”
What is the biggest risk of impairment on ASC842 Compliance:
Know is the optimal time to be renegotiating real estate leases, as the market has been hammered by Covid induced rent concessions, as well as the shelter in place impact on office space. Having Lease Accounting as a service, can provide immediate visibility into lease dates and help you avoid missing out on a cost-saving negotiation.
Let the experts help you, Leaseology has a subscription model that achieves compliance and removes risk, schedule a free assessment of your most complex leases now – the clock is ticking.
Ken Royce * Leaseology Inc * Board of Directors
ABOUT Leaseology Inc|
Leaseology, Inc is a North America-based business advisory services firm committed to accelerated marketplace adoption of digital technology, financial management innovation, and business operations practice excellence. These core competencies apply to real estate and equipment portfolios.
