Impairment Considerations When Adopting ASC 842
Impairment Considerations When Adopting ASC 842
While most public companies have already adopted the new lease accounting standard ASC 842, adoption of ASC 842 is looming for private companies.
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For calendar year-end private companies, the standard becomes effective on January 1, 2022. Regardless of adoption status, all companies should be considering the potential impairment risk introduced by ASC 842. Similar to owned long-lived assets held and used, right-of-use, or "ROU" assets, recorded in accordance with ASC 842 must be tested for impairment under ASC 360, Property, Plant, and Equipment.
For the purposes of impairment testing, these ROU assets are included within asset groups, which are the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. Thus, individual asset groups can contain a mix of owned equipment, leased equipment, owned real estate, and leased real estate, depending on the nature of the company's business and its lease portfolio.
While ROU asset impairment testing may seem like an issue for the future, it has implications that companies should consider when adopting ASC 842.
Applying the risk-free rate
Lease liabilities are computed by discounting future lease payments. Most commonly, the discount rate is the company's incremental borrowing rate, or IBR, although the rate implicit in the lease is used if known. However, private companies may elect to use the risk-free rate.
While the risk-free rate alleviates the burden of computing the IBR, it will result in a lower discount rate than that at which the company could borrow, resulting in a larger lease liability and related ROU asset. This dynamic is particularly acute in today's low-interest-rate environment. Notably, the higher the ROU asset's carrying value, the greater the risk of impairment such as the carrying value exceeding the fair value. For example, assuming the asset group fails the recoverability test, rent payments of $1,000 per year for 10 years would have a present value of $8,983 if discounted at 2% and $6,145 if discounted at 10%. If the asset had a fair value of $7,500, it would be impaired at a 2% discount rate but not at a 10% discount rate.
Following the initial adoption of ASC 842, the discount rate applied to each lease is based on the information available as of the lease commencement date. Even as interest rates rise, the risk-free rate will continue to be lower than that at which the company can borrow. Applying the risk-free rate both at adoption and for subsequent leases can save significant time compared with determining the IBR. However, be sure to consider the trade-off of higher liability and asset values, and increased impairment risk as a result.
Under both ASC 840 and ASC 842, a lessee is required to assess whether it is reasonably certain that available renewal options will be exercised. If the lessee is reasonably certain, the term of the lease will include the renewal period. The incremental lease payments for the period are included in the initial computation of the lease liability and the ROU asset, driving up their respective values. Thus, not only does adopting ASC 842 impact the balance sheet, but the reasonable certainty around exercising renewal options increases the magnitude of this impact and thus the risk of impairment.
In evaluating the probability of exercising renewal options, the company should take a holistic approach by considering all contract-based, asset-based, market-based, and entity-based economic factors. Specifically, the company should consider the following: Whether the lease payments during the renewal period are above or below market. It should also consider: future operational needs such as whether the leased asset is critical to business operations or strategy, the value of leasehold improvements at the end of the base term, and the availability of alternative assets and purchase options. These and other considerations will impact the reasonable certainty of exercising a renewal option. For example, if a below-market purchase option is only exercisable at the end of the renewal period and leasehold improvements hold significant value, these factors together could indicate that renewal is reasonably certain.
Impairment risk is not consistent
When recording journal entries related to the adoption of ASC 842, existing balances in the initial direct costs, tenant-improvement allowances, and deferred rent are reflected as adjustments to the ROU asset. Notably, deferred rent in leases with rent escalation provisions results in the ROU asset having a lower value than the corresponding lease liability at the time of adoption. This reduces the risk of impairment because the lower the asset's carrying value, the lower the risk of impairment when compared to fair value.
As the deferred rent balances are no longer recorded under ASC 842 on a post-adoption lease, there may not be any adjustments to bridge from the liability down to the asset. This results in a higher carrying value for the ROU asset than would have been recorded at adoption-provided there was a deferred rent balance. Thus, assets may initially be shielded from impairment based on adoption adjustments. However, companies should understand that this benefit does not continue as new leases are added after adoption.
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