Lease impairments refer to accounting scenarios where the carrying value of a right-of-use (ROU) asset associated with an operating lease may need to be reported or impaired on their balance sheet at the fair market value

If an impairment indicator is present, the lessee must test the ROU asset for impairment by comparing the carrying value of the ROU asset to its fair value. If the carrying value exceeds the fair value, an impairment loss should be recognized equal to the excess amount.

There are numerous scenarios that can adversely impact companies and cause uncertainty. Natural disasters, global pandemics and geo-political conflicts are just a few examples of potential impairments of leased assets. Which, ultimately, forces companies to adapt both their current and future strategies.

Impaired assets, especially due to an economic downturn, can influence a company to re-analyze future cash flows, re-evaluate their current forecasts/budgets and re-consider whether a leased (or owned) location is worth remaining in operation. All of the scenarios above could be considered indications that an impairment has occurred. Both private companies and public companies alike will want to evaluate the financial liabilities and even expected credit losses as a result of lease impairments.

What is an impairment in lease accounting?

An impairment occurs when the cash flows generated by an asset or group of assets decline materially, causing the asset's fair value to fall below its carrying value on the balance sheet. Take a large restaurant chain as an example: if during the pandemic, they were forced to close indoor dining at one of their restaurants the associated cash flows generated by that restaurant would drastically differ from pre-pandemic volumes.

When this occurs a company is required to perform various tests to ensure that the fair value of the asset (or group of assets) has not been significantly impacted by the decrease in generated cash flows.

If the results of the underlying tests reveal that the asset (or group of assets)’s value has fallen below its carrying value then an impairment for accounting purposes has occurred and the asset (or group of assets) value must be reduced to its new fair value for the underlying asset or assets.

Why do lease impairments matter under ASC 842 and IFRS 16?

Under both US GAAP and IFRS, ROU assets must be included in an impairment assessment at least once every reporting period, making impairment analysis a recurring compliance requirement for real estate and finance teams managing lease portfolios. Understanding your financial reporting requirements is crucial to accurate financial records and obtaining a clean audit opinion, under the new guidance.

How do you perform a lease impairment assessment under ASC 842 and IFRS 16?

A lease impairment assessment follows three steps: identify indicators of impairment, perform the recoverability test under US GAAP or the one-step test under IFRS, and if impairment is confirmed, calculate and record the impairment charge. An indicator of impairment is an external or internal event that has taken place that serves as a signal that an impairment could have occurred after the initial measurement. A few examples of indicators of impairment are as follows:

• Significant changes to the way the asset (or group of assets) are being used.
• Legal proceedings impacting the use of the asset (or group of assets).
• Geo-political conflict and/or unrest.
• Natural disasters impacting the use of the asset (or group of assets).

A more in-depth discussion of indicators of impairment can be found in ASC 360-10-35-21 and IAS 36, paragraph 12.

Under US GAAP, if indicators of impairment are present, then the next step is to perform the recoverability test (as per ASC 360-10-35-17). The recoverability test compares the undiscounted future cash flows generated from the asset (or group of assets) to the carrying value of the asset (or group of assets).

If the undiscounted future cash flows generated by the asset (or group of assets) exceed(s) the carrying amount of the asset (or group of assets) then an impairment has not occurred and no further testing is required.

If the undiscounted future cash flows generated by the asset (or group of assets) are less than the carrying amount of the asset (or group of assets) then an impairment has occurred and further steps need to be performed to determine the value of the impairment- this step will be outlined further below.

Under IFRS, if indicators of impairment are present, the next step is to perform what is known as “the one-step test.” This step involves comparing the carrying amount of the asset (or group of assets) to the higher of either: the fair value less any costs to dispose of the asset (or group of assets) or value in use (or VIU) of the asset (or group of assets). The VIU of an asset (or group of assets) equates with the discounted cash flows generated by the asset (or group of assets). When discounting, a company should use its weighted average cost of capital to discount the cash flows.

Under both US GAAP and IFRS if the assessment(s) reveals that an impairment has taken place, the final step is to account for the impairment charge. In the case of a single asset, the impairment charge equates to the difference between the recoverable amount of the asset and the carrying value.

When a company groups assets for the purposes of impairment testing and an impairment is present a company must allocate the impairment charge across each asset based on the fair value of each asset. This process can be quite complex and time consuming as often third-party evaluators are required to calculate fair values of the assets grouped together.

What documentation is required for lease impairments under ASC 842 and IFRS 16?

