Accounting and disclosure considerations for real estate

Persisting economic uncertainties, particularly those currently affecting commercial real estate, might lead to a heightened risk of identifying an impairment indicator. Real estate entities that report their property holdings on a cost basis should assess long-lived assets for potential impairment whenever events or changes in circumstances indicate the carrying amount of an asset (or asset group) might not be recoverable (often called a triggering events review). Examples of triggering events include the following:

• A significant decrease in the market price of a real estate asset
• A significant adverse change to the real estate asset – its physical condition, how it is used, or even overall business climate or legal factors – that affects its value
• An accumulation of costs significantly in excess of the amount originally expected to acquire or construct a real estate asset
• An operating or cash flow loss combined with a history of operating or cash flow losses – or a forecast that demonstrates continuing losses associated with the real estate asset
• An expectation that, more likely than not, the real estate asset will be sold or disposed of well before the end of its previously estimated useful life

When a triggering event occurs, an entity must test whether the carrying amount of the asset (or asset group) is recoverable based on the asset-specific undiscounted cash flows expected to be generated from the use and eventual disposition of the asset. When the carrying amount of an asset (or asset group) is not recoverable, an impairment loss is recognized and measured as the difference between the asset’s (or asset group’s) carrying amount and its fair value. While the recoverability test is performed using an entity’s own assumptions, measurement of an asset (or asset group’s) fair value is based on a market participant’s view rather than the entity’s own assumptions.

Crowe observation: Prior close calls combined with changes in facts and circumstances including trends in occupancy, lease duration and rates, interest rate increases, declines in property valuations for certain asset classes, and increased occupancy costs borne by the property owner might cause the need for an impairment test.

Evaluating long-lived asset impairment requires intricate knowledge and deep analysis of triggering events, asset group determinations, cash flow assumptions and projections, documentation, and real estate disclosures. Moreover, this challenging assessment often involves significant judgment and estimates.

Real estate entities should consider these issues when performing impairment testing:

Crowe observation: Real estate assets that are classified as held for sale under Accounting Standards Codification (ASC) 360 must be carried at the lesser of the asset’s carrying amount or its fair value less cost to sell. Entities with assets classified as held for sale should consider the previously mentioned observations relating to fair value measurements.

Entities exposed to real estate assets through equity method investments and joint ventures might need to consider if macroeconomic trends and circumstances give rise to an other-than-temporary decrease in the fair value of the investment below its carrying amount. An impairment of an entity’s investment is recognized in earnings when it is other than temporary. Impairment indicators might include events or circumstances such as the following:

• A series of operating losses of an investee
• Absence of an ability to recover the carrying amount of the investment
• Inability of the investee to sustain an earnings capacity that would justify the carrying amount of the investment
• A current fair value of an investment that is less than its carrying amount
• A decision by other investors to cease providing support or reduce their financial commitment to the venture

Crowe observation: An investor might need to assess if its investment is impaired, even if the investee has not recognized an impairment. On the other hand, an impairment loss reported by the investee should be considered by the investor.

Determining whether an impairment is temporary or other than temporary might require significant judgment. Some factors that entities might consider in making this determination include:

• The length of time and the degree to which the fair value of the investment has been less than its carrying amount
• The investee’s present financial condition and prospects for recovery, including specific facts and circumstances that might adversely affect the investee’s ability to recover
• Whether the investor has the ability and intent to hold its investment long enough for an anticipated recovery in fair value to materialize

Crowe observation: An entity’s assessment of the degree to which an investment is impaired should consider present economic and entity-specific factors. For example, an entity with maturing debt that anticipates challenges repaying or refinancing the debt might consider the likelihood of its disposal of an investment. If an investor intends to (or must) sell an equity method investment and does not expect to recover its carrying amount before the sale, the impairment is other than temporary.

Some entities measure recently acquired real estate assets at fair value using an original cost approach until circumstances necessitate the use of a different fair value measurement approach, such as a market approach or income approach. Entities in that position should consider the impact of market uncertainties or volatility in certain asset classes and assess the degree to which the cost approach remains representative of the asset’s fair value, including for recently acquired assets.

Lessors might need to consider impacts of macroeconomic conditions and trends on certain aspects of their lease accounting. For example, factors such as the property location and purpose, property values and market rents, and tenant instability could influence the degree to which a real estate organization should devote attention to the following matters.

