Lease Accounting in Business Combinations – Recognition and Measurement of Lease Assets and Liabilities

In a business combination, the acquiring entity must recognize and measure all identifiable assets and liabilities of the acquiree, including lease contracts. Under U.S. GAAP (ASC 805 and ASC 842) and IFRS (IFRS 3 and IFRS 16), leases held by the acquiree are not treated as new contracts—they are evaluated and brought onto the acquirer’s books at fair value, with specific adjustments to lease assets and liabilities.

This article explains how leases are accounted for in business combinations, covering recognition principles, exceptions, purchase accounting adjustments, and key disclosure requirements.

1. Recognition of Acquiree Leases in a Business Combination

At the acquisition date, the acquirer must:

✦ Recognize all lease liabilities of the acquiree as if it were a new lease

✦ Recognize a corresponding right-of-use (ROU) asset adjusted for favorable or unfavorable terms

✦ Determine lease classification based on the acquiree’s classification (i.e., do not reassess classification)

This approach differs from typical lease inception accounting and reflects the fair value emphasis of purchase accounting.

2. Measurement of Lease Liabilities and ROU Assets

Lease Liability:

✦ Measured as the present value of remaining lease payments, discounted using the acquirer's incremental borrowing rate

ROU Asset:

✦ Based on the lease liability, with adjustments for:➝ Favorable/unfavorable terms (compared to market)➝ Deferred rent or lease incentives➝ Impairments or prepayments

Example:

✦ Lease liability = $450,000

✦ Favorable lease terms (below-market rent) = $30,000

✦ Recognized ROU asset = $480,000

Journal entry: Dr. ROU Asset – $480,000 / Cr. Lease Liability – $450,000 / Cr. Bargain Lease Gain – $30,000.

If terms are unfavorable, the difference reduces the ROU asset or may create a separate liability.

3. Exceptions and Special Considerations

✦ Short-term leases and low-value leases (IFRS only) may be excluded if the acquirer elects the relevant exemption.

✦ Lease classification is not reassessed at acquisition—acquirer must maintain the finance or operating classification from the acquiree.

✦ Embedded leases in service or supply agreements must be evaluated and recognized separately if applicable.

✦ If the acquiree is the lessor, the acquirer continues to recognize lease receivables or leased assets based on the classification and terms of the original lease.

4. Accounting for Favorable or Unfavorable Lease Terms

The difference between market rent and contract rent must be reflected as part of the fair value adjustments:

✦ Favorable lease → Increase ROU asset

✦ Unfavorable lease → Decrease ROU asset or recognize separate lease liability

These adjustments ensure the acquirer reflects economic benefit or burden from the lease terms compared to current market conditions.

Example – Unfavorable lease:Dr. ROU Asset – $400,000 / Cr. Lease Liability – $450,000 / Dr. Lease Loss (P&L or goodwill adjustment) – $50,000.

5. Disclosures in Business Combinations

Required lease-related disclosures in business combinations include:

✦ Nature and classification of acquired leases

✦ Amounts recognized for lease liabilities and ROU assets

✦ Adjustments made for off-market terms

✦ Whether exemptions for short-term or low-value leases were applied

✦ Discount rates used to measure lease liabilities

Disclosure example: “As part of the XYZ acquisition, the Company recognized $5.2 million in lease liabilities and $5.5 million in ROU assets. Lease terms were evaluated using the Company’s incremental borrowing rate of 6.2% and included $300,000 of favorable market adjustments.”