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How to avoid valuation-related pitfalls when measuring lease impairment

The pandemic spurred major changes in corporate leasing. Valuation professionals can help companies avoid valuation and impairment missteps.

Executive brief:

  • The leasing market has been shifting as people change when and where they work, shop and collaborate. As a result, corporate real estate needs are changing.
  • Impairment evaluations can become more complex, but accounting and valuation professionals can help companies avoid missteps.

The last two years have led to a seismic shift in the leasing markets. Changes in how people shop and socialize, collaborative technology advances and work-from-home strategies have led many companies to rethink their real estate footprints. These rationalization efforts often trigger impairment evaluations, which can become incredibly complex when leases and right-of-use (ROU) assets are involved.

In-house accounting and valuation professionals can help their companies employ several leading practices to avoid valuation pitfalls in each step of the impairment assessment, obtaining a more accurate result. These tips can be applied to all types of leases, from underperforming retail stores to underutilized corporate office space.¹

Impairment evaluation steps 

As a reminder, ROU assets are evaluated for impairment following the guidance for other long-lived assets in Accounting Standards Codification (ASC) 360, Property, Plant and Equipment. For full accounting guidance on the topic, refer to the EY Financial reporting developments (FRD) publication, Impairment or disposal of long-lived assets. ASC 360 provides a three-step framework to assess, measure and allocate impairment. 


Chapter 1

Identify indicators of impairment

A significant decrease in market rents may indicate potential impairment, requiring analysis.

ASC 360-10-35-21 provides examples of events or changes in circumstances that could indicate that the carrying amount of a long-lived asset (asset group) may not be recoverable. Indicators of impairment include, but are not limited to:

  • Significant decrease in market price of a long-lived asset
  • Significant adverse change in how an asset is used or its physical condition
  • Significant adverse change in legal factors or in the business or regulatory environment that could affect the value of the long-lived asset
  • Costs significantly in excess of expected amounts for the acquisition or construction of a long-lived asset
  • Operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast of continuing losses associated with the use of the long-lived asset
  • A current expectation that a long-lived asset will be sold or otherwise disposed of significantly before its previously estimated useful life

Recent trends in office and retail demands throughout the US have resulted in an increased supply of both office and retail real estate, putting downward pressure on sublease rates and extending the time — and incentives required — to find new or sublease tenants. These market changes can indicate a significant decrease in the market price of an ROU asset.

We often find that companies engage valuation professionals to assist in performing the impairment analysis after an indicator is identified. Sometimes companies expect valuation professionals to determine the fair value of, and impair, an individual asset at this point and may not consider the additional accounting requirements that must be met before an asset (or asset group, as discussed next) is valued and impaired. An impairment indicator alone does not mean an impairment will be recognized. Moreover, absent an indicator, a decline in overall market rents does not guarantee that impairment exists.

Valuation considerations

Valuation professionals may be able to assist companies in determining whether an impairment indicator is present, particularly when there are potential market-based indicators, such as a significant decrease in market rents, increased supply, or other macroeconomic or regulatory trends. In our experience:

  • Companies may request information from valuation professionals to understand whether there has been a decline in market rental rates for retail brick-and-mortar ROU assets or a significant increase in supply. 
  • Companies considering sublease alternatives, particularly for office space, may want to gather information about sublease rates, incentives and current expectations of marketing costs and downtime before sublease arrangements are executed. 
  • Valuation professionals may also have insight to advise management on the likelihood of various scenarios (such as those related to the expected economic recovery timeline in a particular region).

Chapter 2

Perform the recoverability test

A complex recoverability analysis requires collaboration between valuation and accounting.

When an impairment indicator has been identified, the next step is to perform the recoverability test. In our experience, this step is often overlooked or performed incorrectly. Entities cannot record an impairment for a held and used asset unless the asset first fails this recoverability test. The recoverability test consists of:

a. Grouping the long-lived asset for which there is an impairment indicator with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities (referred to as the asset group)

b. Estimating the future net undiscounted cash flows for that asset group (over the life of the primary asset in the group)

c. Comparing the sum of the estimated net undiscounted cash flows identified in (b) to the carrying value of the asset group determined in (a)

It is important to note that this step is not a fair value analysis, but an evaluation of whether the remaining carrying value of the asset group is expected to be recovered on an undiscounted basis, using company-specific assumptions and expectations. Still, it may require an understanding of certain valuation-related issues, such as the expected downtime to find a sublease tenant. Discerning the differences in this analysis from an overall fair value assessment can be complex and valuation professionals alone should not take full ownership of this step, rather it should be performed in conjunction with the accounting function.

Evaluating the asset group

When companies fail to appropriately define asset groups, the unit of account for these analyses, they may inadvertently exclude assets or operations that would affect whether an impairment is required to be recognized. Determining the asset group can be complex and is driven by accounting guidance. Often, it may take a combination of accounting, operations and management — along with an understanding of existing accounting policies — to determine the asset group.