Collectability assessment

• Operating leases. When a lessor determines that collectability of lease payments under a contract is no longer probable, the lessor is limited to recognizing lease income on the basis of the lesser of cash received or straight-line lease income. If probable collection is subsequently restored, the lessor recognizes a cumulative catch-up in earnings for the difference between the lease income recognized to date and the lease income that would have been recognized to date had collectability always been assessed as probable.
• Sales-type and direct financing leases. The net investment in the lease is evaluated for impairment under ASC 310 before adoption of Accounting Standards Update (ASU) 2016-13 or under ASC 326 after adoption of ASU 2016-13. As a reminder, ASU 2016-13 is effective for nonpublic business entities for fiscal years beginning after Dec. 15, 2022 (2023 for entities with a calendar year-end), and it requires entities to use the current expected credit loss impairment model, which is based on expected, rather than historical, credit losses. Further, a lessor’s impairment assessment should consider cash flows the lessor expects to derive from both the lease receivable and unguaranteed residual asset during and following the end of the lease term.

Modifications, terminations, and reassessments

As workplace and retail trends continue to shift, lease modification activity appears to be elevated. Such modifications include reducing a lease term or amount of leased space, negotiating an early termination, or replacing an existing leased asset with a similar leased asset (for example, replacing an existing lease of an office suite with a new lease of a smaller office space in a different building). Accounting for lease modifications (for example, to remeasure and reallocate contract consideration and reassess lease classification) depends heavily on the facts and circumstances of the transaction using assumptions and estimates as of the modification date. Following are some considerations relating to these transactions:

• When a lessee and lessor negotiate to partially terminate a lease (for example, by immediately discontinuing the use of one floor of an office building while several additional floors remain under lease) or to early terminate a lease on a future date, the parties account for the change as a lease modification because the lessee continues to control the right to use the asset (or assets) under the lease contract for a period of time.
• In a lease modification that is not accounted for as a separate contract, any early termination consideration received from or paid to the lessee should be included in the contract consideration that is reallocated to the remaining components in the contract and recognized prospectively over the remaining term of the modified contract.
• If lease terms are revised to immediately terminate all of the lessee’s rights to use the underlying asset in a lease in full, then the lessor must:
  • Derecognize the carrying amount of any deferred rent receivable and initial direct costs relating to an operating lease
  • Derecognize the net investment in the lease and reestablish the carrying value of the real estate asset (while considering if any impairments require recognition) relating to a sales-type or direct financing lease
• Absent a lease modification, a lessor does not reassess the lease term or a lessee’s option to purchase the underlying lease asset.
• If a lessee exercises an existing termination option that the lessor previously determined the lessee was reasonably certain not to exercise, the lessor accounts for the exercise of the termination option in the same manner as a lease modification.

Lease term

A lessor’s determination of the lease term at the lease commencement date includes an assessment of whether the lessee is reasonably certain to exercise renewal and purchase options provided in the lease. This assessment is based on contract-based, asset-based, entity-based, and market-based factors. Accordingly, the previously noted macroeconomic factors and trends and lessee-specific circumstances also might be relevant to the lessor’s lease term assessment.

Many real estate organizations with debt coming due by the end of 2025 will need to refinance their debt obligations. In addition, because of present volatility and uncertainties in the real estate sector, some real estate organizations might need to modify existing loan terms to alleviate financial distress, such as by agreeing to revised terms that defer or forgive certain principal and interest payments, reduce the stated interest rate, or waive or revise debt covenants. Other companies that are on solid footing might modify their debt arrangements to procure additional financing for acquisitions or other strategic initiatives. Still others might prioritize refinancing because of uncertainties surrounding future interest rates.

When macroeconomic conditions and uncertainties are present, some entities might experience financial difficulties, and, consequently, more debt modifications might be accounted for by debtors as troubled debt restructurings (TDRs). To account for a modification or exchange of debt instruments, debtors first must determine whether the modification is a TDR under Subtopic 470-60 before assessing whether the revised terms are accounted for as an extinguishment under Subtopic 470-50.

A restructuring constitutes a TDR if both of the following conditions are met:

• The debtor is experiencing financial difficulties.
• The creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. A concession has been granted if the debtor’s effective borrowing rate on the restructured debt is less than the effective borrowing rate of the old debt immediately before the restructuring.

