A lease agreement represents an arrangement in which one party obtains the right to use an asset from another party for a period of time, in exchange for the payment of consideration. Lease arrangements that exist at the acquisition date may result in the recognition of various assets and liabilities, including separate intangible assets based on the contractual-legal criterion. The type of lease (e.g., operating lease) and whether the acquiree is the lessee or the lessor to the lease will impact the various assets and liabilities that may be recognized in a business combination.
A lessee will record right-of-use assets and lease liabilities on their balance sheet for all leases, unless the lessee makes an accounting policy election that exempts the measurement and recognition of short-term leases. A lessee will record the favorable or unfavorable terms of the lease in the right-of-use asset. A lessee will classify leases as operating or finance leases. Operating leases will be reported on a lessee’s balance sheet.
A lessor will classify leases as operating, sales-type, or direct financing.
See
LG 3 for further information on lease classification for lessees and lessors.
Acquiree is a lessee
Leases are one of the limited exceptions to the recognition (
ASC 805-20-25-17) and measurement (
ASC 805-20-30-12) principles under
ASC 805 and follow specific guidance for acquired leases under
ASC 842 and
ASC 805. Furthermore, paragraph BC416 in the Basis for Conclusions of
ASU 2016-02 acknowledged that the acquiree’s right-of-use assets and lease liabilities would not be recorded at fair value, although the net carrying amount for the lease will approximate the fair value at the date of acquisition.
In a business combination,
ASC 842-10-55-11 requires that the acquirer retain the acquiree’s previous lease classification, unless the lease is modified. 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 further information.
This means that even when the assumptions used to measure the lease liability indicate that the lease would be classified differently, the acquirer is required to retain the classification used by the acquiree. For example, for a new lease, a purchase option that is reasonably certain of exercise would result in the lease being classified as a finance lease. However, if the acquiree classified the lease as an operating lease because, prior to the acquisition date, the purchase option was not reasonably certain of exercise, the acquirer is required to retain the acquiree’s lease classification as an operating lease. The acquirer would include the exercise of the purchase option when measuring the lease liability and right-of-use asset. The acquirer would also consider the purchase option when determining the useful life of the right-of-use asset (i.e., the useful life of the underlying leased asset).
ASC 805-20-30-24 provides guidance on the recognition and measurement of leases acquired in a business combination in which the acquiree is the lessee. This guidance applies to operating and finance leases.
ASC 805-20-30-24
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 or unfavorable terms of the lease when compared with market terms.
The acquired lease liability should be measured as if it were a new lease following the guidance under
ASC 842 (e.g., reassessment of the lease term, discount rate, lease payments, purchase options), except when taking into account the lease classification requirements under
ASC 842-10-55-11.
The right-of-use asset is measured at the amount of the lease liability and adjusted by any favorable or unfavorable terms of the lease as compared to market terms. When determining whether there are any favorable or unfavorable terms of a lease that require recognition, the acquirer should consider all of the terms of the lease (e.g., contractual rent payments, renewal or termination options, purchase options, lease incentives). For example, assume an acquired lease includes an option to purchase the underlying asset for $15 and the option has a fair value of $4 at the acquisition date. If the purchase option is reasonably certain of being exercised, the purchase option payment of $15 would be included in the lease payments used to measure the lease liability and right-of-use asset. Assume that after including the purchase option of $15, the acquirer determines that the lease liability is $20. Besides the purchase option, the terms of the lease are determined to be at market. As such, the favorable terms of the lease are equal to the value of the purchase option of $4. The favorable terms of the lease would be recorded as an adjustment to the right-of-use asset and the value of the right-of-use asset recorded in the acquisition would be $24. Refer to
LG 3.4 and
LG 4.2.1 for more information on the application of the reasonably certain threshold and the measurement of the lease liability, respectively.
If there is a renewal option that allows the lessee to renew with favorable lease terms (i.e., contractual rent payments are less than market rent), the renewal option should be considered in measuring the favorable terms of the lease. Renewal options should also be considered when determining the lease term. When renewal options are reasonably certain of being exercised, the lease term should include the additional term provided by the renewal option. The contractual rent payments made during the lease term will be included when measuring the lease liability and right-of-use asset.
If an option (e.g., renewal option, termination option, purchase option) is not reasonably certain of being exercised, the lease term used to determine the lease liability and right-of-use asset would not be impacted by the option. However, when the option is not reasonably certain of being exercised, there would still be value associated with the option; this value would be included when determining any adjustment to the right-of-use asset for favorable or unfavorable terms of the lease.
