The coronavirus pandemic is upending the ability to collect and pay rents or other lease obligations, as well as hampering ASC 842 and IFRS 16 compliance. In turn, the pandemic may impact a company’s lease accounting in more ways than one. Here are some main issues to consider:
A rent concession could come in the form of deferred rent, rent forgiveness, or some other form of relief. The lessee’s accounting treatment of a concession depends on if they have an enforceable right to a concession.
If there is a force majeure (act of God) clause in the lease agreement, then it would often include pandemics such as COVID-19. If included, it would create a positively impacting variable lease payment due to the rent relief. The Financial Accounting Standards Board has clarified that a variable impact wouldn’t require remeasurement of right-of-use (ROU) assets and a lease liability.
No force majeure? This likely means a lease modification for the rent concessions, which would result in a remeasurement of the leases.
As a result of COVID-19, regulators have dropped interest rates, which most likely will impact a lessee's incremental borrowing rate (IBR). As interest rates fall, so does the IBR of lessees. Discount rates won't impact existing leases but will affect new leases, remeasured leases, or transition to the new lease accounting standard, if the lessee is privately held. Companies should have a practicable, updatable methodology to determine IBR.
If you are an owner-operator, you are most likely concerned with the decrease of activity in housing and commercial real estate. Many lessees have requested a reevaluation because they do not feel valuations done at the beginning of 2020 are reasonable to use anymore. (Historically a 5-month-old valuation would still be used.) Not shockingly, commercial real estate has come down in fair value.
COVID-19 has changed the business climate many operate within today, and the adverse change could affect a company’s long-lived assets or asset group. This could cause assets to be valued below their current balance, resulting in impaired ROU assets. ASC 842 requires a different amortization calculation of operating leases.
The overall process of recording lease-related impairments is complex; working with the right lease accounting software can assist with automating impairment processing. If implementing a new software was already part of your technology roadmap, you may want to consider moving forward.
After calculating the modified lease liability, the lessee should adjust the ROU asset value by a proportionate amount. For example, if the lease liability decreases by 5% based on the new payment terms, the lessee would calculate a 5% reduction in the ROU asset value. Any variance between the adjustment to the asset and the liability should be recorded in current period gain or loss.
One or more actions a lessee takes in response to the effects of the COVID-19 pandemic may lead to their reassessing the terms of a lease (or leases), including options to purchase. It is unlikely but possible that the pandemic will trigger a minimum lease payment or termination right.
The expected residual value of an underlying asset may be affected by the economic circumstances, requiring reassessment by the lessee of the probable amount they will owe under a residual value guarantee.
This is more likely to occur as companies are looking to maximize their efficiencies and use of space. An example would be possible space for overflow in heavy periods of demand – if sales have suffered heavily, there may not be a practical use for the space any longer. A lessee may not be able to sublease the space given lack of demand, which would prompt them to apply abandonment accounting (accelerated amortization of the ROU asset).
For the latest regulatory updates and more information on keeping your business running through disruption, visit our COVID 19 Resource Center.
May 19, 2020
