Lease Concessions triggered by COVID-19 under ASC 842
Introduction
COVID-19 continues to impact many facets of a company’s business with a domino-like effect. Lease accounting is no exception, to stay afloat companies may now be required to revisit pre-existing contracts to try and reduce/defer cash outflows.
Non-payment of a leasing contract is to be avoided at all costs given it’s breaking legally binding contract which can bring additional problems and costs the lessee will have to deal with. As a result, a renegotiation of the lease terms is a legitimate way a lessee can help contain their current cash outflows.
What are the concessions offered by the FASB?
On April 8, 2020, the Financial Accounting Standards Board (FASB) held a discussion of the impacts of COVID-19 on a company’s lease accounting. One of the topics discussed specifically related to concerns around how to account for lease concessions as a result of the current global pandemic.
The FASB noted:
- It is often costly, complex, and burdensome for entities to go through a large number of contracts quickly to determine whether the existing contracts provide enforceable rights and obligations for lease concessions
- If the concession is consistent with the original terms of the contract or is a modification of the original lease
- The impacts of COVID-19 are not in the ordinary course of business
- Modification accounting is complex
Noting the above a number of concessions were given to lessees.
Concession one - no modification accounting in relation to lessor rent concessions
In order to reduce the complexity of adhering to ASC 842 modification accounting guidelines, a company may elect an alternative to modification accounting.
This approach permits entities to treat lease concessions as a direct result of the COVID-19 pandemic as if they existed in the original contract. Instead, companies can elect to treat these new enforceable rights and obligations as if they existed in the original contract and account for the concessions in the current period.
This is can be applied company-wide or for leases with similar characteristics and circumstances as an accounting policy election.
To meet this election the total consideration must be “substantially the same” or less than the total consideration stated in the contract. Furthermore, the concession must be approved by both parties.
Concession two - no reassessment of discount rate during modification accounting
The second concession is straight forward to apply. When modification accounting occurs in relation to a COVID-19 rent concession the lessee is not required to update the discount rate in relation to the lease liability.
This is helpful given the Federal Reserve has dropped interest rates as part of an emergency action plan.
How to account for the concessions
A concession can work in two ways:
- Deferral of lease payments
- Reduction of lease payments
We’ll first tackle deferral of payments.
Deferral of payments
Overview
A deferral occurs when the lessee can defer when a lease payment is due. For example, a lessee pays $1,000 at the start of each month. The lessor provided a concession that for the months of March to May the lessee can defer those payments until October 2020.
There’s a number of ways to account for this scenario:
Raise a liability (no remeasurement of lease liability)
Raise a clearing account with the following journal entries:
Lease expense Dr $1,000
Lease payable Cr $1,000
Record the future payable
When the payment is made:
Lease payable Dr $1,000
Lease liability Dr $1,000
Cash Cr $1,000
Lease expense Cr $1,000
Entries when lease payment is made
This method allows your lease accounting its course, as eventually, it will marry up once the payments are made. As a result, you will not remeasure the lease liability and thus in turn not adjust the ROU Asset or amortization schedule.
Negative variable lease payments (no remeasurement of lease liability)
The deferred payments are recorded as a negative lease expense when the payments would have been incurred in the original lease terms.
To account for the above scenario will result in the following journal entries:
Lease liability Dr $1,000
Negative variable lease expense Cr $1,000
Recording the deferred payment
Negative variable lease expense Dr $1,000
Cash Cr $1,000
Reversing the deferred lease payment and reconciling the cash balance to the in-line with the actual lease liability amount
The method has no balance sheet impact, as a result, the lease liability presented will be less than the amount that the lessee is legally obligated to pay until the payment is made. Why? As this approach doesn’t result in modification accounting the payment and unwinding of the lease liability will follow the legal terms of the lease while in actual fact you have not made this lease payment.
Modification accounting apply the practical expedient of no updated discount rate
As you can see the above two examples are workarounds and are going to result in some discrepancies between your lease accounting present value calculations and actual cash balance. These areas will need to be reconciled potentially creating more harm than good.
If you understand modification accounting or using a lease accounting software like Cradle this might be the route you want to take and it’s the most accurate.
Update the lease payments to represent the updated contractual cash flows and voila lease accounting is done and reconciles.
There will be a remeasurement of the lease liability and right of use asset, refer to the accounting guide here for modification accounting.
A nice area to note also you do not have to consider the reclassification of the lease or other areas of judgement e.g. lease term.
Reduction of lease payments
In this case, let’s assume the Lessor waives the lease payment of $1,000 for the month of March due to the impact of COVID-19.
Raise a liability (no remeasurement of lease liability)
This method will not work for the reduction of lease payments as you will never have to pay that liability you raise.
Negative variable lease payments (no remeasurement of lease liability)
In contrast to a rent deferral, because the reduction will not be paid at a later date, there is no reversal of the negative lease expense previously booked. If a portion of lease payment e.g $600 is forgiven the journal will look like:
Lease liability Dr $1,000
Cash Cr $400
Negative variable lease expense Cr $600
This will result in no remeasurement of the lease liability or right of use asset.
Remeasurement consistent with resolving a contingency
Approach 3 treats reductions to payments as a resolution of a contingency specified in the original lease. The lessee is not required to reassess the classification of the lease, or the lease term and purchase options. However, the lessee adjusts the value of the leased asset and lease liability to the present value of the remaining lease payments using the original discount rate. For how to do modification accounting refer here.
Summary
Trying to learn how to account for COVID-19 concession exemptions could complicate your lease accounting rather than make it easier. If you understand modification accounting it’s probably the easiest route especially if there are multiple members of the finance team involved who understand the current lease accounting processes. Not to mention if you use lease accounting software, modifications should be able to be done in less than a minute with a couple of clicks.
If you like to avoid modification accounting at all costs, use the FASB electable alternative to recognize the financial impact of the concessions in the current period. If any material concessions are granted to the lessee, both the lessee and the lessor should disclose the accounting effects of the transactions in order to provide transparency in regards to the effects of COVID-19.