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8.6 Leases acquired in a business combination
Publication date: 31 Oct 2023
us Leases guide
The accounting for a lease acquired in a business combination depends on whether the acquiree is the lessee or lessor. See LG 7.4 for information on the accounting for a leveraged lease acquired in a business combination.
8.6.1 Acquiree in a business combination is a lessee
ASC 842-10-55-11 requires the acquiring entity in a business combination to retain the acquiree’s previous lease classification unless the lease is modified. (We generally believe that the acquirer should reassess classification of an acquired lease in an asset acquisition.) If the lease is modified and the modification is not accounted for as a separate new lease, the modification is evaluated in accordance with the guidance on lessee lease modifications. See LG 5.2 for information. ASC 805-20-30-24 (as amended by ASC 842) provides guidance on the recognition and measurement of leases acquired in a business combination in which the acquiree is the lessee.
8.6.1.1 Acquirer assesses renewal or purchase options differently
Notwithstanding that an acquiring entity should retain the acquiree’s previous lease classification, an acquirer’s assumptions as to whether it is reasonably certain to exercise an extension or purchase option are independent of an acquiree’s prior assumptions. For example, when an acquiree originally classified a lease as an operating lease pre-acquisition, because it concluded that it was not reasonably certain to exercise a purchase option, an acquirer may still conclude that it is reasonably certain to exercise the purchase option. In that case, the acquirer would continue to classify the lease as an operating lease, in accordance with ASC 842-10-55-11, even though it should include the purchase option in the measurement of the lease liability. We believe the acquirer should then recognize the lease cost over the useful life of the asset rather than over the lease term. This is consistent with the Board’s conclusion, per BC 218, “… that a purchase option is the ultimate option to extend the lease term.” As such, the purchase option should be accounted for in the same way as an extension option for a term equal to the remaining useful life of the underlying asset at the purchase option date.
We believe that there are two acceptable approaches for subsequently recognizing lease expense:
- Approach 1: Recognize expense over the remaining useful life of the asset on a straight-line basis. Under this approach, the periodic expense remains constant throughout the useful life of the asset. The periodic amortization of the asset before the purchase option is exercised should equal the single lease expense recognized, less the interest on the lease liability consistent with the recognition pattern of an operating lease. When the purchase option is exercised, the asset should be reclassified to property, plant, and equipment, and it should be subsequently depreciated as an owned asset over its remaining useful life.
- Approach 2: Amortize the asset on an “other than straight line basis, as permitted by ASC 842 when that is more representative of the pattern in which benefit is expected to be derived from the right-to-use the underlying asset. Under this approach, a lessee would recognize a single lease expense as an operating lease, but it would compute the single lease expense as an amount necessary to amortize the right-of-use asset over the remaining lease term to the balance that it would have had if it were a finance lease. A lessee would typically recognize more lease expense before the purchase option is exercised than in Approach 1. After the purchase option is exercised, the asset should be reclassified to property, plant, and equipment, and the remaining net book value should be subsequently depreciated as an owned asset over its remaining useful life.
For leases in which the acquiree is a lessee, the acquirer shall measure the lease liability at the present value of the remaining lease payments, as if the acquired lease were a new lease of the acquirer at the acquisition date. The acquirer shall measure the right-of-use asset at the same amount as the lease liability as adjusted to reflect favorable and unfavorable terms of the lease when compared with market terms.
As discussed in ASC 805-20-25-28B, an acquirer may elect to apply the short-term lease measurement and recognition exemption to leases that have a remaining lease term of 12 months or less at the acquisition date. In addition to not recording the lease on the balance sheet, under this exception, the acquirer would not recognize an intangible asset if the terms of an operating lease are favorable relative to market terms or a liability if the terms are unfavorable relative to market terms. See LG 2.2.1 for information on the short-term lease measurement and recognition exemption, BCG 4.3.3.5 for information on favorable and unfavorable contracts, and BCG 4.3.3.7 for information on lease arrangements.
