COVID-19’s Impact on Lease Accounting

In a turbulent market, lease modifications and concessions have become common but still require careful analysis.

One of the many consequences of the current economic environment has been an impact on rental markets. The sudden slowdown has compelled many lessors to make concessions to lessees whose ability to pay has been impacted. In many cases, lessors have made amendments to existing leases that created rent holidays or lowered rents, often in exchange for lease extensions, reduced space requirements, and even lease terminations— which complicates the financial reporting of these deals. The FASB staff issued a Q&A to address some of the most pressing issues, but the broader perspective requires an understanding of how the accounting for lease modifications under ASC 842 differs from the accounting under the previous provisions of ASC 840 and how a lease modification impacts transition accounting.

As a quick refresher, a lease modification is defined in ASC 842 as a change in the scope of or consideration for a lease that was not part of the original terms and conditions of the lease. A lease modification includes adding or terminating the right to use one or more underlying assets or changing the contractual lease term. A modification is accounted as a separate lease only if it creates a new right-of-use asset that is priced commensurate with the cost of a stand-alone lease. Otherwise, the modification is a remeasurement of the original right-of-use asset and lease obligation. Here are four of the major differences and how to navigate them:

Transition Impact

ASC 842 included many provisions that were designed to facilitate the transition to recognition of right-of-use assets by lessees. For example, lessees were permitted to transition existing leases without revisiting the original determination whether the arrangement is or contains a lease, the original lease classification, or the accounting for initial direct costs. The discount rate for all leases could be effective as of the implementation date.

However, none of that applies if the lease is modified or remeasured for any reason (see ASC 842-10-3-4). If a modification to the contractual terms and conditions occurs on or after the effective date and the modification does not result in a separate contract or the lessee is required to remeasure the lease liability for any reason, the lessee must follow the requirements in ASC 842 from the effective date of the modification or the remeasurement date.

Extensions or Terminations

Under ASC 840, most extensions were accounted for as a new lease. Under ASC 842, an extension of the lease is not a new lease but instead a remeasurement event for the existing right-of-use asset and lease obligation. If the lease is extended, the lease liability is remeasured with an adjustment to the right-of-use asset to reflect the cost of additional rights. The new lease payments are discounted at the lessee’s discretion using a revised appropriate rate on the date of the modification. Any initial direct costs, lease incentives, or other payments in connection with a modification are accounted for as if the modification is a new lease.

Shortening a lease is also a remeasurement event. In order to qualify as a partial termination, there should be a difference between the rights before and after the modification. For example, a lease that reduces the amount of space leased or the number of vehicles leased would be a partial termination. On the other hand, a modification that adds new leased assets would be accounted for as a new lease—but only if the lease payments increase commensurate with the standalone price for the additional rights of use.

Concessions

In normal times, a concession, such as a rent holiday or deferral, would be accounted for as a modification and recognized over the remaining lease term. As these are not normal times, the FASB staff permits a concession due to COVID-19 to be accounted for as contingent rent and recognized immediately. Also, if the concession is not considered a modification, the transition provisions may still apply, an extra incentive to account for the concession as contingent rent. However, accounting for the concession as a modification remains an option.

Impairment

The ongoing crisis is leading to extensive impairment testing of right-of-use assets, a new procedure under ASC 842. Under prior lease guidance, only capital leases were recognized on statement of financial position and therefore subject to the impairment guidance in ASC 360. Now that virtually all leases are recognized, the new right-of-use assets will need to be included in annual impairment testing, whether individually or, more likely, as part of a larger group of assets. For many companies, this will require additional staff time, new skills, and the exercise of professional judgment to determine asset groups, assess recoverability and, if necessary, determine the fair value of asset groups and allocate amounts to right-of-use assets.

In addition, an unremarked provision of the new standard that was added subsequent to the exposure draft requires a major change in the accounting for operating leases once an impairment is recognized. In effect, expense recognition is no longer straight-line. Lease expense will be front-loaded for the remaining lease term, comparable to a finance lease. The FASB did not include any provision to revert to straight-line recognition if the lease is extended, so presumably this accounting will continue through extension periods.

The bottom line: Lease modifications or concessions driven by the current crisis could have major impacts in current and future financial reports and require careful analysis in order to get them right.

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This column was co-authored by John Hepp, Ph.D., clinical assistant professor of accountancy in the University of Illinois’ Geis School of Business.