When recording the right-of-use asset for an acquired finance lease, the acquirer does not record the right-of-use asset at the fair value of the underlying asset. Under the guidance in
ASC 805-20-30-24, the fair value of a purchase option that is reasonably certain of exercise would be included as an adjustment to the right-of-use asset when recording the favorable terms of the lease. When there is an automatic transfer of title at the end of the lease, the fair value of the underlying asset would be included when recording the favorable or unfavorable terms of the lease.
When calculating the adjustment to the right-of-use asset for favorable or unfavorable terms of the lease, market participant assumptions should be used following the fair value principles of
ASC 820. In calculating the fair value of the favorable or unfavorable terms of the lease, the discount rate applied should be that of a market participant which, would not necessarily be the same as the lessee’s incremental borrowing rate that was used to measure the lease liability. When the terms of the lease are above market (i.e., unfavorable to the lessee), the acquirer should use a discount rate that takes into consideration credit risk given that the unfavorable terms are similar to an acquired uncollateralized financing liability.
As discussed in
ASC 805-20-25-28B, an acquirer in a business combination can make an accounting policy election to not measure or recognize leases that have a remaining lease term of 12 months or less at the acquisition date. In addition, under this policy election, 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. The election is made by class of underlying asset and is applicable to all of the company’s acquisitions. See
LG 2.2.1 for information on the short-term lease measurement and recognition exemption.
There may also be value associated with an at-the-money lease contract depending on the nature of the leased asset (e.g., a lease of gates at an airport for which a market participant might be willing to pay for the lease even when the lease is at market terms). See
BCG 4.3.3.6 for further information on at-the-money contracts.
Leasehold improvements of the acquired entity would be recognized as tangible assets on the acquisition date at their fair value.
ASC 805-20-35-6 provides guidance on the amortization of leasehold improvements acquired in a business combination.
ASC 805-20-35-6
Leasehold improvements acquired in a business combination shall be amortized over the shorter of the useful life of the assets and the remaining lease term at the date of acquisition. However, if the lease transfers ownership of the underlying asset to the lessee, or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the leasehold improvements to the end of their useful life.
Acquiree is a lessor: operating lease
In a business combination,
ASC 842-10-55-11 requires the acquirer to retain the acquiree’s previous lease classification, unless the lease is modified. 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 lessor lease modifications. See
LG 5.6 for information.
If the acquiree is a lessor in an operating lease, the asset subject to the lease would be recognized and measured at fair value unencumbered by the related lease. In other words, the leased property (including any acquired tenant improvements) is measured at the same amount, regardless of whether an operating lease is in place. In accordance with
ASC 805-20-25-12, 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 in accordance with
ASC 805-20-30-5 for the value associated with the existing lease (referred to as an “in-place” lease, as further discussed in this section) 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.
If the lease is classified as an operating lease and provides for non-level rent payments, the acquiree will have recorded an asset or liability to recognize rent revenue on a straight-line basis. Such asset or liability would not be carried forward by the acquirer. Rather, the acquirer would recognize rent revenue prospectively on a straight-line basis. See
BCG 2.5.17 for further information on deferred charges arising from leases when the acquiree is a lessor. Additionally, the presence of a straight-line asset or liability is presumed to be indicative of a favorable or unfavorable contract that should be recognized.
Intangible assets related to “in-place” leases
There may be value associated with leases that exist at the acquisition date (referred to as “in-place” leases) when the acquiree is a lessor and leases assets through operating leases. That value may relate to the economic benefit of acquiring the asset or property with “in-place” leases, rather than an asset or property that was not leased. At a minimum, the acquirer would typically avoid costs necessary to obtain a lease, such as any sales commissions, legal, or other lease incentive costs. That value, in addition to any recognized customer-related intangible assets and favorable or unfavorable contract assets or liabilities, is typically recognized as a separate intangible asset in a business combination. Further, the underlying property subject to the operating leases would be measured at fair value, without regard to the underlying lease contracts.
Example BCG 4-6 illustrates the recognizable intangible and tangible assets related to operating leases of a lessor acquired in a business combination.
EXAMPLE BCG 4-6
Lease-related assets and liabilities
Company A, the lessor of a commercial office building subject to various operating leases, was acquired by Company G during 20X1 in a business combination. Included in the assets acquired is a building fully leased by third parties with leases extending through 20X9. As market rates have fluctuated over the years, certain of the leases are at above-market rates and others are at below-market rates at the acquisition date. All of the leases are classified as operating leases, as determined by the acquiree at lease commencement.
How would Company G measure and record the assets and liabilities related to the lease arrangements upon acquisition?
