Whether discussing the coronavirus itself or the countless repercussions lying in its wake, nearly every facet of life has been altered in some way by this pandemic. Obviously, companies aren't immune to such forces, suddenly finding themselves grasping for answers while trying to keep their people safe and businesses afloat. Something like lease accounting, for instance, is now in the spotlight as companies struggle to pay their rent and keep pace with their obligations.
But there's two sides to the rent concession coin, impacting both lessors and lessees under ASC 842. And because we can't help but be thorough here at Embark, we're going to provide some timely insights for each of those two sides – the give and the take behind rent concessions – to hopefully make your accounting team's life a bit easier.
Granting Concessions: A Primer for Lessors
These are challenging times. And, yes, that might be the biggest understatement we've ever uttered. On the corporate side of the spectrum, supply chains are running on fumes, companies are operating at fractions of former capacity, and revenue is reduced to trickles rather than streams in many parts.
Put differently, COVID-19 has had a devastating effect on companies and their customers, leading many organizations to seek some form of relief through future construction & tenant improvement allowances, rent abatement, and rent concessions. From a leasing perspective, rent concessions are the most obvious form of such relief, where companies simply can't pay their rent and need a lifeline just to stay solvent.
For lessors, these rent concessions fall squarely under the jurisdiction of ASC 842, accounted for as a lease modification when they’re not written into the contract. However, if the contract – or law under the governing jurisdictions – includes verbiage that covers rent concessions as an enforceable obligation of the lessor, a lessor accounts for them as variable rental income. In that case, the lessor recognizes the variable rental income through the current period income statement under ASC 842.
On a side note, providing rent concessions, whether contractually obligated or for other reasons, may also raise issues about future collectibility of lease payments and how lessors should account for them. When collectibility is no longer probable, the accounting ultimately depends on the lease classification.
- Operating leases – ASC 842 requires lessors to reassess collectibility throughout the lease term for an operating lease. If the assessment of collectibility changes after the lease’s commencement date, then the lessor’s lease income is limited to the lesser of (1) the lease income that would have been recognized if payment was probable, including any variable lease payments or (2) the lease payments, including variable lease payments if any, that they’ve collected. If actual lease payments collected by the lessor are less than the lease income recognized to date, lease income should be reversed. When collectibility returns back to being probable and the lease is no longer troubled, lease income is trued up for any difference between the cumulative lease income that would have been recognized originally and the actual lease income recognized to date.
- Sales-type and direct financing leases – For these lease types, collectibility is not reassessed after commencement, even when events warrant a change in collectibility assumptions. Instead, when collectibility assumptions change during the lease, a lessor may need to consider a potential lease impairment to the net investment under ASC 326, if adopted, or ASC 310. Alternatively, if collectibility was never probable at the start of the lease, GAAP provides examples of a lessor’s accounting within ASC 842-30-55-18 to 43.
Lessees Receiving Concessions
Now let's look at the other side of the coin. Many lessees are watching their revenue evaporate, without an end in sight. They're scurrying to make arrangements with their landlords and creditors to relieve some of that stress, meet some semblance of their obligations, and keep the doors open.
Zooming in on the lease-related side of that distress, businesses are already closing locations or amending operations under lease, leading them to negotiate some form of relief with their lessors. In fact, as we discussed, many lessors are already providing such relief through rent concessions, either temporary or longer-term, during this crisis. In some cases, these concessions are voluntary, while in others, they're required under the contract or even by law.
Leases Under ASC 842
Because of these unique circumstances, companies that are already applying the new lease standard, ASC 842, must consider how these arrangements impact their accounting for lease-related account balances.
Like our discussion on the proper accounting for lessors under the guidance, lessees must also use ASC 842 as their guiding light. To begin, a company must first consider the enforceable rights and obligations under the lease agreement or as permitted by law. Likewise, the nature of the amendments to the lease arrangement is another determining factor. Ultimately, as the following decision tree demonstrates, you're trying to determine if a rent concession is considered a modification of the original lease or a variable lease payment under the original contract.
Question 1 – Does the lessee have the enforceable right to a rent concession under the contract?
- If yes, then see Question 2.
- If no, the rent concession is considered a modification of the original lease.
Question 2 – Were other changes or amendments to lease terms for the original lease contract made during negotiations?
- If yes, the rent concession is considered a modification of the original lease.
- If no, the rent concession is considered a variable lease payment under the original contract. The variable lease payment in this circumstance is a negative lease payment.
Also, lessees should keep in mind that a force majeure clause might outline an enforceable right under the lease contract. Always look at the fine print and consider any such provisions to see if the lessor is required to provide relief – rent concessions, in this particular discussion – under the circumstances.
Lastly, if, after following our decision tree, you determined that ASC 842 considers a concession to be a lease contract modification, then the accounting is similar to any other contract modification under the guidance. Generally speaking, you account for these modifications on a prospective basis. However, if a concession is a variable lease payment and not a modification, then you should only recognize the amount that is probable and estimable of being conceded in the arrangement if the amount is uncertain.
It goes without saying that we all wish circumstances were very different than our current reality. However, Embark will continue to provide much-needed insights and guidance to help companies and their people navigate through these incredibly choppy waters. Whether it's for lease accounting assistance or virtually anything else impacting your accounting and finance functions, we'll be here if you need us.
Update as of 4/14/20:
On April 8th, the FASB provided additional guidance over accounting for rent concessions due to the COVID-19 outbreak. Recognizing the amount of effort it may take for companies, especially those with significant leasing activities, to evaluate whether an enforceable right or obligation exists for any rent concessions in leasing contracts, the FASB provided an option for companies to forego that assessment.
Specifically, for leases where the total cash flows of the modified lease will remain substantially the same (or even less) than the original lease, a company would account for any rent concessions by selecting one of two approaches:
- As if the enforceable right or obligation exists (regardless of whether it does or does not) under the original lease agreement – in other words, as a variable lease payment in the period a concession is granted; or
- As a lease modification
Regardless of which approach is used, a company should apply the same election to all leases with similar circumstances. Finally, while companies will find relief foregoing the detailed lease contract review, their ability to select an approach to account for rent concessions may result in diversity in practice. Companies should be cognizant about providing additional disclosure over the approach selected to account for rent concessions, especially where they are significant to the business.