Accounting Implications of Lease Rationalization Programs
How to account for right-sizing a corporate real estate portfolio in today’s changing business environment.
Organizations in almost every industry sector around the globe are changing how they operate in reaction to shifting capabilities, technologies, and customer and employee preferences. One way in which these changes are affecting business models and strategies is that many companies have realized they can function effectively in a virtual or semi-virtual environment. That discovery has put pressure on the C-suite, including CFOs, to reassess their real estate needs in the name of managing capital allocation and enabling a modern business model.
Although some companies continue to maintain or even expand their real estate footprint, other organizations have shifted from a “being in the office live” business model to a virtual environment that relies on Web-based tools for real-time communication and execution of day-to-day tasks. Even some companies that historically relied primarily on brick-and-mortar real estate for selling and marketing their services are now pivoting to conduct many core business activities online, within virtual marketplaces.
To that end, where employees work—and the extent to which they rely on brick-and-mortar real estate assets—are under review by many CFOs and their teams. Whether they are transitioning to a hybrid work model or moving marketing and sales activities online, they are initiating a real estate rationalization program that focuses on right-sizing the company’s real estate footprint to accommodate its evolving business structure.
The Purpose of Lease Rationalization
The ultimate goal of lease rationalization programs is to build a real estate portfolio that manages costs while supporting the organization’s changing business needs. To meet that goal, CFOs and their teams are evaluating whether various levers should be pulled, including:
- Exiting leased space before the end of the contract term,
- Modifying existing lease agreements, and/or
- Purchasing or leasing additional space.
So, finance leaders in a wide range of industries are revisiting their company’s lease portfolios and making decisions that could potentially shift how they are using certain real estate assets within their organization.
The Accounting Implications of Lease Rationalization
Each real estate rationalization initiative has accounting implications that could potentially introduce uncertainty around outcomes. Although the accounting for the lease or purchase of additional space is straightforward, accounting for other real estate rationalization strategies can be challenging.
Accounting for changes in the use of a property. When revisiting their real estate portfolio, finance leaders need to see whether the Accounting Standards Codification Topic 360 (ASC 360), “Property, Plant, and Equipment,” impairment or abandonment guidance may apply. Since right-of-use (ROU) assets were first recognized for operating leases with ASC 842, “Leases,” the ASC 360 guidance is relatively new in this area, and many lessees are finding the related accounting requirements challenging.
The ASC 360 impairment model requires that the evaluation of a long-lived asset or asset group for impairment should be performed “at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities.” This means a lessee must assess all cash flows, considering both cash outflows and inflows, when identifying the asset group to be evaluated. This is often one of the trouble spots when applying the impairment guidance.
It may initially seem that the individual ROU asset should be evaluated in a vacuum, since it’s the one asset impacted by real estate rationalization. However, it is generally inappropriate to apply the impairment test at that level because it’s not the lowest level for which identifiable cash flows exist. Consider, for example, a leased headquarters building that’s considered a corporate asset. Proper evaluation of the prospect of impairment for that building may require corporate assets to be allocated to the relevant asset groups or may result in a conclusion that the ASC 360 asset group is the consolidated level.
Accounting for abandonment of a property. Some companies are similarly struggling to understand how and when to apply ASC 360 abandonment guidance to an ROU asset. While the ASC 360 impairment guidance is applied at the asset group level, the abandonment guidance is applied at the lease component level. The abandonment framework generally results in acceleration of an ROU asset’s amortization. But a lessee needs to use judgment in evaluating whether an abandonment has truly occurred.
If a property is being used for minor operational needs (e.g., storage), or if there is an intent and ability to sublease the property, then the assets aren’t subject to abandonment accounting because the lessee is still receiving, or plans to receive, economic benefits from the property. ROU assets are subject to abandonment accounting only when they are no longer being used for any business purposes and no future economic benefit is anticipated—in other words, when the company doesn’t intend to, or isn’t able to, sublease the property.
Understanding the appropriate level for applying the ASC 360 impairment and abandonment requirements can also raise issues for the CFO. For example, a company may plan to exit and sublease a property that’s currently part of a larger asset group—such as a satellite corporate office—or it may have historically accounted for the property as a single lease component (i.e., accounted for the entire building as one unit of account). In such cases, the lessee must use judgment to determine whether it is appropriate to revisit the asset group or the identified lease components before applying the ASC 360 abandonment requirements.
Modifying existing lease arrangements. As part of a real estate rationalization program, some lessees work with their landlords to modify existing lease agreements. This could include eliminating or scaling back on office space or, alternatively, expanding office space to accommodate social distancing and open floor plans.
The accounting for these kinds of modifications under the ASC 842 model depends on, first, whether the modification is accounted for as a separate contract and, second, the nature of the modification. Further complicating the accounting: If the lease amendment results in multiple changes to the agreement or affects different lease components, then applying the ASC 842 framework may introduce unexpected complexity, such as reducing the term of one floor and extending the term of another.
Certain other accounting nuances may exist in applying the lease modification accounting guidance when a lessee exits a property early. Consider a modification inked as an “early termination.” Unless the space were vacated immediately, this type of change would simply be considered a reduction in lease term. For example, if a lease with three years remaining were modified to have only 60 days left on its term—to allow the lessee time to vacate the property—this would result in the lease term being reduced from three years to 60 days, not in the lease simply being terminated.
Another complicating factor is the accounting around any termination penalties that the company may owe the landlord. The accounting team’s knee-jerk reaction may be to recognize payment of these penalties in the income statement immediately, but that may not be permitted. The ASC 842 lease accounting modification guidance actually considers a termination penalty as a lease payment and part of the contract consideration. Any changes in the consideration due to a lease modification require the remeasurement of the lease, with the revised consideration allocated to all of the remaining lease components in the contract over any revised term. This results in the prospective recognition of the termination penalty as part of the lease cost across the remaining lease components for the remaining lease term.
The Bottom Line
Understanding U.S. GAAP accounting requirements in ASC 360 and ASC 842 may be challenging for organizations trying to account for changes to their property and real estate strategy. However, this is one area in which the CFO and finance team can play a crucial role in supporting overall business growth and capital allocation.
It is vital for CFOs and their teams to work to understand the direct impact that these guidelines will have on the company’s financial statements and, ultimately, its bottom line.
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