Overview
A right-of-use asset is tested for impairment under IAS 36, like any other non-financial asset (IFRS 16.33). It is impaired when its carrying amount exceeds its recoverable amount: the higher of fair value less costs of disposal (FVLCD) and value in use (VIU). The impairment loss is recognised in profit or loss, and the asset is depreciated on its reduced carrying amount from then on.
Three aspects are specific to leases:
- Impairment replaces onerous lease provisions. IAS 37 excludes leases within the scope of IFRS 16, so a loss-making lease is reflected by impairing the right-of-use asset, not by a provision.
- The asset is usually tested within a cash-generating unit (CGU), because leased premises and equipment seldom generate cash on their own.
- Lease payments and the lease liability are kept out of the test, because they are financing.
The general IAS 36 requirements are covered in impairment of assets under IAS 36.
Where IAS 37 still applies
An onerous contract provision is still recognised for a lease that becomes onerous before its commencement date, for short-term and low-value leases expensed under IFRS 16.6, and for non-lease components such as service charges and maintenance contracts.
Indicators of Impairment
A right-of-use asset is tested when there is an indication of impairment at the reporting date. Indicators common to leases include:
- A decision to close a store, branch or site, or to vacate leased premises;
- An asset that is idle, such as a leased warehouse that is no longer used;
- A store or branch that is making losses or performing below budget;
- A decline in market rentals below the rent payable under the lease;
- Subletting, or expecting to sublet, at a lower rent than the head lease; and
- A restructuring or discontinuation of the operation that uses the asset.
Individual Asset or Cash-Generating Unit?
A leased store generates cash only together with the inventory, staff and fittings in it, so the right-of-use asset is tested as part of the store's cash-generating unit. A leased head office is a corporate asset and is allocated to the CGUs it serves. Any impairment of the CGU is spread across its assets, including the right-of-use asset, as explained in allocating impairment losses.
The position changes when premises are vacated. Once an entity stops using a property and plans to sublet it, the right-of-use asset no longer contributes to the operating CGU. Its cash inflows are now the sublease rentals, which are independent of the entity's other cash flows, so it is tested individually.
Treatment of the Lease Liability
The lease liability is a financing liability. For consistency on both sides of the test:
| Approach | Carrying amount tested | Recoverable amount |
|---|---|---|
| Default | Excludes the lease liability | VIU excludes lease payments (financing cash flows) |
| Net of the lease liability | Deducts the lease liability | Determined net of the lease, such as a fair value that reflects a buyer assuming the lease |
The net approach is often used when FVLCD is based on what a buyer would pay for a business that includes its leases. Either approach is acceptable, provided the liability is treated the same way in the carrying amount and in the recoverable amount.
Excluding lease payments generally makes the VIU of a CGU higher than it was when rent was an operating expense. This is offset by the right-of-use asset now being included in the carrying amount.
Practical Example: A Vacated Office
A company leases an office floor with four years of the lease remaining. At year-end it relocates its staff and decides to sublet the floor. The right-of-use asset has a carrying amount of 900,000, and the lease liability is 960,000.
Because the floor will be sublet, the right-of-use asset is tested individually. Market rentals have fallen, and the company expects:
- No sublease income in Year 1, while it incurs letting fees of 30,000 and holding costs (rates and maintenance) of 40,000;
- Sublease rentals of 200,000 a year in Years 2 to 4; and
- A pre-tax discount rate of 11%.
The head lease payments are excluded from the cash flows: they settle the lease liability.
| Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|
| Sublease rentals | - | 200,000 | 200,000 | 200,000 |
| Letting fees and holding costs | (70,000) | - | - | - |
| Net cash flows | (70,000) | 200,000 | 200,000 | 200,000 |
Discounted at 11%, the VIU is 377,246. The company estimates that FVLCD, the amount a market participant would pay to take over the right of use, is 340,000. The recoverable amount is therefore 377,246.
| Account | Debit | Credit | |
|---|---|---|---|
| Dr | Impairment loss (P/L) (900,000 − 377,246) | 522,754 | |
| Cr | Accumulated depreciation and impairment losses: right-of-use asset (SFP) | 522,754 |
The lease liability of 960,000 is unchanged.
After the Impairment
Depreciation. The right-of-use asset is depreciated on its impaired carrying amount over the remaining four years: 94,312 a year (377,246 ÷ 4), down from 225,000.
Lease liability. The liability continues to accrue interest and is reduced by the lease payments. The impairment does not remeasure it.
Subleasing. When the sublease is signed, the company classifies it as a finance or operating lease by reference to the right-of-use asset. If it is a finance lease, the right-of-use asset is derecognised and a net investment in the sublease is recognised, as described in subleases under IFRS 16. Testing for impairment first ensures any loss is recognised before that classification.
Deferred tax. The lower carrying amount changes the temporary difference on the right-of-use asset, and therefore the deferred tax on the lease.
Reversal. If the estimates later improve, for example because the floor is sublet sooner or at a higher rent, the impairment is reversed. The carrying amount cannot exceed what it would have been, net of depreciation, had no impairment been recognised. The increase in VIU that arises only because time passes does not justify a reversal.
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Conclusion
Right-of-use assets are tested for impairment under IAS 36, usually as part of the CGU they serve, and individually once vacated premises are held for subletting. Lease payments are excluded from value in use and the lease liability from the carrying amount, unless both are included consistently. The impairment reduces the right-of-use asset only, and future depreciation follows the reduced amount while the lease liability continues unchanged.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.