Impairment of right-of-use assets

Impairment of right-of-use assets explains the lease assets now on the balance sheet and as a result also susceptible of impairment risks to be accounted for. Impairment of right-of-use assets

Right-of-use asset is an asset that represents a lessee’s right to use an underlying asset for the lease term. Impairment of right-of-use assets

Right-of-use

A contract conveys the right to control the use of an identified asset if the customer has both the right to obtain substantially all of the economic benefits from use of the identified asset and the right to direct the use of the identified asset throughout the period of use/lease. Impairment of right-of-use assets

The right-of-use asset is depreciated over the lease term

  • The carrying amount of the asset and liability will no longer be equal in subsequent periods Impairment of right-of-use assets
  • In general, the asset will be below the carrying value of the lease liability as the asset will be depreciated on a straight-line basis while the effective interest rate method on the lease liability results in a decreasing lease expense throughout the lease term Impairment of right-of-use assets

In IFRS 16, lessees must record a right-of-use asset and a lease liability for all lease arrangements in their statement of financial position. Under IFRS 16, these ‘new’ right-of-use assets will be subject to the impairment requirements of IAS 36. Impairment of right-of-use assetsImpairment of right-of-use assets

When to test for impairment? Impairment of right-of-use assets

Similar to other assets, a right-of-use-asset will only be tested for impairment when impairment indicators exist. If impairment indicators exist, an entity must determine whether the right-of-use-asset can be tested on a stand-alone basis or whether it will have to be tested at a Cash Generating Unit level (GCU-level). This will depend on whether the right-of-use-asset generates largely independent cash inflows from other assets or groups of assets.

Leased investment property

While there may be instances where leased assets generate largely independent cash inflows, an example would be a leased investment property, many leased assets will be used by an entity as an input in its main operating activities whether these are service-providing or production-of-goods related. It is therefore likely that many right-of-use-assets will be assessed for impairment at a CGU-level rather than at an individual asset level. Impairment of right-of-use assets

Even if there are no impairment indicators at the right-of-use-asset level or the respective CGU-level, right-of-use-assets will impact the annual goodwill impairment test by increasing the carrying amount of the CGU, or group of CGUs, at which goodwill is assessed for impairment. Impairment of right-of-use assets

In summary

There will be situations in practice where right-of-use-assets generate largely independent cash inflows and will be required to be tested on a stand-alone basis. This will depend on the actual facts and circumstances and may require significant judgment.

In many situations, the leased assets and, therefore, the right-of-use assets will not generate largely independent cash inflows. It will be necessary to determine the CGU to which the right-of-use assets belong and to perform the impairment test at that level.

Cash generating unit

An asset’s CGU is the smallest group of assets that includes the asset and generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. IAS 36 contains detailed guidance and examples on the determination of the CGUs. The example below aims to illustrate the CGU application to leasing arrangements in the lessee’s financial statements.

CGU identification

Background Retail store chain M entered into the following three leases:

  • Lease for ground floor in building A: used for M’s store X, leasehold improvements were made at the beginning of the lease;
  • Lease for the second floor in building B: originally it was planned that space would be utilized for the payroll department, but then it was sub-let to a law firm;
  • Lease for two floors in building C: used for M’s HR and marketing department.

Store X makes all its retail purchases through M’s purchasing center. Pricing, marketing, advertising, and human resources policies (except for hiring X’s cashiers and sales staff) are decided by M. M also owns five other stores in the same city as X (although in different neighborhoods) and 20 other stores in other cities. All stores are managed in the same way as X.

What are the cash-generating units and at which level are the leased floors and therefore the right-of-use-assets assessed for impairment?

AnalysisImpairment of right-of-use assets

In identifying cash-generating units for the stores, M considers whether, for example:

  1. Internal management reporting is organized to measure performance on a store-by-store basis;
  2. The business is run on a store-by-store profit basis or on a region/city basis.

