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Favorable and Unfavorable Leases in a Business Acquisition

Acquisition accounting can be a bit tricky, and one item that companies often overlook is the accounting for operating leases in a business combination. The accounting rules for leases acquired in a business combination are not very intuitive and can raise a host of considerations. If you acquire a business with multiple locations, this should definitely be on your radar. The basic accounting rule for acquisitions is that all assets and liabilities of the acquiree in an acquisition need to be recorded at fair value upon the acquisition or change of control.

How do you fair value deferred rent balances?

Interestingly, deferred rent balances don’t get recorded at the acquisition date at all. Instead, companies should perform an analysis of leases acquired to see if there is a favorable lease asset or an unfavorable lease liability that needs to be recorded. This should be done regardless of whether there is a deferred lease on the balance sheet of the acquiree or not, as long as there are leases assumed by the acquirer. To illustrate, the Company assumed an office lease for which there was a free rent period (which ended before the acquisition). The lease has escalating payment terms, so the monthly rent going forward will probably be above market (i.e., entering into a new lease agreement for the Company would be on more favorable terms).

That means the Company has an unfavorable lease liability for that particular lease. And vice versa, if the acquiree negotiated a great deal for the whole duration of the lease and the payments going forward will be below market, then the Company has a favorable lease asset to be recorded. The resulting unfavorable lease liability or a favorable lease asset will then get amortized to lease expense on a straight-line basis over the remaining term of the operating lease.

How do you determine the amount of a favorable lease asset and/or unfavorable lease liability?

As with anything at fair value, there is no one correct answer. Some subjective judgment is involved. For each lease a company should find a few comparable properties on the market and run a calculation for the remainder of the term to determine the difference between the market rate and the actual payments for the remaining term of the lease. And remember to factor in the discount rate and the market growth rate in your calculation, but not the cost to move out. Although moving costs would affect the Company’s decision on whether to stay with the current lease or enter into a new lease, they are not taken into consideration for determining whether there is a favorable or unfavorable lease.

For example, one of our clients said, “Although the comparison to market shows that we have unfavorable lease terms, we wouldn't move out as all the moving costs wouldn't make it worthwhile. So common sense tells me these leases are at market.”

Definitely a good point, but the accounting rule doesn't let you take moving costs into consideration. So our client had to record a liability for those unfavorable leases.

April 15, 2019

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