Economic factors affecting lease accounting & reporting

Entities in almost every industry sector continue to reevaluate how they are doing business as well as the impact of their ever-evolving business strategies on their brick-and-mortar real estate needs. For instance, certain entities in the retail sector have shifted from brick-and-mortar stores to online shopping. Moreover, such entities have been considering where their employees conduct their required business activities and to what extent brick-and-mortar real estate assets will be needed for such activities on a go-forward basis. Specifically, many entities continue to undertake real estate rationalization programs to determine their appropriate organization-wide real estate footprint. The goal of initiating such programs may be for entities to right-size their real estate portfolios to manage costs while adequately supporting their business needs.

In addition to adjusting to the evolving macroeconomic environment, entities continue to refine their hybrid-work approaches. While vacancy rates for office properties in certain areas may have been higher a couple of years ago because more professionals were allowed to spend a greater percentage of their time workingfrom home, many entities are now requiring their employees to work more days in the office, emphasizing theimportance of collaboration.

Entities continue to reassess their real estate footprint and adjust their real estate portfolios. Some entities are moving to different-sized spaces in the same geographical area, while others are changing the amount ofspace they are leasing in their current location. In addition, some entities have been consolidating multiple lease locations into a single office campus where all employees can colocate. Such entities may abandon existing properties, sublease space they are no longer using, or modify existing leases to change the amount of spaceor the lease term. Further, as a financing method to improve their liquidity, entities are increasingly entering into sale-and-leaseback transactions involving real estate. As a result of these real estate rationalization efforts, companies are also more frequently evaluating leases for impairment. Each of these topics is addressed belowand within this publication.

See Deloitte’s March 30, 2021, Accounting Spotlight and April 16, 2024, Financial Reporting Alert for furtherdetails on the impact of real estate rationalization and commercial real estate macroeconomic trends,respectively, on an entity’s lease accounting.

The right-of-use (ROU) assets recorded on a lessee’s balance sheet under ASC 842 are subject to the ASC 360-10 impairment guidance applicable to long-lived assets; such requirements are applied at the asset group level. When events or changes in circumstances indicate that the carrying amount of the asset group may not be recoverable (i.e., impairment indicators exist), the asset group should be tested to determine whether an impairment exists. The decision to change the use of a property subject to a lease could be an indicator that the property may now represent a separate asset group that may be subject to the impairment requirements in ASC 360-10.

Although the existence of an impairment indicator would not itself be a reason for a lessee to reevaluate the lease term for accounting purposes, an entity should consider whether any of the reassessment events in ASC 842-10-35-1 have occurred simultaneously with the impairment indicator.

The guidance in ASC 360-10 on accounting for abandoned long-lived assets also applies to ROU assets. The lessee would apply this guidance at the lease component level. In the context of a real estate lease, when a lessee decides that it will no longer need a real estate asset to support its business but still has a contractual obligation under the underlying lease, the lessee needs to evaluate whether the ROU asset has been or will be abandoned. Abandonment accounting only applies when the underlying property subject to a lease is no longer used for any business purposes, including storage. If the lessee intends to use the space at a future time orretains the intent and ability to sublease the property, abandonment accounting would be inappropriate.

Common Pitfall

We have seen some companies assert that they are abandoning the property, even though it is only temporarily idled, or that they may still be using it for minor operational needs or may have the intent and ability to sublease it. Under these circumstances, abandonment accounting would not be appropriate. An entity may need to use significant judgment in evaluating whether abandonment has occurred, and a high bar has been set for concluding that a property has been abandoned.

In our experience, establishing management’s intent regarding subleasing involves judgment and depends on various facts and circumstances, such as the remaining lease term, the nature of the property, and the level of demand in the rental market. For example, it may be reasonable to conclude that an ROU asset is subject to abandonment accounting when the remaining lease term is shorter and the rental market is, and is expected to remain, weak. On the other hand, it may be more challenging to conclude that management has forgone the opportunity to sublease the property if the remaining lease term is longer, given the increased uncertainty about the level of demand in the rental market over a longer time horizon. It may be particularly difficult to reach such a conclusion in an environment in which there are significant economic uncertainties that may affect the real estate strategy of other market participants going forward. There are no bright lines regarding the duration of the remaining lease term in this analysis, and the exercise could differ from one rental market to the next. We would also expect specialized properties to be more difficult to sublease than more generic properties such as retail shopping units and office space. Entities should carefully evaluate their specific facts and circumstances when determining whether the ASC 360 abandonment accounting applies to the ROU asset.

A lessee may enter into a sublease if the lessee no longer wants to use the underlying asset but has identified a third party to which the asset will be leased. In a sublease, the original lease between the lessor and the original lessee (i.e., the head lease) typically remains in effect and the original lessee becomes the intermediate lessor. Generally, the lessee/intermediate lessor should account for the head lease and the sublease as separate contracts and should consider whether the sublease changes the lease term of the head lease or its classification. The head lessor’s accounting is unaffected by the existence of the sublease.

