Lease Impairments Impact on ROU Assets

Last Updated on March 14, 2024 by Morgan Beard

With the adoption of the new lease accounting standards, IFRS 16 and ASC 842, Right-of-Use (ROU) assets have become an integral part of financial reporting for companies with operating leases. However, like any other asset, ROU assets are susceptible to impairment, and understanding the impact of lease impairments on these assets is crucial for accurate financial reporting. In this blog post, we will delve into the concept of lease impairments, their impact on ROU assets, and the accounting treatment associated with these impairments.

Understanding Lease Impairments

A lease impairment occurs when the carrying value of an ROU asset exceeds its recoverable amount, which is the higher of its fair value less costs of disposal and its value in use. This situation can arise due to various factors, such as changes in the economic environment, alterations in the terms of the lease agreement, or a decline in the expected benefits from the underlying leased asset. Accounting for a potential impairment charge is foundational to FASB’s Accounting Standards Codification.

ROU Assets and Their Significance

ROU assets represent the lessee’s right to use an underlying asset during the lease term. These assets are recognized on the balance sheet at the commencement of the lease, and their value is calculated based on the present value of the lease payments, adjusted for any initial direct costs, lease incentives, and estimated costs for dismantling or restoring the leased asset.

The recognition of ROU assets has significant implications for companies’ financial statements, as it increases their reported assets and liabilities. Consequently, understanding and properly accounting for potential impairments of these assets is essential for maintaining the integrity of financial reporting.

Factors Influencing ROU Asset Impairments

Several factors can contribute to the impairment of ROU assets, including. For impairment testing purposes, qualitative and quantitative judgments must be evaluated across the individual asset level during the reporting period. Here are a few factors to consider:

• Economic Conditions: Changes in the broader economic environment, such as a recession or industry-specific downturns, can impact the expected future benefits from the leased asset, leading to potential impairments.
• Lease Modifications: Significant changes to the terms of the lease agreement, such as early termination, extension, or modification of lease payments, can affect the carrying value of the ROU asset and potentially trigger an impairment.
• Asset Utilization: A decline in the expected utilization of the leased asset, due to factors like changes in business operations or technological advancements, can reduce the asset’s recoverable amount and result in an impairment.
• Asset Obsolescence: The introduction of newer, more efficient assets or technological advancements can render the leased asset obsolete, decreasing its fair value and potentially leading to an impairment.

Impact of Lease Impairments on Financial Reporting

The recognition of lease impairments can have significant implications for a company’s financial statements, affecting various aspects, including:

• Balance Sheet: Impairment losses reduce the carrying value of the ROU asset on the balance sheet, reflecting the diminished future economic benefits associated with the leased asset.
• Income Statement: Impairment losses are typically recognized as an expense in the income statement, potentially impacting the company’s reported profitability for the period.
• Cash Flow Statement: While impairment losses are non-cash expenses, they can indirectly impact cash flows by reducing future depreciation charges associated with the impaired ROU asset.
• Financial Ratios: Impairment losses can affect key financial ratios, such as asset turnover, return on assets, and debt-to-equity ratios, potentially impacting the company’s perceived financial health and performance.

Measuring Impairment Losses for ROU Assets

To determine the impairment loss for an ROU asset, companies must calculate the asset’s recoverable amount and compare it to its carrying value. The recoverable amount is the higher of the asset’s fair value less costs of disposal and its value in use.

The fair value less costs of disposal represents the amount that could be obtained from selling the ROU asset in an arm’s length transaction, less any direct costs associated with the disposal. The value in use is calculated by discounting the future cash flows expected to be derived from the continued use and eventual disposal of the leased asset.

If the recoverable amount is less than the carrying value of the ROU asset, an impairment loss is recognized, and the asset’s carrying value is reduced to its recoverable amount.

To illustrate the calculation of an impairment loss for an ROU asset, consider the following example:

Suppose a company leases office equipment with an initial ROU asset value of $100,000 and a remaining lease term of 5 years. Due to a decline in the expected utilization of the equipment, the estimated future cash flows from its use have decreased to $80,000. Additionally, the fair value less costs of disposal for the ROU asset is estimated to be $75,000.

In this scenario, the recoverable amount would be the higher of the fair value, less costs of disposal ($75,000), and the value in use ($80,000), which is $80,000.

Since the carrying value of the ROU asset ($100,000) exceeds its recoverable amount ($80,000), an impairment loss of $20,000 would be recognized, and the ROU asset’s carrying value would be reduced to $80,000.

Accounting Treatment of Lease Impairments

The accounting treatment of lease impairments for ROU assets is governed by the applicable accounting standards, such as IFRS 16 or ASC 842, and typically involves the following steps:

1. Identify Impairment Indicators: Companies should regularly assess whether there are any indicators that the ROU asset may be impaired, such as significant adverse changes in the economic or legal environment, physical damage to the underlying asset, or evidence of technological obsolescence.
2. Estimate Recoverable Amount: If impairment indicators are present, the company must estimate the recoverable amount of the ROU asset, considering both its fair value less costs of disposal and its value in use.
3. Recognize Impairment Loss: If the carrying value of the ROU asset exceeds its recoverable amount, an impairment loss is recognized in the income statement for the difference between the two values.
4. Adjust Carrying Value: The carrying value of the ROU asset is reduced by the amount of the impairment loss, reflecting its revised recoverable amount.
5. Subsequent Reversal: In some cases, impairment losses recognized in prior periods may be reversed if there has been a change in the estimates used to determine the asset’s recoverable amount. However, the carrying value of the ROU asset after reversal cannot exceed the amount that would have been reported if no impairment had been recognized.

By understanding and properly accounting for lease impairments, companies can ensure the accurate representation of their ROU assets and lease liabilities as well as maintain the integrity of their financial reporting. Regularly assessing ROU assets for impairment indicators and promptly recognizing any necessary impairment losses is crucial for providing stakeholders with a transparent and reliable picture of the company’s financial position and performance.