As shutdowns and business interruptions took hold in 2020 due to the COVID-19 pandemic, finance leaders were forced to switch their focus from business growth to strict cost management. Disruptions in operations left storefronts and corporate offices relatively vacant or underutilized. In addition, with personnel productively working remotely from home (and quickly trending toward permanence), the pressure to reevaluate corporate facilities needs had never been greater. However, at the onset of the pandemic, the impacts on lease accounting were unclear.
Undoubtedly, vacant or underutilized leased storefronts, office spaces and equipment would be effective candidates for renegotiations with lessors to seek financial relief—either through lease concessions, modifications to lease agreements or early terminations. It goes without saying that under the current ASC 842 lease accounting standard, lease modifications have balance sheet and, potentially, income statement impacts. What may not be top-of-mind is the amount of effort and judgment required in assessing the accounting treatment of lease modifications as a direct result of the pandemic.
Digging into Lease Accounting Modifications
Per ASC 842, lease modifications typically will require lessees to remeasure lease liabilities (to account for the revision to future lease payments) with an offsetting entry to the respective right-of-use (ROU) assets. Should the remeasurement to lease liabilities exceed respective ROU assets balances, the difference shall be recorded in the income statement as a gain or loss.
When remeasuring lease liabilities, the discount rate is also to be updated as of the remeasurement date, save for the following exceptions noted in ASC 842-20-35-5:
- “A change in the lease term or the assessment of whether the lessee will exercise an option to purchase the underlying asset and the discount rate for the lease already reflects that the lessee has an option to extend or terminate the lease or to purchase the underlying asset.”
- “A change in amounts probable of being owed by the lessee under a residual value guarantee…”
- “A change in the lease payments resulting from the resolution of a contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based…”
Furthermore, the lease classification may also need to be reassessed upon remeasurement. For example, a finance-type lease is modified to reduce scope and consideration that results in a change in classification to an operating lease relative to remaining economic life and fair market value of the leased asset.
When facing the prospect of modifying lease terms, some lease agreements may require additional legal interpretation and scrutiny to formulate an appropriate accounting response. For example, there may be a “force majeure” clause that may allow lessees and/or lessors to claim relief from events outside of either party’s control that inhibits their ability to fulfill contractual obligations. Depending on how the clause is written, government-mandated business shutdown due to the pandemic may be interpreted as a consummation of an interpreted contingency affecting lease payments. In which case, the resulting lease modification would exempt the lessee from updating the discount rate used to remeasure the lease liability as well as exempt the lessee from reevaluating the lease classification, which undoubtedly would save time and resources.
A business entity may have multiple leases that may require modifications, and the resources required to individually scrutinize each lease can be overly burdensome, a reality that the Financial Accounting Standards Board (FASB) duly recognizes. In April 2020, the FASB held a meeting to discuss issues related to the COVID-19 business disruptions, including how “…it may be exceedingly challenging for entities to determine whether existing contracts provide enforceable rights and obligations for lease concessions…”
Optional Lease Accounting Elections
Furthermore, the FASB concedes that ASC 842 did not fully anticipate “…concessions being so rapidly executed as a result of a major financial crisis arising from the COVID-19 pandemic.” As such, the FASB provided an optional election to treat the pandemic-driven lease concessions “…as though enforceable rights and obligations for those concessions existed (regardless of whether those enforceable rights and obligations for the concessions explicitly exist in the contract)” as allowed for under ASC 842, or ASC 840 for business entities that have not yet adopted ASC 842.
Still unsure about implementing the new standard? Learn more about ASC 842 implementation.
As such, consequent lease modifications would result in a remeasurement of respective lease liabilities (and offsetting entries to ROU assets and/or income statement) without revisions to discount rates and lease classification.
The FASB noted that this election is only available to pandemic-related concessions that do not significantly increase the rights of the lessor or decrease the obligations of the lessee. For example, total payments per the modified lease agreement should be “substantially the same as” or less than the prevailing pre-pandemic agreement. The FASB also provided guidance related to concessions where total consideration and scope of a lease agreement remain unaltered but lease payments are deferred. In which case, the lessor/lessee would either continue to record lease accounting entries as normal and book a separate receivable/payable for the deferred rental payments or treat the deferred payments as variable lease payments. This lease accounting election was intended to provide administrative ease and conserve time and resources especially when applied across multiple affected leases.
Need Technical Accounting Support?
As the United States and the rest of the world transition from a reactionary vantage to a more proactive one as the COVID-19 pandemic continues to fundamentally alter business operations, added flexibility like the aforementioned lease accounting election for pandemic-related lease concessions are welcomed tools to employ in a business entity’s recovery. At 8020 Consulting, our experience and expertise afford us the ability to provide our clients executive-level resource enhancements and the necessary flexibility to meet company objectives.
If you would like to learn more about ASC 842 lease accounting and the practice of reviewing new and existing leases, check out our helpful resource below. It offers a clear process for review, as well as relevant questions and codification guidance:
About the Author
Kevin is an accounting and finance professional with nearly 20 years of experience. He started his career in San Francisco in the audit and assurance service division of Deloitte serving major public and private clients spanning banking and finance, not-for-profit, manufacturing and hospitality industries. Subsequently, he joined PG&E Corporation serving first in the regulatory accounting group and later as an accounting supervisor in the corporate reporting group. Kevin moved to Los Angeles and joined the Corporate Controllership team at The Walt Disney Company and enjoyed many successful years as a Senior Manager leading efforts pertaining to equity-based compensation and SEC and other external reporting for the Media, Theme Parks and Studio segments. Prior to joining 8020 Consulting, Kevin had previous consulting experience ranging from SEC reporting, process improvement, monthly close, forecast and budgeting, and project management at clients like Toyota Motor Credit Corporation and Southern California Edison. Kevin is a Certified Public Accountant and holds a Bachelor’s of Science degree in Accounting from the University of San Francisco.
