ASC 805 and Accounting for Pandemic-Linked Lease Concessions
Expanding on factors related to business combinations (ASC 805) and fresh-start accounting, this article contains updates to information originally published in April 2020 about lease accounting relief for businesses impacted by COVID-19.
In early April 2020, the Financial Accounting Standards Board (FASB) held a special meeting to address concerns regarding the COVID-19 pandemic, including application of guidance on lease concessions, interest income, hedge accounting, fair value measurement, and a proposal to defer the adoption dates of the new revenue recognition standard (ASC 606) for certain private franchisor companies and the new lease accounting standard (ASC 842) for private companies.
Following this meeting, the FASB staff released answers to pressing questions on accounting elections for lease concessions provided by lessors who have been impacted by COVID-19. Here is what companies should know about the FASB’s decisions on these accounting elections.
Lease Accounting Relief
Weakened capital movement and consumer confidence since the onset of the outbreak has resulted in mounting economic pressure on businesses. As a result, some lessors may provide concessions over the coming months. Should these concessions (e.g., payment deferrals, rent reductions, and payment forgiveness) not be specified in the original lease contract, historically, they would have generally been accounted for as lease modifications under ASC 842 (and ASC 840). According to the FASB, entities may now choose not to evaluate whether lease-related relief that lessors provide to mitigate the economic effects of COVID-19 on lessees is a lease modification under ASC 842 or ASC 840. The FASB stated that both lessees and lessors could make this election.
Reasonable judgement-based options
In making this election, entities will account for COVID-19 related concessions as though the enforceable rights and obligations for the concessions existed in the original contract, provided the concessions do not result in a substantial increase in the rights of the lessor or the obligations of the lessee. Reasonable judgement is expected to be applied in considering what constitutes a “substantial increase.” Furthermore, consistent with the lease guidance, this election should be applied consistently to leases within the portfolio that contain similar characteristics and similar circumstances. An entity need not apply the same approach to the entire portfolio, however, reasonable judgement must be applied to each scenario if this approach is taken.
Some concessions will provide a deferral of lease payments with no substantive changes to the consideration in the original contract. The accounting for these lease concessions can be accomplished in multiple ways. Two of those methods are:
- Account for the deferred payments as variable lease payments.
- Account for the concessions as if the lease contract was unchanged. A lessor would increase its lease receivable, and a lessee would increase its accounts payable as receivables/payments accrue. In the income statement, a lessor continues to recognize income, and a lessee continues to recognize expense during the deferral period.
Following existing disclosure requirements of GAAP, companies should consider additional relevant information to give financial statement users so they may better understand the financial effects of granting concessions as a result of COVID-19.
Consistency is key for audit preparation
This guidance will come as welcome relief to companies that struggled through adopting the new lease accounting standard and continue to refine lease accounting policies and procedures. Auditors will likely require documentation relating to this policy election (i.e., reasonable judgements taken), and companies with substantial lease portfolios (both lessee and lessor) that are entering into concessions should begin assessing their approach and documenting financial impacts. Companies can operationalize this process by building it into their future-state processes in order to ensure that a proactive approach is taken, alleviating the need for last minute audit preparation.
In addition to the concessions discussed above, several other areas of lease accounting may be affected by the economic impacts of COVID-19, including potential impairment of lease right-of-use assets, accounting for lease abandonments, and changes to incremental borrowing rates used in computing lease liabilities.
JULY 2021 UPDATE:
Accounting for COVID-19 abatements and the effects of ASC 805 and fresh-start accounting requirements
An additional observation to this topic relates to how business combinations guidance (ASC 805) intersects with the FASB’s previously provided relief election discussed above.
Instances where companies are undergoing a business combination or fresh-start accounting will treat leases as if starting on the ASC 805 date. This means all leases will be “reset” and the lease liability will be calculated using future payments from that date onwards, consistent with the principles of ASC 805. For companies that have that elected to apply the FASB’s relief, complexity arises where a company has remaining abatements on its lease agreements because of lessor concessions due to COVID-19.
If these abatements are known or easily calculable at the “reset” date, they will need to be included in the liability calculation rather than being treated as variable payments per the relief. This will result in a lower liability and right-of-use-asset, and no impact to rent expense over the course of the lease as these concessions have already been accounted for in the lease liability. Practically speaking, companies will be required to update payment schedules to include the adjusted payment amounts—rather than simply recognizing a decrease to rent expense as the concessions are realized. In practice recently—amid significant transaction activity and a number of companies applying fresh-start reporting—the application of ASC 805 overrides the practical expedient guidance issued by the FASB which states that that the COVID-19 lease concessions do not create a need to remeasure the lease liability.