Lease Impairment: What It Is and How to Account for It
Understand the accounting principles for lease impairment. This guide explains how to assess a right-of-use asset's value and record any necessary adjustments.
Lease impairment is a reduction in the value of a leased asset as it is recorded on a company’s balance sheet. Under Accounting Standards Codification (ASC) 842, companies recognize a “Right-of-Use” (ROU) asset for nearly all their leases. This ROU asset represents the company’s right to use the leased item for the duration of the lease term. An impairment is not a routine, scheduled adjustment but rather an accounting event prompted by specific circumstances suggesting the asset’s value has declined. When such an event occurs, the company must perform a test to determine if the ROU asset’s recorded value is still recoverable. If it is not, the company must write down the asset’s value to what it is currently worth, recognizing a loss in the process.
Identifying Impairment Triggers
A company tests its leased assets for impairment not on a fixed schedule, but when specific events or changes in circumstances occur. The guidance for these “triggers” comes from ASC 360, which covers the accounting for property, plant, and equipment, and extends to ROU assets.
Common triggers include a significant decrease in the market price of a similar asset or a substantial adverse change in the way the asset is being used. For instance, if a company leases a retail store and decides to permanently close that location, this would be a clear trigger. A major negative shift in the business or regulatory environment that directly impacts the asset’s value can also serve as an indicator.
Another significant trigger is a projection that demonstrates ongoing financial losses directly associated with the use of the ROU asset. If a leased manufacturing facility is failing to generate enough revenue to cover its operating costs, an impairment test is warranted. A formal decision to dispose of the asset significantly before its lease ends, such as through abandonment or a sublease at a substantial loss, also necessitates an impairment review.
The Lease Impairment Test
Under U.S. GAAP, the impairment test for ROU assets is the same for both operating and finance leases and follows a two-step model for long-lived assets.
The first step is a recoverability test. A company compares the carrying amount of the asset group, including the ROU asset, to the sum of the future undiscounted cash flows expected from its use. These cash flows include remaining lease payments and any other income, such as potential sublease revenue. If the carrying amount is higher than the undiscounted cash flows, the asset is not considered recoverable, and the company must proceed to the second step. If the cash flows are higher, no impairment is recorded.
The second step is to measure the impairment loss. An impairment loss is recognized for the amount by which the asset’s carrying amount exceeds its fair value. Fair value is the price that would be received to sell the asset in an orderly transaction between market participants.
Calculating and Recording the Impairment Loss
Once an ROU asset has been identified as impaired, the company must calculate and record the financial loss. Fair value can be determined through various methods, such as looking at market prices for similar assets or using a discounted cash flow analysis, which projects future cash flows and discounts them to their present value. For example, if an ROU asset has a carrying amount of $500,000 and its fair value is determined to be $350,000, the impairment loss is $150,000.
The accounting entry to record this loss involves a debit to an “Impairment Loss” account, which appears on the income statement, and a credit to the “ROU Asset” account on the balance sheet. This entry reduces the asset’s value and recognizes the expense in the current period.
Impairment Loss $150,000 (Debit)
ROU Asset $150,000 (Credit)
The corresponding lease liability on the balance sheet is not affected by the impairment of the ROU asset; the company is still legally obligated to make its contractual lease payments.
Post-Impairment Accounting and Disclosures
After an impairment loss is recorded, the ROU asset has a new, lower carrying value that serves as its new cost basis. For an operating lease, the company will no longer recognize a straight-line lease expense. Instead, the new, lower ROU asset balance is amortized on a straight-line basis over the remaining lease term.
For a finance lease, the reduced carrying amount of the ROU asset is also amortized over the remaining lease term. The accounting for the lease liability continues as before, with interest being recognized as part of the regular amortization schedule. A rule under U.S. GAAP is that once an impairment loss is recognized for an ROU asset, it cannot be reversed in future periods, even if the asset’s fair value subsequently recovers.
Companies are required to provide specific disclosures in their financial statement footnotes regarding the impairment. These disclosures must include a description of the impaired ROU asset and the facts and circumstances that led to the impairment. Additionally, the company must disclose the amount of the impairment loss and specify where the loss is included in the income statement.