Analysis
Using the acquisition method, Company G would consider the following in recognizing and measuring the assets and liabilities, if applicable, associated with the lease arrangements:
- Building: A tangible asset would be recognized and measured at fair value. Although the building is fully leased, it should be valued without regard to the lease contracts under FAS 141(R).B147. Company G may also need to recognize other lease or building-related tangible assets (e.g., tenant or building improvements, furniture, and fixtures) not included in this example.
- Favorable or unfavorable leases: Intangible assets or liabilities would be recognized and measured for the original lease contracts that are considered favorable or unfavorable, as compared to market terms at the acquisition date. For purposes of measuring the liability associated with an unfavorable lease, renewal provisions would likely be considered because there would be an expectation that a lessee would renew. On the other hand, it would be difficult to assume renewals of favorable leases as the lessees typically would not be economically motivated to renew.
- “In-place” leases: An intangible asset that represents the economic benefit associated with the building being leased to others would be recognized because the acquirer would avoid costs necessary to obtain a lease (e.g., sales commissions, legal, or other lease incentive costs). The “in-place” lease value recognized should not exceed the value of the remaining cash payments under the lease; otherwise, the asset would be immediately impaired.
- Customer (tenant) relationships: An intangible asset may be recognized, if applicable, for the value associated with the existing customer (tenant) base at the acquisition date. Such value may include expected renewals, expansion of leased space, etc.
Acquiree is a lessor: sales-type or direct financing lease
The acquired entity may also be a lessor in a lease other than an operating lease, such as a direct financing or sales-type lease. In those situations, the acquirer recognizes and measures its net investment in the lease in accordance with
ASC 805-20-30-25, which will be equal to the sum of the lease receivable and the unguaranteed residual asset. In applying this guidance, the acquirer will need to determine the fair value of the net investment in the lease that takes into account the terms and conditions of the lease. The acquirer would incorporate into the fair value of the net investment in the lease any terms or conditions in the lease that are favorable or unfavorable (i.e., off market contract terms which could include rental payments, residual value guarantees, purchase options, renewal options, termination options, etc.). Therefore, the acquirer would not record a separate intangible asset or liability for any favorable or unfavorable terms of the lease.
An intangible asset may be recognized for any value associated with the relationship the lessor has with the lessee (e.g., customer or tenant relationships). Generally, we believe the value of an in-place lease is incorporated in the fair value of the net investment in the lease. However, we are aware of an alternative view in practice in which an in-place lease intangible asset is separately recorded.
ASC 805-20-30-25
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):
- 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:
- The remaining lease payments
- 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.
- 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.
Items to consider when recognizing lease-related assets and liabilities
Figure BCG 4-3 summarizes the typical items to consider in the recognition of assets and liabilities associated with lease arrangements in a business combination.
Figure BCG 4-3
Items to consider when recognizing lease-related assets and liabilities
Lease classification |
Lease-related assets and liabilities |
Acquired entity is a lessee in an operating lease or a finance lease |
- Right-of-use asset
- Lease liability
- Intangible asset or liability - premium paid for certain at-the-money contracts (BCG 4.3.3.6)
- Leasehold improvements
The following are not recorded as a separate intangible, instead they are included as an adjustment to the right-of-use asset:
- Favorable or unfavorable rental rates
- Purchase or renewal options
|
Acquired entity is a lessor in an operating lease |
- Leased asset (including tenant improvements) recognized without regard to the lease contract
- Intangible asset or liability - favorable or unfavorable rental rates
- Unfavorable renewal or written purchase options
- “In-place” leases
- Customer (or tenant) relationships
|
Acquired entity is a lessor in a sales-type or direct financing lease |
- Net investment in the lease - equal to the sum of the lease receivable and the unguaranteed residual asset, measured following ASC 805-20-30-25
- Customer (or tenant) relationships
|
Acquiree entered into a sale and leaseback transaction prior to being acquired in a business combination
An acquiree may have previously applied sale and leaseback accounting in a transaction with a third party that was separate from the business combination. When the acquiree’s original sale and leaseback transaction qualified as a sale, the acquisition accounting will depend on whether the acquiree had previously recognized additional financing under
ASC 842-40-30-2. Refer to
LG 6 for more information on sale and leaseback transactions.
In the acquiree’s original sale and leaseback transaction, if the sale proceeds exceeded the fair value of the asset, the seller-lessee would have recorded a financing payable to the buyer-lessor for the excess, while the buyer-lessor would have recorded a financing receivable from the seller-lessee. The seller-lessee and the buyer-lessor would have allocated the contractual lease payments between the lease and the financing arrangement. In the subsequent acquisition accounting, the financing arrangement will continue to be recorded separate from the lease and will be recorded following
ASC 805 (i.e., a financial liability when the acquiree was the seller-lessee, a financial asset when the acquiree was the buyer-lessor). The portion of the contractual payments relating to the lease will be used to record the lease in acquisition accounting. These lease-related payments will be used to assess whether there are any favorable or unfavorable terms of the lease that need to be included as an adjustment to the right-of-use asset (seller-lessee) or as an intangible asset or liability (buyer-lessor).
