Accounting Elective for Rent Concessions During COVID-19
One of the effects of cash flow shortages from COVID-19 has been an increase in rent deferments or abatements. It’s one thing to alter the language of a contract, but the question becomes how to treat rent concessions in the financial statements, and which set of guidelines to follow. FASB has lease modification guidance that exists in both ASC 840 and ASC 842, which address lease changes that occur in the ordinary course of business. With the global scale of the COVID-19 pandemic, the FASB acknowledged the difficulty companies may have in determining whether lease concessions are considered a lease modification.
The FASB meeting in April 2020 discussed the impacts of COVID-19 on lease accounting. The FASB’s Staff Q&A on accounting for leases is available here.
The FASB Accounting Policy Elective provides an option to not account for rent concessions as lease modifications if certain conditions are met. This election means that lessors and lessees may have an easier, more streamlined option to allocate rent income and expenses on the financial statements. Companies with a significant amount of rent concessions in 2020 will need to evaluate whether this election can apply to them and plan accordingly.
Types of Rent Concessions
There are three main types of rent concessions:
- Deferral of rent payments, interest-free
- Free or reduced rent
- Cash payments to the lessee if lessee’s operations were interrupted or affected by COVID-19
- Concessions can be consecutive
Rent concessions have evolved throughout the year. For example, early in the pandemic, it may have been more common for lessors to defer base rent interest-free. Over the summer, conditional abatements were introduced, and lately, renegotiated leases have emerged as an option to share the risk and get through the short-term challenges. Lessors have recognized that for quality tenants, it’s usually a better option to retain the tenants and adjust lease terms rather than terminate the lease and end up with a vacancy.
Is a Rent Concession a Lease Modification or a Concession Stipulated in the Original Lease?
Under the existing guidance, lessors and lessees are required to treat rent concessions as either a lease modification, or not, depending on whether the rent concessions adhere to certain circumstances. Circumstances are whether:
- There are existing enforceable rights and obligations of the lessee and lessor in the original contract; for example, force majeure or similar provision; AND
- There are applicable local laws of the jurisdiction in which the lease contract is governed.
Whether the lease contract provides for changes to payments when certain events or circumstances arise, and whether the COVID-19 concessions qualify, can become a lengthy process, and is complex and may require a legal interpretation. If the lease concession is considered a lease modification, it will be accounted for as a modification of the original contract and not a new, separate contract. This is because the lease modification will not grant the lessee any additional right of use.
The accounting required to modify an existing lease contract is, as stated above, complex. The lessee must remeasure and reallocate the remaining consideration in the contract, remeasure lease liability using an updated discount rate, reassess classification, and more.
Rent Concessions Under FASB Lease Accounting Policy Election due to COVID-19
The process of analyzing every lease contract that received rent concessions can become extremely tedious, especially if there are several contracts. In that regard, FASB determined that instead of going through each individual contract to determine whether enforceable rights and obligations for concessions exist, lessors and lessees have two options.
- The first option is to account for the rent concession as if it is NOT a lease modification. In other words, rent concessions arise from the ordinary course of applying existing enforceable rights and obligations.
- Or the lessor can treat the rent concession as if it’s a lease modification under either ASC 840 or ASC 842.
The decision to apply either of these elections requires that rent concessions do not result in a substantial increase of the lessor’s rights nor lessee obligations. For example, total payments stipulated in the modified contract must be the same or less than the total payments in the original contract.
In the case of consecutive concessions, companies should look at contract combination guidance. For example, they have the option to treat the consecutive concessions as one combined concession or separate concessions.
Also bear in mind that if a lessee fails to make scheduled payments, whether part of an existing concession or not, periods of non-payment do not qualify as rent concessions. Accounting methods do not change unless both the lessor and lessee agree to revised terms in the contract.
Some rent concessions simply defer payments instead of altering the contract terms. Rent deferrals merely affect the timing of rent payments, not the amount. There are two ways to account for rent deferrals.
- Account for concessions as if there was no change to the contract.
- Account for deferred payments as variable lease payments.
In the first option, a lessor would increase its lease receivable and continue to recognize income. The lessee would increase accounts payable as payments accrue and continue to recognize expenses during the deferral period.
In either case, the lessor will need to provide appropriate disclosures about material concessions granted or received and the accounting affects.
When rent concessions result in a portion of forgivable rent payments, companies can elect not to treat the abatement as a modification. Instead, the rent abatement would be treated as if it were included in the original contract. This could allow a company to treat rent abatements as variable lease payments, that is as a negative expense for the periods affected.
If companies choose not to avail the FASB policy election, they would treat rent concessions as a lease modification under ASC 840 and ASC 842 and will be accounting for the modification of the original contract – not a new, separate one.
Implementing FASB Lease Accounting Policy Election for Rent Concessions
Companies faced with a substantial amount of rent concessions in 2020 or 2021 should consider the extent to which these revised guidelines will apply. The first step is to decide whether to take the election to not analyze each contract for concessions, and then whether such concessions even qualify for the election.
Next, companies can decide whether they want to apply the lease modification guidance, and if so, take steps to ensure transparency and consistency.
In applying these revised standards, lessors and lessees should ensure they have appropriate processes in place to identify qualifying concessions accurately and consistently. Companies can work with their accounting advisor to include complete disclosures, as required. FASB states that they expect companies to act in good faith and use reasonable determination to identify qualifying concessions; nevertheless, companies may still need to exercise a fair amount of subjective judgment.