ASC 470-60-55-8 lists several indicators that a debtor is experiencing financial difficulty, though additional indicators could be present depending on an entity’s specific facts and circumstances. Management might need to use considerable judgment to determine if the totality of facts and circumstances at the time of the restructuring and the weight of evidence suggest that the entity is experiencing financial difficulty.

Crowe observation: Some notable indicators of financial difficulty include when the debtor is in default on any of its debt, projects an inability to service the debt with its cash flows based on present business capabilities (for example, the entity can service the debt only if it obtains additional financing or restructures its debt), or cannot obtain alternative financing at market rates for a nontroubled debtor other than from its existing creditors. In addition, analysis of projected future cash flows to service the debt might be subject to significant uncertainty to the extent a company is significantly affected by factors such as those previously described.

If a company restructures term debt under nontroubled circumstances, it will determine if the new terms of the revised debt arrangement are substantially different from the original debt, often by applying a 10% cash flow test, as described in ASC 470-50-40-10. If the change in cash flows is at least 10% different (that is, substantially different), the restructuring is treated as an extinguishment. If the restructuring does not result in substantially different terms, it is treated as a modification.

Crowe observation: Other aspects of debt modification accounting that real estate entities should consider are described in the Crowe article “Debt Modification Accounting Complexities for Real Estate.”

Real estate organizations, particularly those facing maturing debt, might need to closely monitor economic conditions and industry uncertainties for their potential effects on conditions that could give rise to substantial doubt about the entity’s ability to continue as a going concern (Subtopic 205-40). Some conditions that might be sensitive to adverse changes or uncertainties in a real estate entity’s operating environment include the ability to refinance or repay maturing debt; debt covenant compliance; denial of credit or covenant waivers from lenders; dependence on the success of a particular property, lessee relationship, region, or industry subsector; and expected costs of a development project. Management’s evaluation of these risk factors should consider whether:

• Existing conditions and events can be mitigated by management's plans and the effective implementation of such plans
• The company has the ability to control the implementation of mitigating plans rather than being dependent on the actions of others
• The company’s assumption about its ability to continue as a going concern is based on realistic, rather than overly optimistic, assessments of its access to needed debt or equity financing or its ability to sell assets in a timely manner
• Liquidity challenges have been appropriately satisfied and disclosed

Crowe observation: Conditions such as rising costs of capital and tightened access to credit could make it more difficult to obtain waivers or modify debt compared to an entity’s historical experience. Additionally, revised debt terms might reflect less favorable terms than an entity’s present debt facilities. When financial projections are used in management’s plans to overcome a going concern uncertainty, the projections should reflect any revised debt service requirements (if applicable) and must consider only information known at the date of the assessment (for example, macroeconomic conditions or rental income) and not impute assumptions that do not presently exist.

Increased pressures on management to maintain or achieve financial targets might heighten the risk of improper accounting or inadequate disclosure of related-party transactions. Related-party transactions lack the independent negotiations about structure and price that are present in transactions with unrelated parties. Difficult or uncertain economic conditions also increase the possibility that the economic substance of certain transactions might be other than their legal form or that transactions might lack economic substance. For example, parties that have no independent substance might have no separate ability to carry out transactions or stand behind agreements. Companies should verify that:

• Management’s accounting for, and disclosure of, the transaction includes an appropriate evaluation of the parties’ substance and ability to carry out the transaction
• The disclosures are complete with respect to the nature and effect of the transaction and the relationship among the parties in conformity with Financial Accounting Standards Board and Securities and Exchange Commission rules, as applicable

Economic pressures or liquidity concerns might cause some companies to enter into nonroutine transactions such as an uncharacteristic entry into unconsolidated investments or joint ventures, or a significant and unexpected sale of assets or a segment outside the ordinary course of business. Entities must disclose the nature and financial effects of transactions that are of an unusual or infrequently occurring nature when considering the environment in which the entity operates (Subtopic 220-20).

Risks and uncertainties disclosures (ASC 275) might also be required if an entity is exposed to a significant concentration (for example, reliance on a particular lessee, geography, or subsector of real estate) that poses a risk of near-term significant adverse impact.

Crowe observation: Organizations should continuously assess the impact on their business and financial statement disclosures of macroeconomic conditions and trends relating to the real estate sector, through the date the financial statements are issued or available to be issued, as applicable.

FASB materials reprinted with permission. Copyright 2024 by Financial Accounting Foundation, Norwalk, Connecticut. Copyright 1974-1980 by American Institute of Certified Public Accountants.