ASC 805 Business Combinations and Lease Accounting: How an Acquirer Measures the Acquiree's Leases
Questions this article answers
- How does an acquirer account for the acquired company's leases in a business combination?
- What discount rate is used for acquired leases under ASC 805?
- Does deferred rent carry over in an acquisition under ASC 842?
- Is the right-of-use asset equal to the lease liability in a business combination?
Under ASC 805 business combinations and lease accounting rules, the acquirer measures each acquired lease again on the acquisition date. ASC 805-20-30-24 sets the lease liability at the present value of the remaining lease payments, as if the lease were a new lease of the acquirer. The right-of-use asset equals that liability, adjusted for rent above or below market. Classification carries over; the acquiree's deferred rent does not.
This page covers the common private-company case: a US company buys another company, and the acquiree is the lessee on office, warehouse, vehicle or equipment leases. Leases where the acquiree is the lessor follow different paragraphs and are not covered here. If you need the lessee basics first, start with lease accounting explained: key concepts or the ASC 842 lease accounting guide.
What happens to the acquiree's lease liability on the acquisition date?
As a rule, ASC 805 measures assets acquired and liabilities assumed at fair value. Leases are one of the limited exceptions to those principles (ASC 805-20-25-17 and ASC 805-20-30-12). For an acquiree that is a lessee, the rule is ASC 805-20-30-24. It sets the lease liability at "the present value of the remaining lease payments, as if the acquired lease were a new lease of the acquirer at the acquisition date."
"As if it were a new lease" means the acquiree's judgments are not binding. Paragraph BC415 of the basis for conclusions on ASU 2016-02, reproduced in Deloitte's Roadmap: Leasing at section 8.3.5.1.1.3, lists what the acquirer reassesses. That list is the lease term, any purchase options, the lease payments (including amounts probable under a residual value guarantee), and the discount rate.
So a renewal option the acquiree treated as not reasonably certain can be reasonably certain for the acquirer, and the reverse.
On the books, the acquiree's lease liability, whatever it was, is replaced. The acquirer builds a fresh schedule from the payments left as of the closing date. The same reasoning applies to the trigger events on an existing lease; see remeasurement triggers under ASC 842 for how the lease term test works.
Which discount rate does the acquirer use for acquired leases?
Because the lease is treated as new, the normal lessee hierarchy applies as of the acquisition date. ASC 842-20-30-3 requires the rate implicit in the lease whenever it is readily determinable. When it is not, the lessee uses its incremental borrowing rate. A lessee that is not a public business entity may instead elect a risk-free rate, by class of underlying asset, for a period comparable with the lease term.
The rate is set at the acquisition date and covers the remaining term. It is not the acquiree's rate from the original commencement date, and it is not the rate the acquiree used at its own ASC 842 transition. Whose rate it is depends on the facts.
KPMG's Handbook: Leases, Question 11.1.100, takes the view that the answer turns on who is the legal counterparty. When the acquirer becomes the counterparty, through an assignment of the lease for example, it uses its own incremental borrowing rate.
When the acquiree remains the legal counterparty as a subsidiary, the rate may instead be the acquiree's incremental borrowing rate reassessed at the acquisition date. That reassessment uses the acquiree's credit standing as part of the acquirer's group.
Once the deal closes, the acquirer's own policy elections govern the acquired leases going forward. PwC's Business combinations guide makes that point for separating lease and nonlease components: "an acquirer generally must conform an acquiree's accounting policy elections to its own upon a business combination." It does not resolve whose discount rate applies, which is the question above. See how to calculate the incremental borrowing rate for what the auditor expects behind the number.
One distinction matters for the next section: the lease liability uses an ASC 842 discount rate determined at the acquisition date. The adjustment for off-market rent is a fair value measurement. For that adjustment, PwC's Business combinations guide notes that "the discount rate applied should be that of a market participant." It adds that this rate is not necessarily the incremental borrowing rate used for the lease liability.
How is the right-of-use asset measured when the acquired rent is above or below market?
For a lease the company signs itself, ASC 842-20-30-5 builds the right-of-use asset from the lease liability, plus prepaid lease payments less incentives received, plus initial direct costs. That formula does not apply in a business combination. ASC 805-20-30-24 replaces it. The acquirer measures the right-of-use asset "at the same amount as the lease liability as adjusted to reflect favorable or unfavorable terms of the lease when compared with market terms."
Read that as two steps. Start with the lease liability you just measured. Then compare the contract rent with market rent for similar space or equipment over the remaining term.
Rent below market is a favorable term and increases the right-of-use asset. Rent above market is unfavorable and reduces it. The favorable or unfavorable terms adjustment lives inside the right-of-use asset, not as a separate intangible asset or liability.
Separate lease-related intangibles can still arise. PwC's Business combinations guide notes that an at-the-money lease may carry value a market participant would pay for. KPMG's Handbook: Leases takes the view that an in-place lease intangible should be measured separately.
The market test needs proof: a broker's view, rents on similar leases nearby, or a report from a valuation specialist. It is the same market-rent check a controller runs when weighing a new space; key financial metrics in lease analysis walks through the inputs.
