Although the US GAAP accounting standards for lessee operating leases impact the stages of valuation analyses to Business Valuation issues (no impact to income statement, but increase in balance sheet so as to the enterprise value increases by the value of operating lease liability and enterprise values are not comparable from the traditional EBIT or EBITDA multiplier) and Business Combination issues (Allocating lease liability and ROU Asset, treatment of leasehold interest and leasehold improvements), we are focusing more on Impairment Considerations.
ROU assets are evaluated for impairment following the guidance for other long-lived assets in Accounting Standards Codification (ASC) 360, Property, Plant and Equipment. Following the adoption of ASC 842, leases are recorded on the balance sheet. These new right-of-use (“ROU”) assets are tested for impairment under ASC 360 in a manner consistent with owned long-lived assets held and used.
The adoption of Accounting Standards Codification (ASC) 842
Leases introduces new considerations that must be made regarding right of use (ROU) asset valuation and impairment. When evaluating ROU assets for impairment, the evaluation must be performed at the lowest level that cash flows can be identified.
Asset impairment will be triggered when the estimated fair value of the ROU asset and property and equipment is less than its carrying amount (CAC, Contributory Asset Charge), and the estimated future cash flows associated with the location will not be sufficient to fully recover its netbook value.
Under Generally Accepted Accounting Principles (GAAP), if any impairment indicators are present, a recoverability test must be performed as specified by ASC 360 to determine whether further impairment analysis is required.
This recoverability step determines whether carrying amount of asset group is recoverable based on management's plans for the asset group and include only the future cash flows that are directly associated with and that are expected to arise as a direct result of the use and eventual disposition of the asset group.
There is a two-step approach whereby first, a recoverability test is performed, and if the fair value of the asset group is less than its carrying amount, then a step two impairment test (Measurement, compare carrying amount of asset group to its fair value, based on Market Participant Fair Value on ASC 820 assumptions), is performed.
Impairment calculations have historically not been impacted by an organization’s financing decisions and this is the intent of ASC 842 as well given that ASC 842 looks at operating leases as operating liabilities.
While the recoverability test is calculated using undiscounted cash flows, cash flows would be discounted in calculating the true fair value of the ROU and associated assets to determine the impairment loss. The discount rate utilized would be the rate that a market participant would utilize in calculating fair value.
ROU Asset Impairment - Asset Group Step 1 (Recoverability), then Step 2 (Measurement) as explained in the previous section.
Valuing the ROU asset in the context of ASC 360
Under ASC 360, the ROU asset in its entirety is valued. This differs from ASC 805 where only the off-market component is valued via a DCF and then ultimately added to a remeasured ROU asset based on remaining contractual payments and an updated incremental borrowing rate as of the measurement date.
- Resources to determine market rent:
- ROU market transactions are generally limited and, as such, the discounted cash flow (DCF) methodology is most commonly used.
- The DCF includes estimating market-based lease rate payments.
- If there are obsolescence issues, additional downward adjustments discounts to market rent may be needed.
- Additional downward market rent adjustments to consider:
- Market discount rate can be estimated from:
- A higher discount rate may also be appropriate to reflect the risk of finding a subtenant when the location is no longer in-use by the company and they are seeking a sublease, downtime, free rent, concessions, and a discounted sublease market rent is modeled into the DCF.
Case of Abandonment of ROU Assets
A plan to abandon a ROU asset is considered an indicator of impairment under ASC 360 which results in the lessee assessing the ROU asset or asset group for recoverability and may also result in the lessee reassessing the lease term and classification.
Further Testing Case Scenarios:
Find Out More for Lease Impairment Valuation?
Call the lease impairment valuation expert, David Hahn, ASA, CVA, CCIM, MAFF, CM&AA, MBA at 408-455-4562 or email: david@myfinancialvaluation.com.
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David Hahn, CVA, ASA, MAFF, CCIM, CM&AA, MBA
CVA - Certified Business Valuation Analyst
ASA - Accredited Senior Appraiser
CM&AA - Certified Merger & Acquisition Advisor
CCIM - Certified Commercial Investment Member
MAFF - Master Analyst in Financial Forensics
CA State Certified RE Appraiser, License #AG009828
CA State Licensed RE Broker, License #00902122
Business Valuation, Commercial Real Estate Appraisal.
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