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Abandoning Office Space Creates Lease Accounting Headaches

Sept. 2, 2021, 8:45 AM

Companies like Dropbox Inc., Zynga Inc., and many others have seized on the work-from-home trend during the pandemic to shutter offices and shrink their real estate footprints. But saving money and reducing worker commutes come with a bookkeeping cost: juggling the nuances of new lease accounting rules.

Reducing a few rented floors in an office building or getting rid of leased corporate headquarters isn’t as simple as negotiating new lease terms and erasing a lease obligation from a balance sheet. Add in dozens of changes in a short period of time with rules that are relatively new to public companies, and the headaches multiply. Just ask an accountant.

“I’ve been living and breathing that for the last 18 months,” said Tim Kolber, audit and assurance managing director at Deloitte & Touche LLP.

In some cases, companies that shrink their office space have to book one-time impairment charges, or hits to earnings, to convey how the value of their leased real estate declined.

Mobile game developer Zynga, which makes Farmville and Words With Friends, is reducing its office space by one third and moving its primary office space south, from San Francisco to San Mateo. The company plans to sublease its San Francisco office and expects to record an $80 million impairment charge in the next quarter, it said in its 10-Q filing.

File-sharing company Dropbox is moving to what it calls a “virtual first” operations mode. Reducing the size of its San Francisco headquarters and renting out the space to other businesses could generate $800 million in sublease cash flows, but it could incur up to $450 million impairment charges related to the office space it no longer needs, Dropbox CFO Timothy Regan told analysts on the company’s Aug. 5 earnings call. The company has recorded $415.5 million in lease impairment charges so far, according to its latest quarterly filing.

Lease impairments become more prominent thanks to rules that went into effect for public companies in 2019. Published as ASC 842 by the Financial Accounting Standards Board, the rules require companies to report rented storefronts, factories, or heavy machinery as assets and the liabilities to make payments on their balance sheets for the first time.

The rules made company balance sheets balloon. Then, one year later, the pandemic hit. Companies looking to save money saw opportunities in empty office space. Others, like Irvine, Calif.-based Corvel Corp., which helps companies process insurance claims, saw environmental upside.

“The pandemic demonstrated that working from home is a viable option for many of our teams, significantly reducing the carbon impact from daily commutes,” said Corvel CEO Michael Combs on an Aug. 5 earnings call.

The appeal of reducing real estate increased during the pandemic, but companies have to be aware of the accounting ramifications, said Sarah O’Sullivan, accounting director at lease accounting software provider LeaseQuery LLC.

“Are you going to let your lease run out and not renew it or get out of your lease now and modify it?” O’Sullivan said. “When you modify or terminate it, that gets into a little bit more complex accounting.”

New Assumptions

Companies have to analyze every change to determine if a tweak constitutes a lease termination or a modification to a single lease or group of leases. With each change, they have to assess the adjustments they make to what’s called the right-of-use asset — the rented storefront or office space — and the corresponding liability to make payments.

If changes are significant, they could qualify as the termination of the old lease and the start of a brand new one. In that case, estimates and assumptions that got baked into booking the original lease may have to be redone.

This could include calculating what’s called the incremental borrowing rate, the interest rate companies use to calculate the final number that goes on their books. Considered the cost to borrow their next dollar, it’s a rate that’s specific to each company and each type of asset they rent.

“All those estimates and assumptions they went through when determining how to calculate the lease, now they have to be relooked at and assessed for the new lease,” said Debra McCall, partner at Seiler LLP.

Assessing leases for impairments lead to more sensitive calculations, said Deloitte’s Kolber.

ASC 360, which covers accounting for property, plant, and equipment and includes guidance on impairments, requires businesses to evaluate whether a long-lived asset or asset group has declined in value and must do so “at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities.”

This also can create confusion for companies getting rid of one or two rented floors in an office tower. A company may have trouble figuring out what exactly the “lowest level” is, Kolber said.

More accounting implications arise if a company leaves an office and decides to sublease it. The asset has to stay on the company’s books and the company has to consider the cash flows from renting out the real estate to another tenant.

None of these accounting nuances are dealbreakers for companies eager to save money or give employees work-from-home perks, financial reporting experts say.

It’s just a bit of a learning curve for the companies figuring out the new accounting requirements at the same time as a shift in operations. The confluence of a big change in accounting rules negotiating changes to real estate means extra headaches.

“We’re seeing where there’s challenges with communication within the organization because the requirements are accounting focused, but the people negotiating it are in another organization, be it operations or real estate,” said Matt Hurley, senior manager in Deloitte’s controllership practice.

To contact the reporter on this story: Nicola M. White in Washington at nwhite@bloombergtax.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergindustry.com; Yuri Nagano at ynagano@bloombergtax.com