Theory and Practice
Because IFRS 16 and ASC 842 brought most leases on balance sheet, lessees now have substantial ROU assets that must be tested for impairment.
IFRS
Right-of-use assets are subject to IAS 36 Impairment of Assets (IASB, 2004a). Whenever there is an indication of impairment (e.g., significant sublease losses, damage to the asset, a decision to cease using the leased asset), the lessee must test the ROU asset (or the cash-generating unit containing it) for recoverability. The procedure is the same as for owned assets: compare the asset’s carrying amount to its recoverable amount (higher of value in use and fair value less costs of disposal). If the carrying amount exceeds recoverable amount, an impairment loss is recognized to write the asset down to recoverable amount (IASB, 2004a). For example, if a company decides to exit a leased office and sublet it at a loss, it might determine that the recoverable amount of the ROU asset (based on sublease income) is lower than the asset’s carrying value. The company would then record an impairment to reduce the ROU asset to the sublease income’s present value. Importantly, IFRS has no separate “onerous contract” test for leases – previously, under IAS 37, companies had to provide for onerous operating lease commitments when applicable, but now any potential loss from a lease is reflected by impairing the ROU asset (and recognizing any further necessary provision under IAS 37 for the lease if the impairment is insufficient) (IASB, 2016; IASB, 1998). In practice, if a company permanently ceases using a leased asset, it will often write the ROU asset down to zero. After that, the lease liability remains (a monetary obligation that still must be paid) but the ROU asset is gone – so future rent payments will just reduce the liability without any corresponding asset. IFRS does allow reversals of impairment if circumstances improve (e.g., if an idle leased asset for which an impairment was taken becomes utilized or subleased at better terms, the impairment can be reversed to the extent of the improved recoverable value) (IASB, 2004a). Such reversals cannot exceed the original impaired amount (no writing up above original carrying value).
US GAAP
US GAAP uses the ASC 360 impairment model for long-lived assets, which is similar in spirit to IAS 36 with some differences in methodology. A trigger event (e.g., an asset is not going to be used) requires a recoverability test: if undiscounted future cash flows are less than the asset’s carrying amount, the asset is not recoverable, and an impairment loss is measured as the excess of carrying amount over fair value of the asset (Financial Accounting Standards Board, 2004b). For ROU assets, typically the undiscounted cash flows would include either sublease income or cost savings from use, and fair value can be based on market rentals for the asset. If the company above (with an unused office) is under US GAAP, it might find the undiscounted sublease income is less than the ROU asset’s carrying amount, so a loss is recorded to write the ROU asset down to fair value (in this case, the expected sublease income’s present value). One key difference is that US GAAP prohibits the reversal of impairment losses (Financial Accounting Standards Board, 2004b). So if you write down an ROU asset, you cannot write it back up even if the asset’s value recovers in use or the market improves – you’d simply recognize lower expenses going forward (since depreciation would now be on a smaller asset base). Another difference is that under legacy US GAAP (ASC 420), companies with onerous operating leases recorded an “onerous lease liability” for the least net cost of the remaining lease (e.g., if you vacated a property, you’d accrue a liability for the net rent due minus any sublease income you expect). Under ASC 842, there is no separate onerous lease test – instead, if a lease is onerous, you handle it by impairing the ROU asset (and if the ROU asset is written off and further losses exist, a liability is recognized for the remaining obligations, similar to IFRS) (Financial Accounting Standards Board, 2016b). In effect, both IFRS and US GAAP have converged on the concept that losses on unfavorable leases are recognized through the impairment framework (subject to the no-reversal rule in GAAP).
UK GAAP
The new FRS 102 follows IFRS – ROU assets will be subject to the impairment guidance of Section 27 (which is akin to IAS 36) (FRC, 2018). Under the old FRS 102, an onerous lease (when leases were off-balance sheet) would have been handled by recognizing a provision for the present value of future lease losses (per FRS 102’s Section 21/IAS 37). Now, with on-balance-sheet leases, an onerous lease will result in an impairment of the ROU asset. The FRC explicitly removed the need for a separate onerous lease provision for leases that will become subject to the new model – instead, the impairment of the ROU asset will capture that loss (FRC, 2022). Thus, the outcome is similar across IFRS and FRS 102. UK entities should ensure that where they previously might have booked onerous lease provisions (e.g., under old GAAP for vacant space or loss-making subleases), they transition to the new approach of using ROU asset impairment.