With GAAP-complying companies having to adopt ASC 842 by the end of 2022, understanding the treatment of acquired leases through acquisitions is a relevant accounting consideration for companies.
This publication examines the relationship of Accounting Standards Codification 842, Leases (“ASC 842”) to Accounting Standards Codification 805, Business Combinations (“ASC 805”). This post and the underlying in-depth publication are not an extensive analysis of ASC 842, but rather a discussion of key components relating to acquired leases, whether it be leases acquired in a transaction accounted for as a business combination or in a transaction accounted for as an asset acquisition.
Acquirers of any lease, regardless of whether the acquirer of the acquired lease is in a lessor or lessee position, must treat the acquired lease as if it were a new lease as of the acquisition date. As such, acquirers must assess any differences between initial assessment of a lease under ASC 842, versus when a lease is acquired pursuant to a transaction accounted for under ASC 805. Specific differences are discussed in more depth within the publication and summarized in part below.
Typically, under ASC 805 acquired assets and liabilities through business combinations are recognized at fair value on the acquisition date following the measurement provisions of Accounting Standards Codification 820, Fair Value Measurement (“ASC 820”). Leases under ASC 842 are an exception to the requirement to recognize assets and liabilities acquired at fair value. As previously mentioned and as analyzed further in this discussion, acquired leases are recognized and measured as new leases as of the acquisition date. Lease classification can be reassessed, but if the lease was previously recognized under ASC 842 and is not modified through the acquisition, the lease is not required to be reclassified.
Leases acquired through asset acquisitions are generally recognized and measured similarly to how they are under business combinations with the exception of carrying over the lease classification. Lessors must reassess lease classification and lessee requirements to reassess classification are broadened to include more factors that would trigger reassessment (i.e., renewal and purchase options) when compared to the treatment under business combinations, as discussed below.
1. Lease classification in relation to a business combination
Provided that a lease was previously measured under ASC 842, then in accordance with ASC 842-10-55-11, leases acquired in a business combination should retain their previous lease classification unless there is a lease modification, and that modification is not accounted for as a separate contract (granting a lessee additional right-of-use assets (“ROU”) not included in the original contract and lease payments increase commensurate with the standalone price for the additional ROU).
Any of the following are lease modifications that are not accounted for as a separate contract and therefore represent a need for reassessment of the lease classification:
- Grants the lessee an additional ROU not included in the original contract
- Extends or reduces the term of an existing lease, other than through the exercise of a contractual option to extend (“renewal option”) or terminate the lease
- Fully or partially terminates an existing lease
- Changes the consideration of the contract only
Our observation: Acquirers and acquirees often have different business purposes for leases and other assets and liabilities, especially relating to the exercise of renewal options and purchase options. In practice, these differences in how the lease is intended to unfold are not considered to be a lease modification that would require a change in classification under ASC 842 in relation to ASC 805, as long as they represent rights that were present in the acquired lease. Rather, such rights are viewed as lessee elections for items already present in the lease contract and reflect more of the lessee’s intention rather than a modification of the lease. This conclusion is in line with the reassessment criteria above, especially when referring to the ‘exercise of a contractual option to extend’.
Further, acquirers often are uncertain whether some lease modifications will be made at the time of the acquisition. For modifications that are contemplated at the acquisition date but not put into place at that date, no impact is reflected as of the acquisition date and no classification reassessment is considered. Any reassessment of classification should be assessed when the modification is effective.
If the acquiree has not yet adopted ASC 842, whether it has accounted for leases under Accounting Standards Codification 840, Leases (“ASC 840”), International Financial Reporting Standards (“IFRS”) or other GAAP (non-US GAAP), reassessment of the classification of the acquired lease(s) must occur as of the acquisition date.
For leases where the acquiree is a lessee, the acquirer may elect an accounting policy election by class of underlying asset, which is applicable to all of the acquirer’s acquisitions, not to recognize assets or liabilities at the acquisition date for leases that, at the acquisition date, have a remaining lease term of twelve months or less. These acquired leases are considered short-term leases and the related lease expense is recognized on a straight-line basis over the remaining term.
2. Lease recognition and measurement in relation to a business combination
Acquired leases are accounted for in accordance with ASC 842, but certain aspects that are related to those leases are accounted for under other GAAP as described in ASC 805 for fair value measurement (ASC 820). The following table illustrates some of the key areas of recognition and measurement differences between assets and liabilities related to leases.
|Acquiree as a:
|Directly associated to leases
Recognized & measured under ASC 842
|Lease-related but outside scope of ASC 842
Recognized & measured under ASC 820
either finance or operating
Other considerations of note
sales-type or direct finance
Other assets that are not directly included in the lease calculations but are still related to the lease are accounted for as indicated in the table above. These other assets can include various identifiable intangible assets (i.e., in-place lease intangibles, other intangible rights) that can be recognized related to acquired leases and are measured under ASC 820.
3. Lessee and lessor accounting – initial measurement upon acquisition
ASC 842 defines lease accounting relating to lessors and lessees. The various lease classifications under ASC 842 are as follows:
|Lease holder type
|Finance or operating
|Operating, sales-type or direct finance
For lessee accounting, under ASC 805-20-30 24, an acquirer must measure, or assess, any acquired lease as if the lease is a new lease as of the acquisition date, outside of its classification (see requirements above). If an acquirer acquires a lessee position that is either an operating or finance lease, the acquirer must first determine the lease’s lease liability at present value of the remaining lease payments. Measuring the acquired lease requires reassessment of all of the following:
- The lease term
- Any lessee options to purchase the underlying asset
- Lease payments (e.g., amounts probable of being owed by the lessee under a residual value guarantee)
- The discount rate for the lease
Our observation: One of the most difficult aspects of determining the present value of the lease liability is the conclusion of the discount rate, which is frequently determined by the incremental borrowing rate (“IBR”). This determination can be a judgmental area due to approach and information available. In addition to understanding the term of the lease, understanding the historical borrowing rates for the acquiring entity, if any, the acquisition date credit rating of the acquiring entity (or a near-term evaluation of the credit rating), along with input from the acquiring entity’s external auditors can greatly help this process. Additionally, performing sensitivity analyses around the selected rate can provide context for the selected rate and whether additional work is required for the rate to be more precise.
For lessor accounting, the type of lease matters as operating leases are treated differently than sales-type or direct finance leases.
Similar to operating leases for lessees, an acquirer of operating leases in the lessor position determines if the terms of the leases have favorable or unfavorable market terms when compared to the same or similar items at the acquisition date. The acquirer recognizes an intangible asset if the terms are favorable or a liability if the terms are unfavorable relative to market terms and both are recognized under ASC 820 fair value guidance as indicated by ASC 805.
Both acquired lessor sales-type and direct finance leases are measured in the same manner. According to ASC 805-20-30-25, the acquirer measures its net investment in the lease as the sum of both of the following, which equal the fair value of the underlying asset at the acquisition date:
- The lease receivable at the present value as if the acquired lease were a new lease at the acquisition date, discounted using the rate implicit in the lease, by using the following:
- The remaining lease payments
- The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor
- The unguaranteed residual asset as the difference between the fair value of the underlying asset at the acquisition date and the carrying amount of the lease receivable, as determined in accordance with (a) above, at that date
Effectus Group’s team of highly skilled advisors, with extensive experience in assessing acquired leases as part of business combinations or asset acquisitions, is here to help navigate these areas and other related topics.