Finance teams must document all key assumptions, indicators of impairment, cash flow projections, and impairment calculations to support a clean audit opinion and demonstrate compliance with ASC 842 and IFRS 16 requirements. Under the new Accounting Standards Codification and the IASB , CPA's and their auditors will want a clear trail of documentation that outlines the significant impacts of said lease impairment. 

Within the Occupier platform companies have the ability to calculate impairment(s) associated with an impairment of a right-of-use asset. Occupier will also prepare the associated disclosures related to an impairment of a right-of-use asset during a fiscal period. 

In the video above, we highlighted how you can easily calculate the impairment loss entries and establish a new amortization schedule based on the impairment information. Under the new accounting policy, the future lease payments and the lease liabilities over the remaining lease term will reflect the lease accounting for said impairment and an update of the asset's life.

Frequently Asked Questions

How do I determine which cash flows an asset or group of assets generates?

Under both US GAAP and IFRS, project future cash flows over the asset's remaining useful life using the company's operational forecast as a base. Under US GAAP, exclude taxes, overhead, and financing costs. Under IFRS, exclude taxes and financing costs but include costs to bring the asset to operational state, overhead reasonably allocated to the asset, and net disposal proceeds.

Generally, companies use an operational forecast for the company as a whole (or for a specific region) as a foundational estimate for the cash flows generated by an asset (or group of assets). 

For an assessment prepared under US GAAP a company shall adjust their operational forecast to exclude outflows of cash related to: taxes, overhead expenditures, financing expenditures (such as interest and debt payments). The rationale behind excluding the aforementioned expenditures is due to the fact that they relate to a business as a whole and not a specified asset (or group of assets).

For an assessment prepared under IFRS a company shall adjust their operational forecast to exclude: taxes and financing expenditures (such as interest and debt payments). An important distinction to be made is that unlike under US GAAP the following inflows and outflows of cash are also to be included in the assessment: costs required to bring the asset (or group of assets) into an operational state, net cash flows incurred/received with respect to selling/disposing of the asset (or group of assets) and overhead costs that can be reasonably allocated to the asset (or group of assets).

How do I determine which assets to group together for an impairment assessment?

Group assets at the lowest level where cash flows are independent of other asset groups. Under US GAAP this is called asset grouping. Under IFRS it is called a cash generating unit (CGU). A single restaurant location is a common example, where the real estate lease, equipment, and vehicles are grouped because none generates cash flows independently of the others.

For the purposes of US GAAP companies are permitted to group assets together for the purposes of impairment testing — this concept is also known as asset grouping. Asset grouping is permitted so long as the group of assets represents the lowest level that identifiable cash flows are independent of the cash flows of other groups of assets. 

The grouping of assets for impairment testing purposes is highly judgemental and can be very beneficial to companies who are required to perform impairment assessments as it can remove the burden of preparing numerous assessments.

To provide an example of the concept of grouping assets together for impairment assessment purposes one can revert back to the example of the large restaurant chain utilized earlier. At a large restaurant chain each location or lease is composed of numerous assets, which if impairment indicators were present would each require an impairment assessment (if grouping was not possible). 

In cases such as this (and many others) the FASB has permitted companies to group the assets of a single restaurant location together into one impairment assessment (ex: real estate lease, owned restaurant equipment, delivery vehicles, etc.). These assets can be grouped together, due to the fact that when combined, they all generate the cash flows associated with that restaurant location. In other words, leased real estate space cannot generate cash flows without the restaurant equipment and delivery vehicles and vice versa. 

When performing an impairment analysis under IFRS a company would utilize the same approach of grouping assets; however under IFRS this term is commonly referred to as a cash generating unit (or CGU).

What are common indicators of impairment for leased assets?

‍Common impairment indicators include significant changes in how an asset is used, legal proceedings affecting asset use, geo-political conflict or unrest, natural disasters, and material declines in the cash flows generated by a leased location. When any of these indicators are present, a formal impairment assessment is required under both ASC 842 and IFRS 16.

What is the difference between the US GAAP recoverability test and the IFRS one-step test for impairment?

‍Under US GAAP, the recoverability test compares undiscounted future cash flows to the asset's carrying value. If undiscounted cash flows exceed carrying value, no impairment exists. Under IFRS, the one-step test compares carrying value to the higher of fair value less disposal costs or value in use (discounted cash flows). IFRS uses discounted cash flows, which typically produces a more conservative result.

How is the impairment charge allocated across a group of assets?

‍When an impairment is identified at the asset group level, the total impairment charge is allocated to individual assets based on their relative fair values within the group. This allocation often requires a third-party valuation specialist to determine the fair value of each asset. The impairment reduces each asset's carrying value to its allocated fair value.

What journal entry is required to record an ROU asset impairment?

