COVID-19’s Impact on Lease Contracts and Resulting Lease Modifications
With COVID-19 adversely affecting the global economy, lease holders are re-negotiating lease contracts for concessions and deferrals in an attempt to preserve cash. Such changes include lease terminations or extensions, rent concessions, deferrals, etc. As a result, questions are arising regarding how to account for lease contract changes on their balance sheets. This article highlights events or changes to a lease contract that can result in a modification and discusses rules and reporting requirements regarding lease modifications under FASB ASC Topic 840 and Topic 842. We will further address the latest guidance from FASB that provides a relief for lessees related to modifications due to COVID-19 impacts.
Considering the current situation, FASB issued an update as a limited deferral of the effective dates of Topic 842 to provide immediate, near-term relief for certain entities.
Accounting Considerations for Lease Contract Changes
The following steps outline how to account for changes in lease contracts.
Step 1: Determine if Change is a Lease Modification
Considerations for Force Majeure Clauses, or Lack Thereof
Generally, in the absence of a Force Majeure clause or contract stipulations related to concessions or deferrals due to a pandemic, lease modification guidance per ASC 840 or ASC 842 will be applied for lease considerations changes or deferrals. However, if pandemic effects are explicitly contemplated within the lease terms or a Force Majeure clause is included in the lease, the concessions in lease payments or payment deferrals specifically related to COVID-19 will not be subject to lease modification guidance.
FASB recently provided additional lease guidance related to practical expedient that allows the lessee to not assess if the lease concession received qualifies to be a lease modification. The lease guidance under ASC 840/ASC 842 did not contemplate applying modification guidance on a widescale basis. As an effort to ease the burden of application, FASB is allowing companies to make a one-time accounting policy election to not subject rent concessions and rent payment deferrals due to COVID-19 to lease modification guidance per ASC 840/ASC 842. This is specifically for leases that do not contain a legally enforceable right to that concession or a Force Majeure clause. The company can elect to treat such concessions or deferrals either as a negative variable payment, or no change in rent expense, and only an increase in liability until paid in full.
Considerations for Changes in Lease Payments
The accounting policy election is only available if the lease payments stay substantially the same or lower than original lease payments. If there is an increase in lease consideration or lease term, or an increase or decrease in leased assets, then lease modification guidance must be applied.
Hence, companies may need to determine if their specific situation allows an accounting policy election.
Step 2: Accounting for Lease Modification
If an event or change is considered a lease modification, the next step is to determine the appropriate accounting treatment for said modification. Would the lessee/lessor account for a lease modification as a separate contract (i.e., separate from the original lease)?
The contract is considered a separate lease when the following two conditions are met:
The modified contract grants the lessee an additional Leased Asset or Right-of-Use (ROU) asset.
The new leased asset or ROU asset is priced at market terms and representative of its stand-alone price.
Example: Accounting for Separate Contracts vs. Lease Modifications
For example, changing a lease contract to lease an additional floor in the same building and from the same landlord would result in the addition being represented by a separate contract when the rent amount is the same for the new space, regardless of their current lease with the landlord. If the terms of the addition are independent of the original relationship or lease, the addition will be considered a separate lease. Conversely, if the landlord leased the additional floor at a discount due to the original lease/relationship, the lease would not be representative of its stand-alone price and hence, considered a lease modification.
Accounting from a Lessee Perspective
If the change is determined to be a separate contract, a lessee should apply ASC 840/ASC 842 to the new leased asset or ROU asset and utilize an incremental borrowing rate for the remaining term of the new separate lease contract. Conversely, if the modification does not meet the criterion above, therefore, not a separate contract, the lessee should account for the modification per ASC 840/ASC 842 guidance. Finally, if the modification reduces the leased asset or the ROU assets involved, the lessee should reduce the leased asset or ROU assets proportionately and recognize a gain or loss.
Accounting from a Lessor Perspective
From a lessor’s perspective, remeasurement and reallocation of the remaining consideration in the contract should be completed when there is a contract modification that is not accounted for as a separate contract. To remeasure and reallocate the remaining considerations in the contract, the lessor should follow the guidance per ASC 606, Revenue From Contracts With Customers. The lessor should estimate the amount of variable consideration relating to the non-lease component(s).
Tax Implication Considerations of Lease Modifications
Companies should consider the tax implications of any lease modifications. Generally, a lessee’s current tax deductions will be impacted by normal accrual and deductibility rules if payments are deferred. Additionally, to the extent that any lease changes are considered significant lease modifications under the Internal Revenue Code (IRC), the consequences could be more severe. Any “new” leases require fresh tax analysis to determine if the leases qualify as unfavorable IRC 467 leases, which have complex rules potentially separating the timing of cash rent payments from their tax deduction.
The Importance of Proper Accounting Treatments, Disclosures and Tax Treatments
The COVID-19 pandemic has been an important reminder that companies should remain agile and flexible to adapt to new and unusual situations. Remember to ensure proper accounting treatment is being applied and that disclosures are adequate for financial statement users to understand the impact of lease concessions and other COVID-19 related impacts. Entities should also be mindful that the accounting impacts may have tax consequences that require review.
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