Does the acquirer keep the acquiree's operating or finance classification?
Yes, unless the lease changes. ASC 842-10-55-11 states that in a business combination "the acquiring entity should retain the previous lease classification in accordance with this Subtopic." The one exception in that paragraph is a lease modification that is not accounted for as a separate contract under ASC 842-10-25-8.
So an operating lease on the acquiree's books stays an operating lease on the acquirer's books, even though the liability and asset were remeasured. A finance lease stays a finance lease. The acquirer only reclassifies if it modifies the lease and that modification is not a separate contract. The five classification tests are in applying the right lease classification under ASC 842, and the modification decision tree is in ASC 842 modification accounting.
Can the acquirer leave out leases with a year or less to run?
It can elect to, and PwC's Business combinations guide describes the election in ASC 805-20-25-28B. An acquirer "can make an accounting policy election to not measure or recognize leases that have a remaining lease term of 12 months or less at the acquisition date." The test is the remaining term at closing, not the original term.
A five-year lease with ten months left qualifies. The remaining term is not the whole test, though. ASC 805-20-25-28B makes this an accounting policy election "by class of underlying asset and applicable to all of the entity's acquisitions." An acquirer cannot apply it to selected leases or to selected deals.
Under the election, those leases carry no right-of-use asset and no lease liability on the acquirer's opening balance sheet. The ASC 805 election is a separate policy from the ASC 842 short-term lease exemption. KPMG's Handbook: Leases states that an entity can elect one and not the other. The acquirer should therefore confirm which recognition pattern its ASC 842 policy produces.
Where the ASC 842 short-term exemption applies, ASC 842-20-25-2 has the lessee "recognize the lease payments in profit or loss on a straight-line basis over the lease term."
What happens to the acquiree's deferred rent and lease incentive balances?
They disappear. The acquiree may carry deferred rent from straight-lining rising payments, a prepaid rent asset, or an unamortized lease incentive. None of these transfer.
The FASB's basis for conclusions on ASU 2016-02, reproduced in Deloitte's Roadmap: Leasing at section 8.3.5.1.1.3, gives the reason.
"Prepaid or accrued rent should not be recognized because such amounts do not meet the definition of an asset or a liability in Concepts Statement 6 under the acquisition method of Topic 805, Business Combinations. Instead, the remaining lease payments required under the terms of the lease are considered in evaluating whether the terms of the lease are favorable or unfavorable at the acquisition date."
That does not mean the economics vanish. Escalating rent that is below market today is exactly what the favorable-terms adjustment captures. So the acquirer drops the deferred rent credit, remeasures the liability, and adjusts the right-of-use asset for the off-market rent. Anything left over lands in goodwill.
For how deferred rent arises in the first place, see the guide to deferred rent under ASC 842.
Worked example: one acquired office lease with favorable rent
An acquirer closes on a target on 1 January. The target leases an office with four annual payments of $120,000 left, each paid at year-end. The lease is assigned to the acquirer at closing, so the acquirer's incremental borrowing rate is the rate used. That rate on the acquisition date is 7%, and no rate is implicit in the lease.
Market rent for similar space is $130,000 a year, so the contract is $10,000 a year below market. The acquiree carried an $18,000 deferred rent credit from earlier escalations. Every figure below is computed from these inputs.
| Input | Value |
|---|---|
| Remaining lease payments | 4 × $120,000, paid annually in arrears |
| Remaining lease term at acquisition date | 4 years |
| Acquirer's incremental borrowing rate | 7.0% |
| Market rent for equivalent space | $130,000 per year |
| Annual favorable difference | $10,000 |
| Acquiree's deferred rent credit | $18,000 (not carried forward) |
| Classification on the acquiree's books | Operating (retained) |
The present value factor for a four-year annuity at 7% is (1 − 1 ÷ 1.07^4) ÷ 0.07 = 3.387211. For the rent differential this example uses the same 7% for simplicity. A valuation specialist may apply a market participant rate instead, which changes the adjustment but not the method.
| Year | Payment | PV of payment at 7% | PV of $10,000 favorable difference |
|---|---|---|---|
| 1 | $120,000 | $112,150 | $9,346 |
| 2 | $120,000 | $104,813 | $8,734 |
| 3 | $120,000 | $97,956 | $8,163 |
| 4 | $120,000 | $91,547 | $7,629 |
| Total | $480,000 | $406,465 | $33,872 |
| Acquisition-date measurement | Amount | Basis |
|---|---|---|
| Lease liability | $406,465 | $120,000 × 3.387211 (ASC 805-20-30-24) |
| Favorable-terms adjustment | +$33,872 | $10,000 × 3.387211 |
| Right-of-use asset | $440,337 | Liability plus adjustment (ASC 805-20-30-24) |
| Acquiree's deferred rent credit | $0 | Not recognized by the acquirer |
Had the market rent been $110,000 instead, the contract would be $10,000 a year unfavorable. The liability would still be $406,465, the adjustment would be −$33,872, and the right-of-use asset would be $372,593.