‍The impairment entry debits impairment expense and credits the ROU asset for the impaired amount. When the impairment covers a group of assets, the credit is split across each asset in the group based on its proportionate fair value. After the entry is posted, each asset's carrying value reflects its new fair value for the reporting period.

What does a lease impairment assessment look like in practice?

The following example walks through how a multi-location restaurant chain performs impairment assessments for two locations under US GAAP (ASC 842) and IFRS 16 during a period of significantly reduced cash flows.

During the 2020 fiscal period Pizza Pie Co. felt the wrath of COVID-19 and was forced to close indoor dining across all of their 55 locations. This left these locations with only take-out and delivery as streams of revenue.

Pizza Pie Co.’s auditors, Auditor LLC, have asked Pizza Pie Co. to prepare an impairment assessment for two locations, London, England and Chicago, Illinois under both US GAAP (for the Chicago location) and IFRS (for the London location). 

Step 1- Assess for indicators of impairment

In looking at the financials for both the London and Chicago locations you have uncovered that the gross profit of the London location has reduced by 75% and the Chicago location’s gross profit has reduced by 25%. The downturn in profits is due to not being able to provide indoor dining to customers (which is the main feature of each location). At the moment, there are no known timelines for when indoor dining will return for either location.

You have assessed that there are indications of impairment for both locations due to the ongoing COVID-19 pandemic and the use of both locations being severely limited by the pandemic. You now proceed with a formal impairment assessment under US GAAP and IFRS.

For all other Pizza Pie Co. locations, indoor dining remained uninterrupted and the profits actually grew year-over-year.

Step 2- Group assets (or CGUs) for impairment assessment(s) where possible

Both IFRS and US GAAP allow grouping of assets for impairment assessments. Both the Chicago and London locations are composed of numerous assets that work together to generate cash in flows. Both locations also have independent cash flows as they do not rely on any other location to generate profits.

Therefore, for the purposes of assessing whether an impairment has occurred each location can be viewed as an independent group of assets and be included in two separate impairment assessments.

Step 3 - Assess each location for impairment

Chicago lease impairment assessment under ASC 842

You begin with assessing the Chicago location for impairment under US GAAP. You have just finished your 10-year operational forecast for the Chicago location and have calculated that your net cash flows after the 10-year period (excluding interest, taxes and overhead costs) are approximately $5,000,000.

You then accumulate the total carrying amount of all assets at the Chicago location and note that the total is $3,000,000. 

Given that the undiscounted future cash flows are $2,000,000 higher than the carrying amount of the assets within the asset group you may pass on further assessment and conclude that there is no impairment present for the 2020 fiscal period at the Chicago location.

Now that you have concluded that there is no impairment for US GAAP purposes at the Chicago location you now must assess for impairment at the London location under IFRS. 

London lease impairment assessment under IFRS 16

The first step under IFRS is to accumulate the total carrying values of the group of assets. After review, you note that the carrying value of the CGUs assets equates to £3,500,000. The next step is to compare the carrying value of the CGU to the higher of: the fair value of the CGU less any costs of disposal and the VIU of the CGU.

You hire a third-party external valuations specialist who estimates the fair value, less the costs of disposal of the London location to be £3,000,000

The 10-year operational forecast was also recently completed for the London location and has yielded £1,500,000 (after removing: taxes and interest and including: net cash flows required to bring the CGU into an operational state and salvage/disposal costs) when discounted using the weighted average cost of capital for the London location.

You have concluded that an impairment of £500,000 has taken place as the carrying value of the CGU (£3,500,000) exceeds the fair value less costs of disposal by £500,000 (£3,500,000 less £3,000,000).

Utilizing the valuation report prepared by the third-party valuations specialist you determine that the impairment charge of £500,000 should be recorded as follows:

Dr. Impairment Charge £500,000

Cr. ROU Asset                                   £100,000

Cr. Delivery Vehicles                       £150,000

Cr. Restaurant Equipment             £250,000

Once this journal entry is posted the carrying values of the assets that comprise the CGU will now equate their fair value for the 2020 reporting period.

In Summary

Lease impairments are incredibly common during a time of economic turbulence. Accounting for these types of lease modifications requires that a major part of the cash flows associated with the ROU assets within your lease portfolio undergo a revaluation model. Ultimately, businesses should document their judgements, assumptions and internal control procedures as it relates to the new leasing standard. 

All leased assets, corresponding lease liabilities, and potential lease impairments can have a significant impact on your income statement and financing activities. Clearly documenting your analysis will better prepare your internal teams for auditing activities and of course the lease accounting compliance transition.