All of M’s stores are in different neighborhoods and were determined to have different customer bases. Although X is managed at a corporate level, X generates cash inflows that are largely independent of those of M’s other stores. Therefore, store X is a separate cash-generating unit. The leased ground floor of building A is used for retail store X and does not generate largely independent cash inflows. The right-of-use-asset in relation to the ground floor in building A is assessed for impairment at the store X CGU-level.

The second floor of building B is sub-let to a law firm. Due to the sub-lease, the right-of-use-asset generates largely independent cash inflows and must be assessed for impairment on a stand-alone basis.

The two floors leased in building C are used for marketing and human resources corporate functions. The right-of-use-asset in relation to these floors is a corporate asset and is allocated on a reasonable and consistent basis to the CGUs to which it relates.

In addition, retail chain M assesses goodwill for impairment on a country-by-country basis. The group of CGUs underpinning the goodwill impairment test on a country basis consists of all stores in the relevant country, including any right-of-use assets in relation to these stores, together with any allocated corporate assets, including any right-of-use corporate assets.

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IFRS 16 may impact both a CGU’s carrying amount and the way the recoverable amount of the CGU is measured. Elements to consider include:

  • the cash flow forecast and discounted cash flow models; Impairment of right-of-use assets
  • the discount rate; and Impairment of right-of-use assets
  • the treatment of lease liabilities. Impairment of right-of-use assets

Cash flow forecast and discounted cash flow models
Companies should ensure consistency between the Carrying Amount (CA) and the Recoverable Amount of a CGU in an IAS 36 impairment calculation. The CA will generally include the ROU asset value and the lease liability1 (refer to the section on lease liabilities below for more details).

If an entity uses a ‘free cash flow to the firm2’ valuation approach to determine the Recoverable Amount, both the cash flows and discount rate used are likely to differ under IFRS 16.

IFRS 16 replaces operating lease expenses in the income statement with depreciation of the ROU asset and interest on the lease liability. In the statement of cash flows, the leaseImpairment of right-of-use assets payments split into principal repayments of the lease liability which are included in the cash outflows related to financing activities and an interest element whose classification as operating or financing cash flows depends on a company’s accounting policy3 IFRS 16 50.

The question arises how lease payments should be treated when determining the recoverable amount of a CGU post IFRS 16. Impairment of right-of-use assets Impairment of right-of-use assets

In practice two main approaches could be applied in the discounted cash flow analysis, which, if applied correctly, should lead to the same estimate of the Recoverable Amount. These approaches are:  Impairment of right-of-use assets

  1. follow IFRS 16 classification and treat lease payments as cash flows to debt providers in the discounted cash flow model, and subtract the fair value the lease liability from the outcome as applicable; or Impairment of right-of-use assets
  2. follow IAS 17 cash flow classification and continue modelling the cash flows as before, treating the lease payments (including interest) as a cash outflow in the determination of the free cash flow to the firm. Impairment of right-of-use assets

Approach 1 requires changes to commonly used discounted cash flow models and/or the assumptions used when deriving the cash flows used in these models. The ROU asset and lease liability reflect the actual leases in place on the measurement date. The lease terms are finite and deviate in that respect from the indefinite term implied in the free cash flows used (in a ‘going concern’) when determining the Recoverable Amount. In a going concern, the ROU assets would need to be replaced by owned or new ROU assets after the lease term.

Something else -   Recoverable amount

Discounted cash flow models should appropriately include an element of additional operating cash outflows in relation to the replacement of the ROU assets at the end of the lease term for both the forecast period and the terminal value. Impairment of right-of-use assets

In approach 2 the lease expenses would be classified (back) as operating expenses. This would essentially reflect the way how impairment analyses prior to the introduction of IFRS 16 would have been performed. The ‘old’ approach also assumed, often in a non-conscious way, that new leases would be entered into by growing operating expenses (that included lease payments) at a set rate.

