Are you using the correct ‘unit of account’ when testing your right-of-use assets for impairment?
It is now the fourth year that Tier 1 and Tier 2 for-profit entities reporting at 31 December 2022 have been applying the new lease accounting standard, NZ IFRS 16 Leases. Preparers should be mindful of paying careful attention to impairment testing all their assets, given that the Financial Markets Authority (FMA) has noted impairment as a focus area on its list of surveillance areas. In this regard, preparers need to ensure that this new type of leased asset – right-of-use (ROU) asset – is included in the entity’s overall impairment assessment.
Our June 2020 article illustrates how the impairment test for leased assets differs under NZ IAS 17 Leases and NZ IFRS 16, and how impairment models need to be adapted. It also explains that ROU assets can either be tested for impairment at an individual asset level, or as part of a cash-generating unit (CGU). A ROU asset can only be tested for impairment at an individual asset level if it generates cash flows in its own right. That is, it generates cash flows that are largely independent of those generated from other assets.
It is important to ensure that you are applying the correct ‘unit of account’ when performing an impairment test because it could have a significant impact on the quantum of the impairment loss recognised. This is not always easy to do in practice, and judgement may be required.
Example – Fact pattern
Lessee leases ten floors of a building in one lease contract from Lessor for a non-cancellable lease term of seven years. The building is to be used for its commercial office premises in the Auckland CBD.
Each floor is distinct from one another. That is, each floor could be used by different lessees because each floor has its own lift access, kitchen area and bathrooms.
All lease payments are fixed. Lessee has capitalised a ROU asset and lease liability for the present value of the fixed lease payments in its statement of financial position.
At the end Year three, which coincides with the middle of the Omicron wave of the COVID-19 pandemic, Lessee decides that six floors are no longer needed because most staff have decided that they only want to return to the office two days per week.
Lessee therefore subleases the vacated floors, but sublease rental income is significantly less than lease payments for the head lease due to the oversupply of commercial property in the CBD. The subleases are classified as operating leases.
Lessee’s business remains profitable because it has been able to successfully pivot and have the majority of its staff working remotely. However, there are indicators of impairment due to increasing interest rates and other adverse changes in market conditions. As such, Lessee must perform an impairment test for the ROU asset.
What is the ‘unit of account’ to determine recoverable amount for the ROU asset?
In the above example, there are two schools of thought when determining the appropriate ‘unit of account’ for testing whether the ROU asset (ten-floor lease) is impaired. That is, either:
- Each floor is a separate ‘unit of account’
- All ten floors are a single ‘unit of account’.
Each floor is a separate ‘unit of account’
Each floor is treated as a separate ‘unit of account’ under NZ IFRS 16, paragraph B32 because each floor is a separate lease component. That is, it is capable of being used separately, and the use of one floor is not dependent on the use of other floors in the building.
The fact that there is one lease contract does not change the fact that paragraph B32 requires separate lease components to be identified. In practice, entities would need to determine a basis for allocating lease payments to individual floors so that a lease liability and right-of-use asset can be determined for each floor. For example, in addition to square meterage, allocation could be according to the level of the floor (high or low) and aspect (views or no views).
Applying this approach, recoverable amount is determined as follows:
- Six subleased floors – A ROU asset for each of the six vacated subleased floors are tested separately for impairment because they each generate cash inflows via sublease payments in their own right. Given that sublease income is significantly less than lease payments for the head lease, an impairment loss is likely for each of these six floors.
- Four occupied floors – ROU assets for the four occupied floors are allocated separately to CGUs. These will be shielded from an impairment loss if the relevant CGU is profitable.
All floors are a single ‘unit of account’
Applying this view, the one lease was entered into for a single commercial purpose. Therefore, the ROU asset for all floors is tested for impairment together as ‘corporate assets’. Corporate assets are allocated to various CGUs, which may be shielded from impairment losses if the relevant CGUs are all profitable. Unutilised floors are not tested for impairment separately.
In the circumstances outlined in this fact pattern, treating each floor as a separate ‘unit of account’ is BDO’s preferred view. This is because testing the whole lease contract for impairment as a single ‘unit of account’ may result in shielding of impairment losses for underutilised ROU assets.
What if Lessee is contractually prohibited from subleasing the six vacant floors?
If Lessee is contractually prohibited from subleasing the six vacant floors, it still needs to assess whether the ‘unit of account’ for impairment testing is each floor as a separate ‘unit of account’, or all ten floors as a single ‘unit of account’.
Each floor is a separate ‘unit of account’
Similar to the above, if each floor is a separate ‘unit of account’, the six subleased floors will be tested individually for impairment. Given that there is no sublease income, the ROU asset associated with each floor will be fully impaired. The overall impairment loss would therefore be higher than that in the original fact pattern because there is no sublease income at all. The four occupied floors will then be allocated separately to CGUs. These will be shielded from an impairment loss if the relevant CGU is profitable.
All floors are a single ‘unit of account’
If all ten floors are considered a single ‘unit of account’, the outcome would be the same as noted for the original fact pattern, and the overall impairment loss would also be the same. The ROU asset for all floors is tested for impairment together as ‘corporate assets’, which are allocated to various CGUs. If CGUs are profitable, the ROU asset may be shielded from impairment losses if the relevant CGUs are all profitable.
As for the original fact pattern, BDO’s preferred view is to treat each floor as a separate ‘unit of account’.
Our previous article and IFRS in Practice publication provide more detail on how to perform impairment assessments in practice, including for leased assets.
If you require assistance with your lease accounting, please refer to our website. BDO has a cloud-based lease management solution called ‘BDO Lead’, which you can use to manage your lease accounting inhouse, or we can do all the work for you via our outsourced BDO Lease Management Services. You can also contact our IFRS Advisory team for more information.
For more on the above, please contact your local BDO representative.
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