The requirement to record an asset retirement obligation does not apply to obligations of a lessee in connection with an underlying asset that meet the definition of either lease payments or variable lease payments under
ASC 842, whether imposed by a lease or by a party other than the lessor. In these circumstances, the legal obligation associated with the ARO is that of the lessor who owns the leased asset and who is legally responsible for the associated ARO activities. While a portion of the lessee’s lease payments may indirectly compensate the lessor for the AROs, the legal obligation at retirement would be that of the lessor, and not the lessee. For lessee obligations meeting the definition of either lease payments or variable lease payments under
ASC 842, such amounts should be included in the determination of the lease liability and the right-of-use asset recognized at lease commencement, and would not be separately accounted for under
ASC 410-20.
Alternatively, obligations imposed by a lease agreement that meet the definition of an ARO and do not meet the definition of either lease payments or variable lease payments under
ASC 842 are within the scope of
ASC 410-20 for the lessee.
ASC 842-10-55-37 includes guidance on such obligations.
ASC 842-10-55-37
Obligations imposed by a lease agreement to return an underlying asset to its original condition if it has been modified by the lessee (for example, a requirement to remove a lessee-installed leasehold improvement) generally would not meet the definition of lease payments or variable lease payments and would be accounted for in accordance with Subtopic 410-20 on asset retirement and environmental obligations. In contrast, costs to dismantle and remove an underlying asset at the end of the lease term that are imposed by the lease agreement generally would be considered lease payments or variable lease payments.
The determination of whether an obligation associated with leased property falls within the definition of lease payments or variable lease payments often involves judgment and the conclusion will be based on the specific facts and circumstances. An important factor to consider in making this determination is whether the obligation existed at the inception of the lease or was created through the actions of the lessee following the inception of the lease. For example, a lease agreement might require the lessee to return the leased property to the lessor in its original condition beyond normal wear and tear, such as requiring the removal of leasehold improvements installed by the lessee, at the lessee’s cost. Any costs that the lessee expects to incur to bring the leased property to that specified condition may fall within the scope of
ASC 410-20 and could result in the recognition of an ARO.
Conversely, if the lessee were to lease both the property and leasehold improvements (i.e., the leasehold improvements were already in place at inception of the lease), and the lease required the lessee to remove the existing leasehold improvements at lease termination, this obligation would generally be viewed as a lease payment under
ASC 842. In this case, the cost is a specified payment in the lease agreement and does not result from the lessee’s actions after lease inception. As this obligation would meet the definition of a lease payment or a variable lease payment, it should be accounted for under
ASC 842.
In certain circumstances, the leasehold improvements put into place by the lessee have a useful life shorter than the lease term. As a result, the lessee may expect to retire the old leasehold improvements and install new leasehold improvements during the lease term. If the lessee is required to remove the leasehold improvements at the end of the lease term, the lessee should account for an asset retirement obligation when the leasehold improvements are constructed, and the expected settlement date should be when the specific asset will be retired (i.e., at the end of the useful life of the leasehold improvement). When a new leasehold improvement is put into place, a new asset retirement obligation is incurred and would be measured with a new expected settlement date. Determining the settlement date requires an assessment of whether the lease will be renewed.
See Example PPE 3-1 and Question PPE 3-8 for a discussion regarding the measurement of an ARO when considering lease improvements and renewals.
EXAMPLE PPE 3-1
Determining whether leasehold improvements generate an ARO
Lessee Corp leases an office building that includes pre-existing leasehold improvements from a previous lessee, including interior walls and carpeting. Lessee Corp’s lease agreement states that the company is contractually obligated to remove the pre-existing improvements and any additional leasehold improvements at the end of the lease term.
Does the requirement to remove the pre-existing leasehold improvements create an ARO?
Analysis
No. The requirement to remove the pre-existing leasehold improvements does not create an ARO for Lessee Corp. While a legal obligation exists to remove the pre-existing leasehold improvements, the obligation was not created by the actions of Lessee Corp. Instead, the estimated cost of the required removal of the leasehold improvements that existed at lease inception should be included in lease payments when recognizing and measuring the lease liability and right-of-use asset under
ASC 842.
Alternatively, if Lessee Corp constructs additional leasehold improvements, it should account for the removal cost obligations associated with these additional leasehold improvements as an ARO.
If costs are incurred that relate to both the removal of pre-existing and new improvements (e.g., if one contractor is hired to remove both pre-existing and new internal walls), Lessee Corp should allocate such costs between lease payments used when measuring and recording the lease liability and right-of-use asset under
ASC 842 and the ARO.