Going forward this approach would result in a mismatch between management accounts and model forecast. This mismatch should be carefully analysed and reconciled to ensure consistency between management’s expectations versus impairment model assumptions. Impairment of right-of-use assets

While either of approaches 1 or 2, should result in the same Fair Value Less Cost of Disposal (FVLCD) if applied correctly, IAS 36 78, provides that the carrying amounts of certain recognized liabilities should be deducted in a calculation of the Recoverable Amount under Value in Use (VIU), implying that approach 1 should be applied for VIU, but deducting the carrying amount of lease liabilities rather than their fair value (IAS 36 78 applies to a lessee’s lease liability: “…the carrying amount of the liability is deducted in determining both the cash-generating unit’s value in use and its carrying amount”, i.e. the discounted cash flows will not include the cash outflows resulting from the lease payments to avoid double counting. This is based on the guidance in IAS 36.78 and the IFRS Interpretations Committee discussion [IAS 36 29, IAS 36 78 and IU 05-16]).

Impairment of right-of-use assets

The change in cash flow classification of leases triggers a significant increase in operating cash flow.

The ROU asset balance and depreciation charge only reflects the lease payments over the IFRS 16 lease term – 3 years in the graph. Many DCF models will require an update to include replacement cash flows for ROU assets in the forecast period and terminal value (TV).

Another difference may arise from ROU assets being measured excluding the interest implicit in the payments.

Impairment of right-of-use assets

Impairment of right-of-use assets

Discount rate (WACC) Impairment of right-of-use assets
The way of determining the discount rate should be consistent with what is included in the cash flows. If the lease payments are not deducted from the free cash flows to the firm (approach 1 above), then the resulting net cash flows include the cash that will be used to pay the lease obligation. Impairment of right-of-use assets

In this approach the lease payments are treated as a financing item to the firm. Therefore, to ensure consistency with the cash flows, the capital cost of lease liabilities should be reflected in the weighted average cost of capital (‘WACC’). Impairment of right-of-use assets

Incorporating the capital cost of lease liabilities is expected to result in a reduction of the WACC, relative to a rate measurement that uses only ‘traditional’ debt and equity7.

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Combined impact on net present values due to changes in cash flows and discount rate Impairment of right-of-use assets
Under approach 1 above, the RA of a CGU, before consideration of lease liabilities, would increase due to both higher operating cash flows (because of the exclusion of IAS 17 operating lease payments) and from using a lower WACC. This increase in net present values may be offset by inclusion of the lease liability.

Lease liabilities Impairment of right-of-use assets
Another topic for impairment testing post IFRS 16 relates to the allocation of lease liabilities to CGUs. ROU assets are non-financial assets in the scope of IAS 36 and generally need to be included in the carrying amount of the CGU unless they generate independent cash inflows. The inclusion of the corresponding lease liabilities in the carrying amount depends on whether a buyer would assume the lease liability in a disposal of the CGU. Impairment of right-of-use assets

Under IAS 36, the CA of a CGU does not include the CA of any recognized liability, unless an entity needs to consider that liability to determine the recoverable amount of the CGU [IAS 36 78]. This may occur when a buyer would be required toassume the liability in a disposal of the CGU. This guidance applies to a lessee’s lease liability associated with ROU assets in the CGU. This is based on the guidance in IAS 36 78 and the IFRS Interpretations Committee discussion [IAS 36 29, IAS 36 78 and IU 05-16]. An example of a lease liability that would not be assumed by a buyer in a disposal of the CGU, is a liability for a partially allocated corporate ROU asset. Impairment of right-of-use assets

In cases where the lessee concludes that the buyer would not be required to assume the lease liability upon disposal of the CGU, then the lessee excludes the lease payments from the discounted cash flows used to measure the CGU’s VIU and, in order to ensure consistency, excludes the lease liability from the CA of the CGU. Similarly, the CGU’s FVLCD excludes the lease liability when a buyer would not be required to assume the lease liability. Impairment of right-of-use assets

Similar to what is discussed above with respect to approach 1, due consideration needs to be given to replacement cash flows for the ROU assets after the lease term and the implications of the possible change in composition of cash flows to the discount rates used. Impairment of right-of-use assets

Impairment of right-of-use assets

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