After considerable business and economic disruption in recent months, there is heightened scrutiny of real estate needs as companies deal with changes to how they do business and how people work. The net impact is many companies have been and continue to critically assess their business models to manage risk and adapt to the current environment. Two of the more significant areas being reevaluated are where their employees conduct business, and to what extent they will rely on brick-and-mortar real estate assets.
In March 2021, a Deloitte poll of nearly 7,700 professionals showed that 66.9% have initiated or will be initiating a real-estate rationalization program. The ultimate goal is to right-size the real-estate portfolio, managing costs while supporting evolving business needs. Out of those that have initiated or will be initiating a real-estate rationalization program, more than 43.1% are reducing or plan to reduce their footprint by eliminating owned and leased space, while 16.4% plan to expand their footprint by purchasing and leasing additional space. In addition, 33.1% are or plan to right-size their real estate footprint by both reducing the space that is used in certain parts of the business while expanding the space used in other parts of the business. Meanwhile, 7.4% will or are initiating a sale/leaseback transaction.
Actions being considered in this area include: 1. Exiting leased space before the end of the contract term; 2. modifying existing lease agreements; 3. purchasing or leasing additional space; and/or 4. reducing owned space by executing a sale-and-leaseback transaction.
Some of these actions are not as simple as telling your landlord and packing up boxes. Each rationalization initiative can have accounting implications that may introduce unexpected complexities and accounting outcomes. To avoid decisions that may have unexpected long-term impacts, members of the C-suite, accounting and financial reporting teams and other key stakeholders should be involved as early as possible. Everyone involved should ask questions during the process to properly understand the accounting requirements and the related financial reporting implications. This may mitigate the possible risks associated with these types of transactions and avoid unexpected accounting consequences.
Accounting for Changes in Property Use
When a company decides that it will exit a space before the contract term ends—essentially making the decision that the space will no longer be used in the same manner—there may be a need to see if the Accounting Standards Codification (ASC) Topic 360, Plant, Property, & Equipment (ASC 360) impairment or abandonment guidance apply. Since the recognition of right-of-use (ROU) assets for operating leases are new under the lease accounting standard, the application ASC 360 guidance in these scenarios has introduced somewhat of a learning curve, and many lessees are finding the related accounting requirements challenging and not as straight forward as expected.
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.” A lessee must assess all cash flows and would therefore consider both cash outflows and inflows when identifying which asset group to evaluate. This is often one of the trouble spots when applying the impairment guidance, as the initial reaction may be that the individual ROU asset should be evaluated in a vacuum. However, this may be inappropriate, as it may not be the lowest for which identifiable cash flows (particularly cash inflows) exist. It would apply, for example, to a leased corporate headquarters that is considered a corporate asset. A proper evaluation may require the allocation of the corporate assets to the relevant asset groups, or may result in a conclusion that the ASC 360 asset group would be at the consolidated level.
There are similar challenges when applying the ASC 360 abandonment requirements, which is applied at the individual lease component level. There have been certain challenges with a lessee determining whether an abandonment has truly occurred. For example, even if the space will be fully vacated at a future date, it may just be considered temporarily idled if the company is still using the space for minor operational needs or has the intent and ability to sublease. ROU assets would only be subject to abandonment accounting when they are no longer used for any business purposes and are not the anticipated source of any future economic benefit (e.g., there is no intent and ability to sublease the property).
Modifying Existing Lease Arrangements
Companies have also been working with landlords to modify existing lease agreements, which could include eliminating or scaling back-office space or alternatively expanding to accommodate social distancing and open floor plans. The accounting for lease modifications under ASC Topic 842, Leases (ASC 842) lease accounting model depends on whether the modification is accounted for as a separate contract, as well as the nature of the modification. The C-suite’s understanding of the ASC 842 lease accounting modification guidance is important, as applying these accounting requirements may directly impact the amounts recorded in the company’s financial statements.
Certain other accounting nuances may exist in applying the lease accounting modification guidance when a lessee exits a property early. Consider a modification inked as an “early termination.” Unless the space is vacated immediately, this type of change would simply be considered a reduction in lease term, rather than a true termination. For example, a lease changed from a three-year remaining term to a 60-day period to allow a lessee to vacate the property would be a reduction in lease term that would generally result in no immediate income statement impact, unlike if the modification was accounted for as a full or partial termination.
Another nuance is accounting for termination penalties that may be owed to a landlord. While the knee-jerk reaction may be to recognize this payment in the income statement immediately, that may not be permitted. The ASC 842 lease accounting guidance views a termination penalty as a lease payment, which is considered part of the contract consideration. Any changes in the consideration due to a lease modification will require remeasuring 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 lease cost for the remaining lease components over the remaining term.
The bottom line is that the ASC 842 lease accounting modification guidance is new to US GAAP and presents new challenges. Knowing how the ASC 842 lease modification guidance works, as well as its potential pitfalls, is critical to allow for the proper accounting of a modified lease.
Companies have also been tapping into sale-and-leaseback transactions as part of a broader real estate rationalization program, strategically selling owned real estate assets that are no longer needed in their entirety or for as long as originally forecasted to monetize the assets. After the sale, the original owner leases part or all of the property back for a certain period. Applying the ASC 842 and ASC Topic 606, Revenue from Contracts with Customers (ASC 606) accounting models to such arrangements is not always straightforward.
Certain contract provisions (for example, a repurchase option) could prevent the arrangement from qualifying as a sale. This would affect the entity’s ability to de-recognize the underlying property and recognize a gain on the sale. In addition, other negotiated terms could have a significant impact on accounting. For example, sale-and-leaseback transactions are required to be accounted for at fair value, and the sale price would need to be adjusted for any off-market terms when this is not the case, requiring the recognition of additional financing or prepaid rent.
Understanding the sale-and-leaseback accounting guidance is important to properly account for such a transaction. This may also allow a CFO and their team to structure the transaction to get the desired accounting outcome that aligns with the overall business strategy. The structure could affect whether the transaction is accounted for as a “clean sale” with gain recognition or a “failed sale” and a financing arrangement.