Depreciation Considerations When Adopting ASC 842
While most public companies have already adopted the new ASC 842 rental accounting standard, the adoption of ASC 842 is looming for private companies. For companies closed at the end of the calendar year, the standard takes effect on January 1, 2022. Regardless of the adoption status, all companies must take into account the potential impairment risk introduced by ASC 842. As for 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 in asset groups, which are the lowest level at which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. . Thus, individual asset groups may contain a combination of owned equipment, leased equipment, owned real estate and leased real estate, depending on the nature of the business activity and its location. portfolio of rental contracts.
While ROU asset impairment testing may seem like an issue going forward, it does have implications that companies should consider when adopting ASC 842.
Application of the risk-free rate
Rental debts are calculated by discounting future rents. Most often, the discount rate is the company’s marginal borrowing rate, or IBR, although the rate implicit in the lease is used if known. However, private companies can choose to use the risk free rate.
While the risk-free rate alleviates the burden of calculating the IBR, it will result in a lower discount rate than the company could borrow, resulting in a larger rental liability and related ROU asset. This dynamic is particularly acute in today’s low interest rate environment. In particular, the higher the carrying amount of the ROU asset, the greater the risk of impairment such as the carrying amount exceeding fair value. For example, assuming the asset pool fails the collectability 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 they were discounted at 10%. If the asset had a fair value of $ 7,500, it would be written down 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 at the start date of the lease. Even if interest rates rise, the risk-free rate will remain lower than what the business can borrow. Applying the risk-free rate to both adoption and subsequent leases can save considerable time in determining IBR. However, be sure to consider the trade-off between higher asset and liability values, and increased depreciation risk as a result.
Under ASC 840 and ASC 842, a tenant is required to assess whether it is reasonably certain that the available renewal options will be exercised. If the tenant 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 calculation of the rental liability and the ROU asset, increasing their respective values. Thus, not only does the adoption of ASC 842 impact the balance sheet, but the reasonable certainty around the exercise of renewal options increases the magnitude of this impact and therefore the risk of impairment.
When assessing the likelihood of exercising renewal options, the business should take a holistic approach taking into account all economic factors based on contracts, assets, market and entities. Specifically, the business should consider the following: whether lease payments during the renewal period are above or below market. It should also take into account: future operational needs, for example whether the leased asset is critical to the operations or strategy of the business, the value of leasehold improvements at the end of the base term and the availability of alternative assets and call options. These and other considerations will affect the reasonable certainty of exercising a renewal option. For example, if a below market option to purchase cannot be exercised until the end of the renewal period and the leasehold improvements have significant value, these factors together could indicate that renewal is reasonably certain.
The risk of depreciation is not constant
When recording journal entries related to the adoption of ASC 842, existing balances in up-front direct costs, tenant improvement allowances, and deferred rents are reflected as adjustments to the active ROU. In particular, deferred rents in leases with rent indexation clauses mean that the ROU asset has a lower value than the corresponding rental debt at the time of adoption. This reduces the risk of impairment because the lower the carrying amount of the asset, the lower the risk of impairment compared to fair value.
Since deferred rental balances are no longer recognized under ASC 842 on a post-adoption lease, there may not be adjustments to make the link between the liability and the asset. This results in a higher carrying amount of the ROU asset than would have been recorded upon adoption, provided there is a deferred rent balance. Thus, assets can initially be protected against depreciation based on the adoption adjustments. However, businesses should understand that this benefit does not continue as new leases are added after adoption.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Jeremy Enuson is a director at Stout in the Accounting & Reporting Advisory practice. He has over 13 years of experience providing audit and advisory services to public and private sector clients, particularly in the areas of financial reporting, technical accounting and transactional advice. You can contact Jeremy at [email protected]
Steve Hills is the Managing Director and Head of Accounting and Reporting Consulting Practice at Stout, with over 15 years of experience in accounting and finance leadership roles. His experience includes technical accounting, financial reporting and transaction consulting. He brings diverse transactional experience, including experience in acquisitions and initial public offerings, serving a variety of industries including technology, consumer products, financial services and energy. You can contact Steve at [email protected]
Katelyn Horowitz is Senior Vice President at Stout in the Accounting and Reporting Advisory practice. She has over seven years of experience providing technical accounting and financial reporting services to public and private sector clients. You can contact Katelyn at [email protected]
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