In the acquiree’s original sale and leaseback transaction, if the sale proceeds were less than the fair value of the asset, the seller-lessee and the buyer-lessor would have treated the shortfall as prepaid rent. Prepaid rent will not be recorded in acquisition accounting. The acquirer will use the remaining contractual lease payments to record the acquired lease, including the determination of favorable or unfavorable terms of the lease.
If the acquiree’s original leaseback transaction was a failed sale and leaseback transaction, the acquiree would have recorded the transaction as a financing arrangement and the seller-lessee would not have derecognized the underlying asset. The acquirer would retain the acquiree’s accounting as a failed sale and leaseback and continue to follow the guidance under
ASC 842-40 to determine if and when a sale occurs. If the acquiree is the seller-lessee, the acquirer will value the tangible property independent from the financing arrangement. The financing arrangement will be recorded following
ASC 805 (i.e., a financial liability when the acquiree was the seller-lessee in a failed sale and leaseback, a financial asset when the acquiree was the buyer-lessor in a failed sale and leaseback). Refer to
LG 6.5 for more information on leaseback transactions not accounted for as a sale.
The following table summarizes the accounting for sale and leaseback transactions that an acquiree entered into with a third party prior to being acquired in a business combination.
Sale leaseback transaction (SLB) |
Accounting considerations |
Acquiree is the buyer-lessor, SLB qualified for sale accounting
|
Acquirer values the acquired tangible property independently from the terms of the leaseback
Acquirer will continue to record any financing receivable from the seller-lessee (i.e., a financial asset)
After consideration of the contractual payments that relate to any financing receivable, the acquirer will record an intangible asset or liability for any favorable or unfavorable terms of the lease
|
Acquiree is the buyer-lessor, SLB did not qualify for sale accounting
|
Retain the acquiree’s accounting as a failed sale and leaseback transaction and continue to follow the guidance under ASC 842-40 to determine if and when a sale occurs
Acquirer will record the acquired financial asset (i.e., a loan receivable); the acquirer will not record the tangible property at the acquisition date
|
Acquiree is the seller-lessee, SLB qualified for sale accounting
|
Acquirer will continue to record any financing payable to the buyer-lessor (i.e., a financial liability)
After consideration of the contractual payments that relate to any financing payable, the acquirer will determine whether there are any favorable or unfavorable terms of the lease that need to be included as an adjustment to the right-of-use asset
|
Acquiree is the seller-lessee, SLB did not qualify for sale accounting
|
Retain the acquiree’s accounting as a failed sale and leaseback transaction and continue to follow the guidance under ASC 842-40 to determine if and when a sale occurs
Acquirer values the acquired tangible property independent from the terms of the leaseback
In accordance with ASC 842-40-25-5, the acquirer will record the acquired financing payable
|
Treatment of leases between an acquirer and an acquiree at the acquisition date
An acquirer may have a preexisting relationship with the acquiree in the form of an operating lease agreement (e.g., the acquirer is the lessor and the acquiree is the lessee). The lease contract will effectively be settled for accounting purposes as a result of the acquisition (as the acquirer consolidates the acquiree following the acquisition). The acquirer recognizes a gain or loss on the effective settlement of the preexisting relationship in an amount equal to the lesser of (a) the amount by which the lease is favorable or unfavorable from the perspective of the acquirer relative to market terms, or (b) the amount of any stated settlement provisions in the lease available to the counterparty to whom the contract is unfavorable. See
BCG 2.7.2 for further information on the accounting for the settlement of preexisting relationships.
Question BCG 4-1
How should the acquirer account for the acquisition of an existing lease arrangement with the acquiree (i.e., acquirer leased assets from acquiree) in its acquisition accounting?
PwC response
Before the acquisition, the acquirer would have recognized a right-of-use asset and a lease liability. As a result of the acquisition, the lease arrangement will cease to exist for accounting purposes because it will represent an intercompany relationship beginning on the acquisition date. The right-of-use asset and lease liability of the acquirer is derecognized upon settlement of the preexisting relationship. As a result, the acquirer should recognize a gain or loss for the effective settlement of a preexisting relationship. See
BCG 2.7.2.1 for further information on calculating the gain or loss on the settlement of preexisting relationships.
The acquired underlying asset would be recognized and measured at fair value. The acquirer should also reconsider the useful life of the formerly leased underlying asset.