When negotiating lease concessions, it is important to recognize that details in the existing lease agreements matter and can impact financial reporting for both the landlords and tenants. Most recently, the COVID-19 pandemic has created new considerations when reporting for lease concessions. The following article provides an overview of how to account for rent concessions related to COVID-19. Since most private companies continue to report under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 840, the following information focuses on the financial reporting for leases under ASC 840.
Lease Concessions Overview and Key Accounting Considerations
Lease concessions may include deferrals of lease payments, rent waivers, lease term modifications and variable rent payments (e.g., % rents), among other items. Typically, entities that receive or provide lease-related concessions would need to consider whether the concessions provided by a lessor are a change in the provisions of the lease (e.g., considered substantial under the guidance), in which case the lease may be considered a new lease and the accounting treatment would need to be reevaluated. However, to reduce the complexity and operational challenges of accounting for leases in the current environment, the FASB is allowing relief in certain situations.
The FASB is allowing lessees to elect not to evaluate whether certain concessions provided by a lessor related to the effects of COVID-19 are a change in the provisions of the lease. To qualify for this election, a concession cannot result in a substantial increase in the rights of the lessor or the obligations of the lessee. For example, entities could make the election for concessions that require total payments per the revised lease to be substantially the same or less than total payments per the existing lease; however, if the revised lease extends the term or results in an increase in total payments compared to the existing lease, the election would likely not be allowed.
An entity can elect not to evaluate whether a concession is a change in lease provisions if it can demonstrate that the concession was contemplated by the lease agreement. Making this election would simplify the accounting for both lessees and lessors. Often, Force Majeure clauses in the lease will satisfy this requirement. If the lessee makes this election, the lessee could account for the reduction in lease payments as if it were part of the enforceable rights and obligations of the existing lease agreement.
The FASB guidance states that these elections should be applied consistently to leases with similar characteristics and in similar circumstances, consistent with the overall objective described in ASC 842-10-10-1. Entities applying ASC 840 should use a similar approach.
Accounting for Concessions without Elections
An entity that does not use the elections described by the FASB will have to carefully evaluate the enforceable rights and obligations of each lease to determine whether to account for the concession as a change in the provisions of the lease and, therefore, a new lease agreement.
If the enforceable terms of the existing lease do not contemplate a concession or if other changes to the lease that were not contemplated in the existing lease are made, ASC 840’s guidance on accounting for a change in lease provisions would apply. In this situation, the existing lease would need to be accounted for as a new agreement in accordance with ASC 840.
Below we explore in further detail the two ways to account for concessions without the election:
1.) Accounting for a concession as a change in the provisions of a lease
The lessee or lessor may conclude a rent concession is a change in the provisions of the lease because of any of the following:
- The entity determines that the enforceable rights and obligations of the contract (and related governing law) do not contemplate the concession provided by the lessor.
- The rent concession does not qualify for the election because the total payments of the revised lease are not substantially the same as or less than the total payments of the existing lease, and/or additional changes in lease provisions unrelated to COVID-19 are included in the changes to the contract.
- The entity elects to not evaluate whether a concession is a change in the provisions of the lease, and the entity chooses to adopt a policy to account for the lease as a change in the provisions of the lease.
Now let’s look at the differences in accounting for the concessions for both the lessee and the lessor:
When a lessee determines that an existing capital lease would remain a capital lease if the concession had been in force at lease inception, the recorded asset and obligation balances are adjusted by the difference between the outstanding lease obligation balance and the present value of the future minimum lease payments. The present value of the future minimum lease payments under the revised agreement should be computed using the rate of interest used to record the lease initially.
When a lessee determines that an existing operating lease would remain an operating lease if the concession had been in force at lease inception, the concession is recognized prospectively over the remaining term of the lease, generally on a straight-line basis.
If a lessor determines the classification of an existing sales-type or direct financing lease does not change if the new terms had been in force at lease inception, the remaining balance of the minimum lease payments and estimated residual value, if affected, are adjusted. The net adjustment is recorded as a charge or credit to unearned income.
If a lessor determines an existing operating lease would remain an operating lease if the new terms had been in force at lease inception, any accrued or deferred rents should be amortized over the remaining lease term.
2.) Accounting for a concession that is not accounted for as a change in the provisions of a lease
The lessee or lessor may account for the rent concession not being a change in the provisions of the lease for the following reasons:
- The entity chooses to adopt a policy to not account for the concession as a change in the provisions of the lease.
- The rent concession does not qualify for the election (e.g., because the total payments of the revised lease exceed the total payments of the existing lease), but the entity determines that the enforceable rights and obligations of the contract (and related governing law) contemplate the concession provided by the lessor.
Lessee and Lessor Accounting
There are a couple of approaches for accounting for a rent concession that is not accounted for as a change in the lease provisions that are applicable to both the lessee and the lessor, including (1) accounting for a concession in the form of a deferral of payments as if the lease is unchanged or (2) accounting for a concession as a contingent rental payment.
In addition to the accounting considerations above, some other items to consider include:
- Tax Implications – it is important to consult with your tax professional regarding lease-related concessions as there are several tax considerations to keep in mind.
- Accounting Policy – entities (both lessees and lessors) should document their policy for accounting for lease concessions related to COVID-19.
- Internal Controls – entities should ensure internal controls are appropriately designed, implemented and operating related to lease concessions resulting from COVID-19.
- Financial Statement Disclosures – entities should provide disclosures that make the impact of COVID-19 transparent.
As COVID-19 continues to transform the business landscape, many companies are facing unique challenges that can extend into accounting for lease concessions. If you need additional information on how to account for lease concessions, Moore Colson’s Real Estate Practice is available to help. Please contact us so we can strategize on the best approach for you. Also, be sure to subscribe here to get our news and alerts as they are released as we are committed to keeping you updated on how to navigate financial challenges associated with the COVID-19 pandemic.
Hudson Ireland, CPA, is a Director in Moore Colson’s Business Assurance Practice. Hudson is responsible for planning and overseeing all aspects of financial statement audits and reviews for companies in the firm’s real estate and staffing industries.
Steve LaMontagne, CPA, is a Partner at Moore Colson and leads the firm’s Real Estate Practice. Steve has extensive experience in all sectors of the real estate, construction and hospitality industries, including fund managers and advisors, registered investment advisors (RIAs), REITs, developers, institutional investment vehicles, operating properties, and syndication of private and public partnerships.