Although the valuation in Step 3 is based on a market-participant view, the unit of account for impairment is the asset group determined in Step 2. Management and their advisors should clearly document what comprises the asset group, along with any related accounting policy elections, such as the treatment of lease liabilities, income tax effects and the allocation of certain other types of assets or liabilities to the group. They may also need to understand whether the carrying values of other assets included in the asset group already include the effects of impairment assessments under other accounting rules.

Regarding income taxes, ASC 360 is silent on whether an entity should use pre- or post-tax cash flows in performing a recoverability test. Accordingly, an entity should adopt a formal policy of using either pre- or post-tax cash flows when performing a recoverability test. In practice, we have observed that most companies perform the recoverability test on a pre-tax basis. If an entity elects to perform the recoverability test using post-tax cash flows, the deferred taxes related to the asset group are included in the computation of the carrying value. Similarly, if an entity performs the recoverability test on a pre-tax basis, deferred taxes would not be included in the computation of the carrying value. The asset group and related cash flows must be consistent when performing the recoverability test. Regardless of the method applied (i.e., pre- or post-tax), the recoverability test will generally yield a consistent answer as to whether the assets are recoverable.

Identifying any differences in the unit of valuation and the unit of account (the asset group), and the related carrying values of related assets and liabilities in the asset group can be important to the final analysis.

Determining the term of the analysis

Companies are required to use the term of the primary asset in the asset group for evaluating recoverability. Sometimes companies may try to “back into” the analysis, using cash flow periods that are aligned more with an income-based approach to valuation following fair value measurement principles, and may ask valuation professionals to help determine such periods. The recoverability test, however, is also driven by accounting rules, which limit the cash flow period to the remaining life of the primary asset in the asset group. Although they sometimes align, this period can be significantly different than a market participant assumption.

When an ROU asset is the primary asset in the asset group, the remaining lease term, inclusive of reasonably assured renewal options, is the appropriate term for the recoverability test.

Estimating cash flows using company-specific assumptions

Cash flow estimates used for the recoverability test contain several inputs and assumptions. While these should reflect company-specific expectations, many of these may also involve valuation considerations. For example, if management is planning to sublease a ROU asset, management may need valuation insights to support its company-specific estimates, such as sublease rates, likely incentive cash flows, and estimates of the time and cost to find a sublease tenant.

Even if the company plans to continue to use the assets, valuation specialists may be asked to provide input. While the test presumes that the primary asset is not replaced or subject to major maintenance (routine maintenance is considered), other assets in the asset group may need to be replaced over this period, such as furniture, fixtures or other leasehold improvements. This may require estimates of the cash outflows to acquire a replacement asset. Conversely, estimates of terminal cash flows may be needed for assets that may have a longer life than the primary asset. Each of these inputs may require insights from valuation professionals.

We have increasingly seen cash flow analyses that fail to recognize a residual value or terminal cash flows for one or more of the assets in the asset group, which may often be sufficient to cause the asset group to pass the recoverability test. Even when such analyses include a residual (terminal) value, management often struggles to support this value given the difficulty in forecasting future market conditions.

Cascading effects of the recoverability test

Companies may inadvertently take some “shortcuts” or otherwise incorrectly determine asset groups or evaluate certain aspects of the recoverability test using incorrect assumptions, which can lead to cascading errors in the rest of the impairment analysis.

Errors or omissions in Step 2 can lead to incorrect conclusions about whether an asset group is impaired. Even if an impairment is still triggered, errors in determining the asset group (and its related carrying value) can ultimately lead to errors in the measurement and allocation of impairment losses.

As a result, companies should be careful to understand the accounting-related determinations and management-specific assumptions required and recognize that they may be different from market-participant assumptions.

Valuation considerations

As a leading practice, individuals performing the recoverability test in Step 2 of the impairment model may want to understand:

  • Whether the company has appropriately determined the asset group, including assets and liabilities that are not subject to ASC 360, and any related accounting policy elections that may be necessary — and whether those are consistent with historic groupings, where relevant
  • Whether the company has included the carrying value of all assets and liabilities in the asset group, including considering the ordering of impairments of assets and liabilities (e.g., inventory, accounts receivable, indefinite-lived intangible assets) compared to the long-lived asset impairment model 
  • Whether the term of the recoverability test is consistent with the requirements of the accounting guidance, not a fair value model
  • Whether the future cash flow assumptions used are those consistent with management’s expectations for the use of the asset (and are consistent and supportable compared to other internal projections used for other purposes), rather than a market participant view

Chapter 3

Measure and allocate the impairment

These measurements often require input from management, operations, valuation and accounting teams.

If an asset group fails the recoverability test, the fair value of that asset group is assessed and compared to its carrying value to measure an impairment. Any measured impairment is allocated to the long-lived assets in the asset group on a relative carrying value basis. In this step, formal fair value estimates are required, and companies often turn to valuation professionals to help them assess and document those fair values, including market-participant assumptions, and the reconciliation of more than one approach (e.g., an income approach and a market approach).

