Rent concessions, discount rates, fair market values and more critical lease accounting topics affected by COVID-19.
Originally Published June 2020 by Accounting Today.
The coronavirus pandemic is upending the ability to collect and pay rents or other lease obligations, as well as hampering lease accounting and compliance with ASC 842. Without the right accounting tools to handle the various changes, companies may spend hours or days creating tedious workarounds to make adjustments for compliance requirements. Here are the significant areas of lease accounting that will be affected by Coronavirus or COVID-19.
Many lessees, besieged by the economic impact of COVID-19, have requested rent concessions. Some lease contracts contain clauses regarding unforeseeable circumstances like pandemics, but many don’t. If a contractual or regulatory requirement – such as a force majeure clause – provides an enforceable right to rent relief, the lessee may record the favorable impact as a variable lease payment. If no such enforceable right exists, a rent concession may need to be accounted for as a lease modification. A lease modification will result in the re-measurement of lease accounting calculations. However, a variable impact will not require re-measurement of the ROU asset and lease liability. Lease accounting software should provide different tracks to record variable lease payments vs. lease payments associated with a modification, and provide automatic re-measurement.
Discount Rate (Lessee’s Incremental Borrowing Rate)
In response to COVID-19, regulators have already dropped interest rates, which will likely impact a lessee’s IBR. Lower interest rates increase the calculated amount of a lessee’s right-of-use (ROU) assets and lease liabilities. This affects balance sheets when lessees enter new leases, re-measure leases, or transition to new lease accounting guidance. When lease accounting software is unequipped to quickly ingest IBR data and produce calculations based on rapidly changing rates, it may take hours for companies to recalculate figures.
Fair Market Values
COVID-19 has had an economic impact on commercial real estate. Data indicates that year over year, commercial property sales have dropped by as much as 63 percent in 2020, according to Finance & Commerce. If real estate sales continue to drop, or if companies are forced to close locations due to decreased business, commercial real estate values could sink further.
To meet ASC 842 lease classification tests, companies need to compare the net present value of lease payments to the property’s fair value. This process usually involves communicating with the real estate department and brokers to access reliable and current information. However one lease accounting and administration system on the market, available from CoStar, allows the accounting department to access industry-leading comps and comparable data directly from the system in order to determine fair market value and cut days out of the process.
An economic downturn could cause business assets to be valued far below their current balance, resulting in the impairment of ROU assets. When an ROU asset is impaired, ASC 842 requires a different amortization calculation for operating leases. The process of recording lease-related impairments is complex, but it’s easy with lease accounting software that has automated impairment processing.
As the coronavirus spreads and people stay home rather than go to an office or shop, some businesses will likely reduce their real estate footprint. Companies may be able to negotiate with the lessor to modify their leases or they may be able to invoke clauses in the current contract to reduce square footage. ASC 842 provides two options and guidance for recording a modification that reduces the scope of a lease. One option reduces the ROU asset proportionate to the reduction in the lease liability. The other option reduces the ROU asset proportionate to the reduction in the leased space. Regardless of the selected option, lease accounting software should be able to re-measure the lease amortization schedule, automatically record journal entries, and document workflows and approvals.
The pandemic could trigger a reassessment of key assumptions associated with lease accounting calculations, such as the likelihood of exercising renewal, termination or purchase options. When a reassessment occurs, lease accounting software should be able to follow the organization’s accounting policy to re-measure amortization schedules and automatically record the impact to the general ledger.
Full Termination or Abandonment
If an asset is no longer going to be used by the business, there may be an option for a full termination under the lease. If that option doesn’t exist, the company may have to abandon the leased asset but retain liability to make lease payments. Either way, companies need to record the lease accounting impact and ultimately provide the supporting documentation to auditors.
One example of supporting documentation commonly requested by auditors is the roll forward report, which presents changes to ROU asset balances and to lease liability balances. Changes could include new lease additions, full and partial terminations, abandonments, impairments, other re-measurement events, and scheduled amortization. As changes are processed, lease accounting software should be able to instantly produce the roll forward report with granular lease-level supporting detail.
COVID-19 may present unique challenges that will delay information from flowing into the accounting department. Delays often result in tedious manual true-up entries. Lease accounting software should automate the true-up process with retrospective re-measurement functionality. Based on the dates of an adjustment, the software should automatically calculate the true-up and post the impact to the general ledger in the current period with no impact to a closed accounting period.
Matt Waters, CPA is the Director of Lease Accounting for CoStar.