Changes in the expected use of office space could have significant financial reporting implications. David Drought and Aoife Madden of our Accounting Advisory team delve into this further.
In Ireland, we are seeing many businesses adopt a Hybrid working model. As more and more employees are in favour of working from home, this has given rise to under-utilised / vacant office spaces in many instances, with head office functions often the more significantly impacted. We are seeing an increasing number of clients grapple with vacant office spaces, potential impairments and onerous contracts. Companies that have been affected will need to consider the potential financial reporting implications.
What does the standard say?
IAS 36 Impairment of assets requires management to assess whether there is any indication of possible impairment of non-financial assets at each reporting date.
Do impairment indicators exist?
Indicators of impairment can be wide-ranging and may come from internal or external sources, but the likelihood of some impairment indicators existing has increased for companies impacted by hybrid working. Some relevant indicators that may exist include:
- significant changes in the extent or manner in which an asset is (or is expected to be) used which has (or will have) an adverse effect on the entity. For example, an under-utilised/vacant office space.
- indications that the performance of an asset is, or will be, worse than expected;
- a significant and unexpected decline in market value;
- a rise in market interest rates, which will increase the discount rate used to determine an asset’s value in use; and
- significant adverse effects in the technological, market, economic or legal environment, including the impact of changes in market rents
If an indicator of impairment has been identified, the entity must carry out an impairment test on the asset, or, at the level of the cash-generating unit (CGU) to which the asset belongs, as appropriate.
At what level should you test for impairment?
A key question for consideration is at what level impairment testing should take place. The nature of the indication of impairment, and in some cases the nature of the asset, determines the level at which impairment testing is carried out.
In some cases, it is clear that a CGU rather than an individual asset should be tested for impairment. In other cases, the indication of impairment may be at the level of the single asset.
IAS 36 outlines the approach to determining the appropriate level at which to test for impairment and, in the case of a single asset, considerations such as whether the asset generates largely independent cash flows, whether its ‘fair value less costs of disposal’ exceeds the carrying amount, and whether the asset is held for disposal/will be sub-let in the very near future.
Unused leased office space
A common challenge we are seeing clients face in this area is where a Company has for example leased two floors of an office building as its head office. Pre-pandemic both floors were largely utilised as employees were office based. Due to current remote working arrangements, only one floor is currently in use with no intention that these remote working arrangements will change in foreseeable future. The second floor remains vacant and there is no indication that this will change. Management has assessed that the vacant floor is a separate lease component.
The 50% vacancy of office space (i.e., 1 of 2 floors) may be considered an internal impairment indicator (of the right of use asset) requiring management to carrying out an impairment analysis. Management will need to consider if these assets are in fact impaired, the level at which an impairment review is carried out and determine the impairment charge if appropriate. The same considerations apply to right-of-use (ROU) assets as discussed above as regards testing and recognising impairment at the individual asset level or the CGU level.
After recognition of any impairment loss, future depreciation charges for the right-of-use asset will also be required to be adjusted to reflect any revised carrying amount. In the above simple fact pattern the full lease liability under IFRS 16 remains on balance sheet.
Subletting part of a leased office space
Another common challenge we are seeing Companies face is for example when they have leased two floors of an office building as their head office. Again, pre-pandemic both floors were largely utilised as employees were office based. Due to current remote working arrangements, only one floor is now used. It is management’s intention that remote working arrangements will continue for the foreseeable future. As the Company no longer requires the second floor they have decided to sublet it and generate rental income.
The Company (intermediate lessor) will classify the sub-lease as an operating lease or a finance lease with reference to the original head office lease (to which the Company is the lessee), in accordance with IFRS 16.
- If the sub-lease is classified as a finance lease, the Company will de-recognise the right-of-use (ROU) asset relating to the original head office lease that it transfers and recognise the net investment in the sub-lease as a finance lease receivable (with any gain or loss recognised in profit or loss). The Company will continue to recognise the lease liability relating to the original head office lease and recognise both interest income on the sub-lease and interest expense on the original head office lease. The finance lease receivable is subject to the impairment requirements of IFRS 9.
- If the sub-lease is classified as an operating lease, the ROU asset is subject to the impairment requirements of IAS 36. In this instance management will need to consider:
- If the change in use of the second floor suggest that there is an indicator of impairment?
- Determine whether there is an impairment charge based on expected cash net inflows from the second floor. This determination will include considering items such as:
- Has there been a reduction in market rents?
- Do they have the immediate ability to sublet the second floor? Is there a risk that it may remain vacant for a long period of time?
- Other expected cash outflows related to the sublease
Having considered the above, if management decides to continue with plans to sublease the vacant second floor, a reclassification from right-of-use asset to investment property is required if the asset meets the definition of investment property in IAS 40. Prior to reclassification, the ROU asset would be remeasured in accordance with IFRS 16/IAS 36. Following re-classification, the asset is accounted for under the fair value model under IAS 40.
Getting into more detail
We have updated our Testing leased office space for impairment guide, which addresses ten key questions that can help with your assessment.
Get in touch
Should you have any questions on the financial reporting implications of hybrid working, please contact David Drought or Aoife Madden of our Accounting Advisory team. We'd be delighted to hear from you.
Contact the team
David Drought
Director
KPMG in Ireland
Aoife Madden
Associate Director
KPMG in Ireland