Measuring the potential impairment

In our experience, because the asset groups determined in Step 2 frequently relate to retail locations or corporate office space, the fair value of the asset group is usually determined based on the discounted cash flow (DCF) method of the income approach. However, in some cases, it may be meaningful to consider a market-based method, and/or reconcile between an income and market approach.

Companies often use their company-specific projections from the recoverability test in Step 2 as a starting point for measuring an impairment based on a fair value estimate in Step 3; however, there are important differences, such as:

  • The Step 3 cash flows should reflect a market-participant perspective, rather than the company-specific perspective used for the recoverability test. This nuance may require adjustments for differences between management’s intended use and the highest and best use of the asset group, which could in turn have effects on estimates for capital expenditures, or may result in differences in a company’s specific estimates of overhead allocations compared to a market participant view.
  • The cash flow estimates are discounted in Step 3; these discount rates are different than those used for accounting purpose for initial measurement of ROU assets and lease liabilities, and for ongoing measurement of lease liabilities, which are not fair value measures.
  • The valuation using market-participant assumptions should also be performed to align with market discount rates (e.g., the weighted average cost of capital or WACC). The determination of a market-participant discount rate itself can be a complex analysis.

If an entity determines that the unit of valuation is at a higher level than the unit of account (the asset group) — that is, the unit of valuation includes more of the entity’s assets and liabilities than the asset group — we believe that the entity should reconsider the asset group and unit of valuation. However, it is important to remember that the unit of account is the basis for the recognition and measurement of an impairment loss. As such, while the unit of valuation could potentially consider the effect of other assets not included in the unit of account, the objective in the impairment analysis is to determine the fair value of the asset group as determined under ASC 360-10. Said differently, while the price market participants would be willing to pay for the assets in the asset group determined under ASC 360-10 could be affected by their expected use in combination with other assets, the value of these other assets themselves would not be considered in the impairment analysis.

The measured impairment loss is the excess of the asset group’s carrying value over the fair value of the asset group indicated from the Step 3 estimate.

Allocating and recognizing the impairment

The total measured impairment loss is then allocated on a pro rata basis to the qualifying long-lived assets in the asset group using their relative carrying values; however, the loss allocated to an individual long-lived asset cannot reduce the carrying amount of that asset below its individual fair value, if such amount can be determined without undue cost or effort. Any underallocated impairment based on this limitation is then re-allocated to the remaining qualifying long-lived assets based on their relative carrying values. In limited cases, this may ultimately result in situations where the measured impairment cannot be fully allocated, and the amount of impairment loss recognized may be limited compared to the measured impairment. While uncommon, such scenarios do occur.

The Step 3 allocation substep is often overlooked and can result in misallocated or overstated impairment losses. Allocation based on a relative carrying value basis would typically not result in one asset being reduced to zero, while others take only marginal adjustments.

Valuation considerations

When measuring and allocating impairment losses for asset groups that include ROU assets, including assessing the fair value of individual assets as a potential limit to their allocated impairment, companies and their valuation professionals should keep in mind the following considerations:

  • Individual ROU assets are often valued via the DCF method of the income approach as the present value of market rental rates through the remaining lease term.
  • Market rental rates are estimated using comparable leases and may reflect sublease rates if the company intendeds to sublease the space and this represents the highest and best use of the ROU asset.
  • The discount rate used to value the ROU asset is not the company-specific incremental borrowing rate (otherwise used for lease accounting); rather, it should reflect a market participant rate of return (e.g., pre-tax real estate rate).
  • Determining the fair value of furniture, fixtures and equipment may require consideration of their liquidation value.
  • Replacement cost can be estimated based on recent purchase data, if available, or published cost manuals.
  • Leasehold improvements may have a relatively limited fair value if it is reasonable to assume that a new user of the space would require replacement improvements.

These measurements and allocations can be complex and vary significantly based on individual facts and circumstances. Insights from valuation professionals are often critical, and coordination among management, operations, valuation and accounting are often required to consider the varied aspects of such analyses. Further, documentation of these analyses is often critical to supporting amounts recognized for financial reporting.

Final thoughts 

The impact of the COVID-19 pandemic, changes in consumer and employee preferences, and increased volatility in the leasing markets have all created a need for more frequent coordination among management, operations, valuation and accounting personnel. Increasing the frequency of impairment analyses may also lead to the need for more robust documentation and more formalized processes.

Valuation professionals play an increasing role in these assessments. They are often asked to weigh in throughout the process and need to have a thorough understanding of each impairment step, including which aspects of the assessment are driven by accounting requirements vs. valuation practices. Bringing valuation professionals in earlier in the impairment assessment can result in more consistent, supported and accurate impairment results.


Changes in consumer and employee preferences following the COVID-19 pandemic have led companies to rethink their real estate footprint. Valuation professionals can help companies work through complex evaluations involving leases and ROU assets by employing several leading practices to avoid costly missteps.