Lease modifications & other reductions: Accounting impacts

In the current economic environment, it has become increasingly common for organizations to explore opportunities to reduce or redeploy their real estate footprint (for example, repurposing underutilized office space). As a result, many organizations are amending or early terminating leases, or they are subleasing portions of their leased properties.

Here are four transaction scenarios commonly observed in today’s real estate markets and questions organizations should ask about the scenarios’ financial reporting impacts.

Scenario 1: Lessee subleases all or a portion of an existing leased property

Fact pattern: Entity A leases six floors of an office building from Entity B for six years with monthly lease payments of $10,000 for each floor. With four years remaining on its lease, Entity A decides to sublease one of the six floors, as permitted under the contract, because it no longer needs the space. Entity A enters a separate sublease agreement with an unrelated third party in exchange for monthly sublease income of $5,000. The term of the sublease is coterminous with the term of the head lease.

Questions organizations must consider when facing this scenario include:

Is the right-of-use (ROU) asset from the head lease impaired?

ROU assets are subject to impairment testing under Topic 360, “Property, Plant, and Equipment.” An ROU asset is tested for impairment when events or changes in circumstances indicate the carrying amount of the asset (or asset group) may not be recoverable (Topic 360-10-35-21). One indicator that the carrying amount of an ROU asset might not be recoverable is when a leased asset is sublet for an amount less than the amount an entity pays under a head lease. As such, Entity A likely would view the subletting arrangement for the single floor for an amount less than the amount paid under the head lease as an indicator of impairment.

Is the ROU asset part of an asset group? If so, does the decision to sublease result in a change in asset groupings?

According to Topic 360-10-35-23, an asset group is “the lowest level for which identifiable cash flows [from an asset or group of assets] are largely independent of the cash flows of other [groups of] assets and liabilities.” Determination of asset groupings is based on entity-specific facts and circumstances (for example, how management runs its business) and can require considerable judgment. Often, an ROU asset arising from a real estate lease is part of a larger asset group.

However, when all or part of a leased property is sublet, an entity must consider whether a change in asset groupings has occurred. For example, in the scenario described, Entity A might conclude that the subletting of the single floor results in the ROU asset for that single floor being considered a new asset group. This is because the sublet floor now has identifiable cash inflows (received from the sublease) and outflows (paid under the head lease) for the same term as the remaining period left under the head lease. Entity A also should consider whether any leasehold improvements on the subleased floor should be included in the asset group.

Crowe observation: Other facts and circumstances could exist where an entity subleases all or a part of a leased property and concludes the related ROU asset is not its own asset group. For example, the sublease term might end before the term of the head lease (e.g., month-to-month) and the lessee might at a later date decide to use or repurpose the space. In that scenario, while judgment regarding the specific facts and circumstances would be needed, the lessee might conclude the sublease arrangement does not produce meaningful identifiable cash flows such that the substance of the arrangement does not change an initial conclusion that the ROU asset is part of a broader asset group.

How does an entity account for an ROU asset arising from an operating lease after impairment is recorded?

If an entity concludes an ROU asset is impaired, the entity adjusts the carrying amount of the ROU asset by the amount of the impairment. Subsequently, the ROU asset is amortized, usually on a straight-line basis, over the shorter of the lease term or the ROU asset’s useful life. While the lessee would continue to present a single lease cost line item in the income statement, the single lease cost will no longer be recognized on a straight-line basis. Instead, the lease cost will be calculated as the sum of the amortization of the remaining balance of the ROU asset (amortized on a straight-line basis) and the accretion of the lease liability using the effective interest method (producing a constant discount rate on the remaining balance of the liability).

Consider the following example:

Using the previous facts, Entity A determines that with five years remaining on its office lease, the ROU asset for the single floor being subleased is its own asset group and is impaired. Entity A measures and recognizes an impairment charge of $18,000 at the end of year two. Immediately before the impairment, Entity A’s lease liability and ROU asset (using a discount rate of 5% to initially measure and record the lease at the lease commencement date) are both $35,460. The following calculations illustrate Entity A’s lease cost after the impairment.

Crowe observation: A lessee that recognizes an impairment also should consider financial statement disclosures required by Topic 360, such as qualitative information about the asset (asset group) and the reason for the impairment, the amount of the impairment loss (if not separately presented on the face of the income statement), and how the entity determined the fair value of the asset (asset group).

Scenario 2: Lessee elects to early terminate an existing property lease where the lessee has the contractual right to early terminate

Fact pattern: Entity A signs a five-year lease with Entity B for the use of a building. Under the contract, Entity A has the option to terminate the lease at the end of the second year. If terminated, Entity A pays a termination fee of $100,000 and must vacate the property three months after notification of termination.

At lease commencement, Entity A concludes the lease term is five years; that is, Entity A concludes it is reasonably certain it will not exercise the termination option. However, due to unforeseen circumstances, Entity A decides to terminate the lease at the end of the second year. As a result, Entity A pays Entity B the one-time termination fee of $100,000 and pays monthly lease payments of $10,000 for the remaining three months during which time Entity A still has the right to access and use the property.

Questions organizations must consider when facing this scenario include:

Does the lease termination guidance in Topic 842-20-40-1 apply to this scenario?

No. Although the arrangement is characterized as a termination under the terms of the agreement, Entity A’s election to terminate the lease should be accounted for as a remeasurement event under Topic 842-20-35-4. This occurs because Entity A continues to control the right to use the leased property for a period of time – three more months. Said differently, when a termination agreement does not result in the immediate termination of a lease, the guidance in Topic 842-20-40-1 does not apply.

