COVID-19 is impacting leases in a variety of ways. Thankfully, the Financial Accounting Standards Board (FASB) granted a one-year delay for applying ASC Topic 842, Leases. Otherwise, contractors would have a lot more to consider when accounting for leases.
The Lease Accounting Standard
Generally, all contractors (lessees) that lease assets such as real estate, equipment or vehicles must be in compliance with ASC 842. It requires that capital and operating leases are recognized on the balance sheet. Former capital leases will now be treated as finance leases.
The “right-of-use” value of property or equipment must be recorded as an asset and the present value of scheduled lease payments as a liability. Right-of-use assets include initial direct costs, such as legal fees, advanced payments and lease incentives.
This ASC applies to related party leases based on the legally enforceable terms of the agreement. Short-term leases of 12 months or less that do not include an option to renew may be exempt.
Private company contractors may apply the lease standard for fiscal years beginning after Dec. 15, 2021, and to interim periods within fiscal years beginning after Dec. 15, 2022. Early application is allowed.
Impact of COVID-19 on the Lease Accounting Standard
The ability to collect and pay rents, as well as lease obligations, is affecting lease accounting and compliance with ASC 842. Depending on the situation, contractors may have to adjust the treatment of rent concessions. For example, contracts with a force majeure clause can provide relief to the renter. The lessee may record it as a variable lease payment. Without this clause, the transaction will have to be recorded as a lease modification.
The Federal Reserve lowered interest rates in response to the pandemic. The new leasing standard requires companies to use either the interest rate implicit in the lease, or the incremental borrowing rate (IBR) to calculate the lease liability. Lower interest rates increase the calculated amount of a lessee’s right-of-use assets and lease liabilities which will impact the IBR. This must be accounted for on a company’s balance sheet.
The value of commercial property and other assets could be less than it was before COVID-19. ASC 842 requires companies to compare the net present value of lease payments to the property’s fair value to meet the standard’s lease classification tests. It could be difficult to find valid comparables during the pandemic to make a fair assessment.
According to Investopedia, “impairment describes a permanent reduction in the value of a company’s asset, typically a fixed asset or an intangible asset.” COVID-19 caused the impairment of undervalued right-of-use assets. ASC 842 requires that a different amortization calculation is used for impaired assets.
Leases may be partially or completely terminated. ASC 842 allows contractors to reduce the right-of-use assets proportionate to the reduction in the lease liability or in the lease space. Either way, the change must be updated on the lease amortization schedule.
The Treatment of Lease Concessions and Modifications
A lease concession is when the lessee changes the terms of the original lease such as asking for a rent reduction. A lease modification is a change in the scope of the original contract like leasing less space. ASC 842 requires that changes in the terms of a lease are treated differently.
FASB ruled that it is acceptable for entities to treat any lease changes made because of the pandemic as a lease concession rather than a lease modification. This election is available for concessions related to the effects of the COVID-19 that do not result in a substantial increase in the rights of the lessor or the obligations of the lessee. This election is available for concessions that result in the total payments required by the modified contract being substantially the same as or less than total payments required by the original contract.
Some concessions will provide a deferral of payments with no substantive changes to the consideration in the original contract. Contractors can account for the concessions as if no changes to the lease contract were made or account for the deferred payments as variable lease payments.
The International Accounting Standards Board has not proposed delays to the International Financial Reporting Standards (IFRS) 16. That lease standard is effective for private companies for fiscal years beginning after Dec. 15, 2020. Public companies were required to comply with the leasing standard for fiscal years beginning after Dec. 15, 2018.
Private contractors with international operations and reporting obligations under IFRS must be ready to adopt IFRS 16 under the standard’s original timeline. These companies should consider implementing the ASC 842 at the same time.