What is the acquisition-date entry, and how does it move goodwill?
The lease is one line in the purchase price allocation. In isolation, the entry for the example above is a debit to the right-of-use asset of $440,337 and a credit to the lease liability of $406,465. The $33,872 difference is a net identifiable asset.
Under ASC 805-30-30-1, goodwill is the excess of the consideration transferred over the net acquisition-date amounts of identifiable assets acquired and liabilities assumed. A larger net asset means less goodwill. Before any deferred tax effect, the favorable lease therefore reduces goodwill by $33,872 compared with a lease at market rent.
The unfavorable case runs the other way. A right-of-use asset of $372,593 against a liability of $406,465 is a net liability of $33,872, and, before any deferred tax effect, goodwill rises by that amount. Either way, the acquiree's $18,000 deferred rent credit never appears; the acquirer's opening balance sheet starts from the remeasured figures.
After closing, the acquirer accounts for the lease like any other operating lease it holds. The remeasured liability accretes at 7% and unwinds against the $120,000 payments. The month-end entries follow the pattern in operating versus finance lease journal entries, using the acquisition-date balances as the starting point.
What support does the auditor expect for acquired leases?
The acquisition audit will trace each acquired lease from the target's lease listing to the opening balance sheet. Expect requests for the following.
- A lease-by-lease schedule of remaining payments and remaining term as of the closing date, with the lease term reassessed by the acquirer.
- Support for the discount rate: the rate concluded on at the acquisition date and why it is the acquirer's or the acquiree's, or the written risk-free election (ASC 842-20-30-3).
- Market rent evidence for the favorable or unfavorable adjustment, and the rate used to discount it.
- A memo retaining classification under ASC 842-10-55-11, and any modification analysis if terms changed at closing.
- The short-term election under ASC 805-20-25-28B, if made, and the list of leases it removed.
- A schedule showing the acquiree's deferred rent, prepaid rent and incentive balances written off, with the effect on goodwill.
If the acquirer tracks its own leases in a system, load each acquired lease as if it started on the closing date. Use the remeasured liability and the adjusted right-of-use asset. Loading the target's old schedule instead is how these balances go wrong.
Frequently asked questions
How does an acquirer measure the acquiree's lease liability in a business combination?
ASC 805-20-30-24 requires the acquirer to measure the lease liability at the present value of the remaining lease payments, as if the acquired lease were a new lease of the acquirer at the acquisition date. The acquirer reassesses the lease term, purchase options, lease payments and discount rate as of that date rather than carrying over the acquiree's balance.
Is the right-of-use asset equal to the lease liability when a lease is acquired?
Not always. Under ASC 805-20-30-24 the right-of-use asset starts at the same amount as the lease liability and is then adjusted for favorable or unfavorable lease terms compared with market terms. Below-market rent increases the asset; above-market rent reduces it. The favorable or unfavorable terms adjustment sits inside the right-of-use asset, not in a separate intangible, although a separate in-place lease intangible can still arise.
Does the acquiree's deferred rent carry over to the acquirer?
No. The acquiree's deferred rent, accrued rent and prepaid rent balances are not carried forward. The economics they represented are captured instead through the favorable or unfavorable terms adjustment to the right-of-use asset, and any difference lands in the goodwill residual.
Sources and further reading
- ASC 805-20-30-24 — measurement of the lease liability and right-of-use asset when the acquiree is a lessee.
- ASC 805-20-25-28B — the acquirer's election for leases with a remaining term of 12 months or less.
- ASC 805-30-30-1 — measurement of goodwill.
- ASC 842-10-55-11 — retention of lease classification in a business combination, with reference to ASC 842-10-25-8.
- ASC 842-20-30-1, 842-20-30-3 and 842-20-30-5 — lessee initial measurement, the discount rate hierarchy and the private-company risk-free election, and the composition of the right-of-use asset outside a business combination.
- PwC, Business combinations and noncontrolling interests guide, section 4.3 (acquisition accounting for lease agreements, BCG 4.3.3.7).
- PwC, Business combinations guide, section 2.6 (goodwill, bargain purchase gains and consideration transferred).
- PwC, Leases guide, section 4.2 (initial recognition and measurement, lessee).
- Deloitte, Roadmap: Leasing, section 8.3, including 8.3.5.1.1.2 (the short-term election, ASC 805-20-25-28B) and 8.3.5.1.1.3 (measurement of leases acquired in a business combination, quoting ASU 2016-02 BC415).
- KPMG Handbook: Leases, chapter 11, including 11.1.50 (prepaid and accrued rent), 11.1.80 (the short-term election), Question 11.1.100 (whose incremental borrowing rate) and Question 11.1.110 (in-place lease intangibles).
- ASC 805-20-25-17 and ASC 805-20-30-12 — the recognition and measurement principles leases are excepted from; ASC 842-20-25-2 — the short-term lease election.
- Deloitte, Roadmap: Leasing, section 7.2 (determination of the discount rate for lessees).
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