How does the exercise of a termination provision in a lease contract affect the measurement of an ROU asset and lease liability when the original lease term does not contemplate exercise of the termination option?

Consistent with guidance in Topic 842-20-35-4 and 35-5, a change in lease term triggers a remeasurement of the lease liability. To remeasure the lease liability, the lessee would determine the revised lease term, the remaining lease payments – which includes the termination fee – and an updated discount rate. The remeasurement of the lease liability is recorded by a corresponding adjustment to the ROU asset.

In the scenario described, upon exercise of the termination provision, Entity A would remeasure its lease liability for the revised lease term of three months. The remaining lease payments would consist of the upfront termination penalty of $100,000 and the three remaining monthly payments of $10,000. Entity A should update its discount rate considering a remaining lease term of three months and total lease payments of $130,000. Any change in the measurement of the lease liability would be recorded as an adjustment to the ROU asset.

Crowe observation: In scenario 2, the termination penalty payment is not recognized as an immediate charge to the income statement; rather, it is included in the revised lease payments and recognized over the revised lease term.

However, an entity that early terminates a lease also should consider whether its decision to early terminate represents an indicator of impairment for the related ROU asset. If so, the entity must determine whether an impairment charge should be recorded before remeasuring the lease liability. For example, an entity exercising an early termination option in a lease might have already formally committed to a plan to abandon the ROU asset. In that case, the lessee should consider if the ROU asset (or asset group including the ROU asset) is impaired before performing a remeasurement of the lease.

What is the effect of the exercise of the termination provision on any recognized leasehold improvements associated with the lease?

Upon exercising a termination option, organizations will need to reassess the remaining useful life, and evaluate potential impairment, of any leasehold improvements. For example, due to the revised lease term resulting from the termination option exercised, the period over which Entity A will receive economic benefits (if any) from its leasehold improvements is shortened. Consequently, Entity A must consider if any leasehold improvements that remain in use are impaired and shorten the remaining useful life of any leasehold improvements to the revised lease term of three months.

Scenario 3: Lessee elects to early terminate an existing property lease where no contractual right to early terminate is present

Fact pattern: Entity A signs a five-year lease with Entity B for the use of a building. At lease commencement, Entity A concludes the lease term is five years. At the end of year two, Entity A wishes to terminate the lease but does not have a contractual right to do so. Entity A and Entity B agree to modify the existing lease so that it terminates three months from the modification date. As consideration for the lease modification, Entity A must pay Entity B a one-time termination fee of $100,000 and must continue to pay monthly lease payments of $10,000 for the remaining three months during which time Entity A still has the right to access and use the property.

Questions organizations must consider when facing this scenario include:

Does the lease termination guidance in Topic 842-20-40-1 apply to this scenario?

No. Refer to the explanation under scenario 2.

How does Entity A account for the modification to terminate the original lease?

Consistent with guidance in Topic 842-10-25-8, the first step in accounting for the lease modification is to assess whether the modification in and of itself represents a new (separate) contract or a modification of an existing contract, as shown here:

Because the revised terms don’t grant Entity A an additional ROU asset, the lease modification is not accounted for as a separate contract.

Next, Entity A concludes that neither a full nor partial termination has occurred because a reduction in lease term is not considered a reduction in the assets subject to the lease but rather a change in attribute of the lease. Consequently, Entity A treats the amendment as a modification of an existing lease. That is, Entity A reallocates the remaining consideration in the contract, reassesses lease classification, and remeasures the lease liability using a discount rate for the lease determined at the effective date of the lease modification and the revised lease term of three months.

Crowe observation: As previously noted, the lease modification does not result in a full or partial termination of the lease because the modification does not reduce the assets subject to the lease; it merely reduces the period over which those assets can be used. In contrast, had the modification reduced the scope of the lease – for example, by immediately reducing the number of floors leased by Entity A – the partial termination guidance would apply.

Scenario 4: Lessee agrees to lease a smaller space from the same lessor

Fact pattern: Entity A signs a 10-year lease with Entity B for the use of a building. At lease commencement, Entity A concludes the lease term is 10 years. At the end of year five, Entity A concludes it needs to reduce its leased space. To effect the reduction, Entity A and Entity B agree to terminate the original lease and enter into a lease for a smaller property owned by Entity B for five years.

Lease reduction transactions involving the same lessor raise unique accounting considerations, including how to account for any difference between the carrying amounts of the ROU asset and lease liability recognized for the lease being terminated. In many cases, the termination of the original lease and the execution of the new lease would need to be assessed on a “combined” basis (see Topic 842-10-25-19) to determine the appropriate accounting treatment.

Questions organizations must consider in determining the appropriate accounting treatment for such transactions as that described in this scenario include (but are not limited to):

• Does the original lease terminate immediately – that is, at the date of the lease modification – or at a later date (that is, a reduced lease term)?
• Does the transaction involve the payment of additional consideration, such as a lease termination fee – whether specified in the original lease or added by way of the revised terms?
• Are the new lease terms at, above, or below market terms?
• Is the lessor a related party?

Moving forward

Overall, accounting for changes in real estate leases is heavily dependent on the facts and circumstances of the transaction, and knowing where to start can be difficult. Organizations might find it helpful to turn to a team of specialists to help them understand how guidance in Topic 842 applies to strategic changes in leasing arrangements.