ASC 842-20-35-13 provides guidance on the amortization of leasehold improvements acquired in a business combination.
Leasehold improvements acquired in a business combination or an acquisition by a not-for-profit entity shall be amortized over the shorter of the useful life of the assets and the remaining lease term at the date of acquisition.
8.6.1.2 Acquirer’s policy to combine lease and nonlease component differs
As discussed in LG 2.4.5.1, lessees may elect an accounting policy to not separate lease and nonlease components, and account for both as a single lease component. The election to not separate lease and nonlease components, and ascribe all the consideration to the lease component, may result in classifying the lease as a finance lease. However, as noted in LG 8.6, ASC 842-10-55-11 requires the acquiring entity in a business combination to retain the acquiree’s previous lease classification unless the lease is modified. A question arises as to how this guidance should be applied when an acquirer and acquiree elected different accounting policies regarding separation of lease and nonlease components.
We believe that an acquirer, generally, must conform an acquiree’s accounting policy elections to its own upon a business combination. Therefore, the acquirer would measure the assumed lease liability in accordance with its own election to separate or not separate lease and nonlease components. However, we believe that with respect to lease classification, the acquirer should retain the acquiree’s lease classification in accordance with the guidance in ASC 842-10-55-11, notwithstanding that the acquiree had a different pre-acquisition policy regarding separating lease and nonlease components.
8.6.1.3 Acquisition of a related party lease with off-market terms
As discussed in LG 3.2 ASC 842-10-55-12 requires entities to account for related party leases based on their legally enforceable terms and conditions. Related parties, therefore, do not adjust their related party lease accounting for off-market terms or conditions. However, as discussed in LG 8.6.1.1, per the guidance in ASC 805, the carrying amount of a right-of-use asset acquired in a business combination is adjusted to reflect favorable or unfavorable market terms. The related party guidance in ASC 842 does not address whether it applies in a business combination in which either the acquirer or acquiree, and the lessor, are related parties. We believe that the acquirer in a business combination should follow the guidance in ASC 805-20-30-24; it should measure the lease liability at the present value of the remaining lease payments (consistent with related party lease guidance in ASC 842) but should adjust the measurement of the right-of-use asset for favorable or unfavorable terms.
8.6.2 Acquiree in a business combination is a lessor
ASC 805-20-30-25 provides guidance on the recognition and measurement of sales-type and direct financing leases acquired in a business combination.
For leases in which the acquiree is a lessor of a sales-type lease or a direct financing lease, the acquirer shall measure its net investment in the lease as the sum of both of the following (which will equal the fair value of the underlying asset at the acquisition date):
a. The lease receivable at the present value, discounted using the rate implicit in the lease, of the following, as if the acquired lease were a new lease at the acquisition date:
1. The remaining lease payments
2. 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.
b. 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), at that date.
The acquirer shall take into account the terms and conditions of the lease in calculating the acquisition-date fair value of an underlying asset that is subject to a sales-type lease or a direct financing lease by the acquiree-lessor.
A customer relationship intangible or other nonlease-related assets associated with the lease may also be recognized.
When the acquiree in a business combination is a lessor in a lease classified as an operating lease, the underlying asset would be recognized and measured at fair value unencumbered by the related lease. In other words, the leased property (including any acquired tenant improvements) would be measured at the same amount, regardless of whether an operating lease is in place. An intangible asset or liability may also be recognized if the lease contract terms are favorable or unfavorable as compared to market terms. In addition, in certain circumstances, an intangible asset may be recognized at the acquisition date for the value associated with the existing lease (referred to as an “in-place” lease) and for any value associated with the relationship the lessor has with the lessee. Further, a liability may be recognized for any unfavorable renewal options or unfavorable written purchase options if the exercise is beyond the control of the lessor. See BCG 4.3.3.7 for more information.
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