Common Pitfall

In practice, we have seen situations in which a lessee may execute an assignment agreement to transfer its rights and obligations under a lease agreement to another third party (i.e., the assignee). In many cases, this assignment agreement may include the original lessor since it needs to approve the assignment. The original lessee must carefully evaluate such assignment agreements. We have observed that the assignment agreement often does not relieve the original lessee from being the primary obligor under the lease. Rather, in such cases, the original lessor is simply giving the original lessee permission to assign its rights under the lease but is not removing the original lessee from being the primary obligor (i.e., the assignment agreement specifies that the terms and conditions of the original lease remain in effect). The overall conclusion will affect whether the lessee would be permitted to apply the ASC 842 lease termination guidance to derecognize the lease liability and ROU asset or whether the assignment would be accounted for as a sublease between the original lessee and assignee. A lessee may often need to use judgment in evaluating whether it has been relieved from being the primary obligor under a lease. In some cases, legal questions may arise that should be evaluated with the assistance of legal counsel.

In the current environment, tenants may negotiate with lessors to exit early from a leased space, decrease the amount of leased space, or terminate the lease in its entirety. Some lessees are modifying existing lease agreements by (1) eliminating or scaling back office space as a result of hybrid models, (2) reducing space to cut or maintain costs because of changes in the current environment, or (3) expanding space as warranted in response to business needs. The accounting for a lease modification under ASC 842 depends on whether the modification is accounted for as a separate contract as well as the nature of the modification.

Common Pitfall

Many amended contracts describe a lease amendment as an early termination. In evaluating these types of amendments, a lessee must determine whether the amendment is actually a modification to reduce the lease term. If a termination takes effect after a specified period (even a relatively short period), the lessee still has the right to use the leased asset for that period. In such cases, the modification consists of a reduction in the lease term rather than a full or partial termination. The guidance on full or partial terminations only applies when all or part of the lessee’s right of use ceases contemporaneously with the execution of the modification (i.e., the space is immediately vacated). As a reminder, an immediate charge to the income statement is only appropriate when the lease is fully or partially terminated.

Evaluation of Lease Term

When determining the lease term at lease commencement, an entity should determine the noncancelable period of a lease together with lessee renewal option periods whose exercise is believed to be reasonably certain (and lessee termination option periods when exercise is reasonably certain not to occur). The likelihood of whether a lessee will be economically compelled to exercise or not exercise an option to renew or terminate a lease is evaluated at lease commencement. In performing this assessment, an entity would consider contract-based, asset-based, entity-based, and market-based factors (e.g., the market rental rates for comparable assets), which may be affected by changes in the macroeconomic environment.

A lessee would reevaluate the lease term in certain scenarios; however, a lessor would not reassess the lease term unless the lease is modified and the modification is not accounted for as a separate contract. When a lessee informs the lessor that it is exercising a renewal or termination option, such exercise would be accounted for as a lease modification.

A sale-and-leaseback transaction is a common and important financing method for many entities and involves the transfer of a property by the owner (“seller-lessee”) to an acquirer (“buyer-lessor”) and a transfer of the right to control the use of that same asset back to the seller-lessee for a certain period.

It is important for an entity to evaluate the provisions of any sale-and-leaseback arrangement since the contract terms may significantly affect the accounting. For example, the seller-lessee would not be able to derecognize the underlying asset (i.e., a failed sale) or recognize any associated gain or loss on the sale if (1) the contract includes a provision that grants the original owner (future tenant) an option to repurchase the property or (2) the leaseback would be classified as a finance lease. Rather, both parties would account for the transaction as a financing arrangement. The below graphic outlines key considerations related to the accounting for a sale-and-leaseback arrangement.

In addition to the lessee impairment considerations in ASC 360-10 for owned assets and ROU assets, there are separate impairment considerations for lessors. Lessors should be aware that net investments in leases (arising from sales-type and direct financing leases) are subject to the CECL impairment model, which is based on expected losses rather than historical incurred losses. See Section 5.3 of Deloitte’s Roadmap Current Expected Credit Losses for further discussion of the application of the CECL model to the net investment in the lease (i.e., lease receivables and the unguaranteed residual asset).

Lessors with outstanding operating lease receivables must apply the collectibility model under ASC 842-30. Entities should apply this collectibility model in a timely manner in the period in which amounts under the lease agreement are due. Under the ASC 842-30 collectibility model, an entity continually evaluates whether it is probable that future operating lease payments will be collected on the basis of the individual lessee’s credit risk. When collectibility of the lease payments is probable, the lessor will apply an accrual method of accounting. When collectibility is not probable, the lessor will limit lease income to the cash received, as described in ASC 842-30-25-12. Entities should continue to assess the impact of the current environment when determining whether to move tenants either to or from this cash basis of accounting as opposed to the accrual method of accounting.