Changes in the economy are signaling that the “new normal” may significantly reshape business leasing strategy and, therefore, lease accounting. FASB has pushed back the implementation deadline for ASC 842, the new standard for lease accounting that private companies and nonprofits must be ready to comply with, to December 2021. Though private companies and nonprofits received this reprieve, it remains important to stay prepared, due to the complex and time-consuming process.
To help companies organize their accounting responsibilities during this challenging time, consider the following key points.
Analyzing Lease Contracts for Cost Savings
The assessment of the full breadth of contracts is crucial in lease accounting. Companies that started the lease transition process know the importance and value of analyzing all lease arrangements, which starts with companies contacting all internal units, as leases and contracts are typically spread out across multiple divisions.
Many service contracts may contain embedded leases, which are lease agreements that exist within contracts. In the identification of leases, organizations can uncover information to help choose between leasing and buying. This allows company accounting departments to monitor notice periods and renewal/termination periods to help companies manage their lease costs, resulting in the discovery of possible cost saving opportunities during this time of extreme economic unpredictability.
Despite potential cost saving opportunities, companies are feeling the impact of COVID-19, especially to their bottom lines—causing them to consider decreasing or increasing their leases, based upon their needs.
Potential Impacts for Lessees and Lessors
The current economic landscape is driving companies to make significant decisions regarding their costs and leases. For some companies, the reduction of overall leases stems from workplace transitioning to more remote work; for others, decreasing real estate leases comes as a result of the shutdown of physical storefronts and lack of customers due to social distancing guidelines. For material leases (likely to include all real estate leases), lessees must compare the net present value of lease payments to the property’s fair value in order to comply with ASC 842. If the carrying value of an asset is less than its fair value, the sum of the estimated undiscounted cash flows attributable to the long-lived asset (or asset group) should be compared to the carrying amount of the long-lived asset (or asset group). If the asset fails this test, it is compared with fair value to determine if impairment exists. Nonetheless, in these cases, lessees should determine all the implications of lease modifications and terminations when they discuss lease contracts with lessors.
Determining Right-of-use Asset Impairments
Prior to speaking with lessors, companies should consult their accountants and attorneys to ensure lease agreements intended to be modified undergo an in-depth analysis, similar to the beginning stages of implementation in the lease accounting transition process. In addition, research on applicable state laws on nonessential court functions (including evictions) should be conducted.
During this time, companies must determine if a contract contains an identified asset and if the right to “control” that asset is determined by the lessee. Lessees in a lease agreement have the license to hold, operate, or occupy a leased property or item over the lease term under the right-of-use (ROU) asset.
It is essential for companies to analyze the impairment of ROU assets for leases, as there could be more ROU asset impairments due to COVID-19. For example, this could be triggered by a change in customer demand or if assets are not as valuable as they were initially. If there are assets that no longer have the same value that they previously had, companies would need to evaluate the agreement as impairments may happen. Quarterly reporting is likely to bring this issue to light.
Because of COVID-19, there are many retailers and restaurants that are unable to open their doors to customers. If a restaurant is leasing dishwashers and is not able to reopen, it might not get the same value from that equipment if it had to sell them at auction. Ultimately, it is difficult to say for sure how the value will be determined, because it is uncertain if there will be a long-term change to those ROU assets. Moreover, it is important to note the incremental borrowing rate of lessees for their lease accounting transition process: As lower interest rates increase a lessee’s ROU assets and lease liabilities, the company’s balance sheet will be affected as it adds new leases and remeasures existing leases.
Making Lease Decisions
Once organizations determine the leases to be shelved due to impacts of COVID-19, determining their course of action for each specific lease is advisable. Companies with leases that include force majeure clauses, which speak to unanticipated circumstances, may request lease concessions to adjust their lease contracts. However, in these situations, lessees can record these favorable impacts as variable lease payments. Lessees who request lease concessions in leases that do not include force majeure clauses as a result of the COVID-19 pandemic do not need to mark leases as modifications, as companies can elect to record these new enforceable rights as if they existed in the original contract, which need to be documented for auditor use. This means that a lessor would increase its lease receivables and a lessee would increase its accounts payable as receivables and payments begin to accumulate. When reporting, the lessor would have to continue acknowledging income and the lessee would have to continue to acknowledge expenses during the deferral period.
Conversations with lessors about rent obligations, including potential deferral and the restructuring of rent, are imperative, especially as the ambiguity of the COVID-19 crisis remains. Leases will still be in effect though a lessee may benefit from a moratorium.
For companies that decide to opt for full lease termination or abandonment noted in lease contracts, it is necessary for documentation to be provided for possible future use of auditors. The roll forward report, which records changes to ROU asset and lease liability balances, can feature lease additions, impairments, full and partial terminations and abandonments. Of course, prior to making any final decisions, companies need to acknowledge the possible consequences, such as legal actions, that may result from any lease terminations or abandonments.
Ultimately, businesses during this crisis need to determine initiatives to be addressed that will best serve their employees, customers, stakeholders, and partners. To prepare for compliance, companies should be earmarking leases they currently have and anticipate reporting all lease agreements on their balance sheets.
Implications of a Remote Workforce
As the outcome of the COVID-19 pandemic remains uncertain, CPAs are being called upon to support companies the best they can to manage accounting compliance. While management has largely shifted its focus toward keeping the business running, caring for the health and safety of employees and continuing to serve customers, now is the time for CPAs to do their duty to prevent a lapse in lease accounting compliance. For companies with cloud-based lease accounting software, the transition to the new accounting standard will be available when they are ready. Even though the lease accounting deadline has been postponed to December 2021, communication and collaboration across private companies and nonprofits is all the more crucial at this time.
With so many companies unable to afford their rent payments in the months ahead, there are important financial and operational decisions to make in terms of lease arrangements. Businesses will ultimately need to make difficult choices throughout and beyond the COVID-19 crisis about which leases are truly needed. Careful consideration and thoughtful conversations need to be held for organizations to emerge on the other side.