Case Study
Imagine a start-up service organization Pluto~Charon Inc. (PCI), whose operations began just before the pandemic. Its ability to be immediately profitable had proved so convincing that it needed to quickly secure a location that would attract the desired additional sales personnel it required to expand. To accommodate its current and anticipated near-term employee growth, PCI proceeded to enter into a 10-year lease in mid-town Manhattan. All build-out costs were included in the lease, which included an option to renew for no less than an additional five years. In the interest of full transparency, PCI chose to be proactive and early-adopt the new capitalization rules: A right-of-use (ROU) asset was recorded as an intangible long-lived non-financial asset as specified by ASC Topic 842, with the corresponding lease/liability debt.
Then the COVID-19 pandemic hit, and the resulting change in work habits could cause a marked increase in impairment issues for PCI and similar entities, issues that were not anticipated when capitalizing a lease on the balance sheet initially seemed like an obvious improvement. Impairment issues due to COVID are certainly not unique to an ROU asset, but the result of ASC Topic 842 is that additional assets have been generated that need to be assessed for impairment. Impaired leases were always a consideration under the previous lease standard (ASC Topic 420).
Despite the pandemic, the projected volume of services PCI was to supply was not only realized, but in fact increased. But the employees hired to provide these services were all able to do so working from home. Senior management was likewise able to work from home. This unanticipated “new model” became so successful that management (with the blessing of PCI employees) decided to adopt it going forward, thus allowing all employees to permanently work from home.
The dilemma now facing PCI is what to do with the unused office space—the company’s sole long-term asset and asset class due to its size and business model, specifically designed and constructed for PCI. A long-lived asset must be analyzed for impairment whenever events or circumstances—in this case the New York City commercial real estate market during a pandemic—indicate a carrying value which might not be recoverable. Might the economic environment indicate the need for a write-down? According to recent articles from assorted periodicals, the Manhattan office market was at a risk of oversupply before the pandemic. As a result of COVID, additional commercial space became abruptly available, and there was over 20 million square feet of NYC sublet space actively looking for tenants. In the week ending August 25, 2021, offices in 10 major cities were just 33% occupied. Even in 2022, “office availability in Manhattan, a measure of vacancy and space about to be vacated, reached a record-high 17.4% in February … offices are currently less in demand than they were after the terrorist attacks of Sept. 11th” (“Midtown Manhattan Imagines Life with Fewer Office Workers,” Wall Street Journal, March 23, 2022). At PCI, there is a reasonable concern that the company’s unused space might never be used, let alone be sublet or possibly reverted to the landlord to secure another tenant.
PCI’s financials thus have an intangible capitalized lease that, for all intents and purposes (in substance), is impaired, because it is not being used at all. Its financial statements now might need to reflect a write-down at minimum, or even a complete write-off, of the asset while the lease obligation is retained. The lease liability would continue at the contract amount, unless re-leased, settled, or renegotiated.
What would the amount of the write-off and the potential ongoing amortization be? ASC Topic 842 says that a lessee shall determine whether a right-of-use asset is impaired and shall recognize any impairment loss in accordance with ASC 360-10-35. Impairment under this guidance is usually measured by comparing the undiscounted future cash flows of the space against the carrying value of the asset, and then assessing the fair value of the property against that result if it indicates an impairment. The impairment charge would be limited to the fair value shortfall. What are the future cash flows of empty office space? What if 50% of employees return, resulting in not empty space but excess space? What if only management returns? These are significant adverse changes to the intended use of the ROU asset. And what assumption could be made as to the possibility of a future sublet of the space given the current glut of similar space available? And what would the revised amortization timetable and amounts be, if not a complete write-down?
Can this alternately be considered an abandonment? It would be—if PCI commits to no longer using the leased space for any business purpose, decides there is no longer economic benefit to attain, or has no intent and ability to sublet the property—which would result in a write-down to zero.
With critical audit matters now included in the auditor’s report, there would be a need to explore this area at a more granular level, and consideration of a full or partial write-off would probably find its way into the body of the auditor’s report as well. Depending upon the materiality of the write-off, separate disclosure would be a consideration, as would exclusion of the write-off for non-GAAP income disclosures.
Although the COVID-19 pandemic brought these issues to the forefront, it seems that more and more businesses will have to wrestle with whether the work habits of its employees are now permanently altered, and weigh such changes against space that they may be contractually obligated to pay for under leases that stretch out over a number of years.
These are issues that will have to be addressed by companies with experiences like PCI, which have already adopted, and by those that have yet to adopt. (For example, upon adoption of the standard, should an entity fully capitalize space that is currently fully or substantially empty and will be for the foreseeable future? Which cash flows should be used for the calculation?) Although the COVID-19 pandemic brought these issues to the forefront, it seems that more and more businesses will have to wrestle with whether the work habits of its employees are now permanently altered, and weigh such changes against space that they may be contractually obligated to pay for under leases that stretch out over a number of years.
The above is a narrow example of when a single ROU asset is its own asset group. However, if it is included in a larger asset group that is doing well, it might pass the initial undiscounted cash flow test, as the test would involve the cash flows from the entire asset group. In that case, there would be no impairment. If it still failed, the next step would involve the fair value of the asset group as a whole, which might yet allow it to pass with no impairment.
In conclusion, although the current reduction in usage of office space would not automatically cause an impairment charge, for small organizations like PCI, it is imperative to seriously consider this collision of ROU and impairment when preparing their financial statements.
