Recent decisions by the Financial Accounting Standards Board (FASB) in reaction to the COVID-19 pandemic offer significant relief for many organizations that are required to prepare GAAP-compliant financial statements.The FASB's decision to delay implementation of its new lease accounting standard for some privately held entities was welcome news for many businesses and not-for-profit (NFP) organizations. But another recent decision – regarding how lessees account for lease concessions that lessors make due to the pandemic – could have an equally significant impact on many organizations.
Delayed implementation of Topic 842The FASB’s new lease accounting standard – Accounting Standards Update 2016-02, “Leases (Topic 842)” – was first published in 2016. Public companies were to begin using the new standard in fiscal years beginning after Dec. 15, 2018, with implementation by privately held organizations scheduled for fiscal years beginning after Dec. 15, 2019.
While public companies began implementing the new standard as scheduled, private companies continued to express concerns over the complexity of applying the standard’s transition provisions, citing challenges that public companies faced when adopting the standard. This led the FASB to postpone the scheduled implementation of Topic 842 in private organizations by one more year – to fiscal years starting after Dec. 15, 2020.
On May 20, 2020, in response to the added financial and accounting pressures stemming from the economic shutdown driven by COVID-19, the FASB decided to defer the effective date for private organizations for another year. Now, nonpublic business entities and NFPs that have not already adopted the standard will be required to begin using Topic 842 for fiscal years beginning after Dec. 15, 2021, and for interim periods in fiscal years beginning after Dec. 15, 2022. As before, these entities still may choose early adoption of Topic 842, but for many businesses, this deferral provides welcome relief at a time when they already are confronted with a variety of business, economic, and administrative challenges.
Simplified accounting for lease concessionsIn addition to the deferral of the Topic 842 effective date for certain entities, the FASB also provided, by way of a staff Q&A document, much-needed interpretive guidance and relief to organizations relating to applying the accounting rules for lease contract concessions provided to lessees stemming from the COVID-19 pandemic and ensuing economic shutdown.
Determining how to account for rent abatements, deferrals, or other lease concessions can be complex, particularly for restaurants, retailers, and other entities with a large portfolio of leases to administer. An accounting policy election provided in the FASB staff Q&A may simplify things for such organizations. What’s more, this policy election applies both to organizations already following Topic 842 and to organizations that still are operating under the old lease accounting standard, Topic 840.
Both the new and previous standards contain lease modification guidance that outlines how lessors and lessees should account for concessions or changes to lease terms. At a very high level, if a lease contains a force majeure clause or other similar contract language that requires the lessor to make certain concessions in the event of a natural disaster or some other event beyond the control of the lease parties, the concession might not require application of the lease modification guidance. But if a lessor chooses to make a concession beyond what is required by the contract, the concession should be treated by both lease parties as a contract modification. That distinction is important particularly for companies with hundreds or even thousands of leases.
Because of the unprecedented nature of the global slowdown driven by COVID-19, the FASB recognized that the lease modification guidance contemplated routine negotiated lease term changes in the ordinary course of business, not sweeping concessions executed in a rapid manner as a result of the global pandemic. Accordingly, the FASB acknowledged that applying the lease modification guidance on a contract-by-contract basis across a broad portfolio of leases could be a costly and complex undertaking. To avoid imposing this burden on already stressed businesses, the FASB determined that it would be acceptable for an entity to make an accounting policy election for lease concessions directly related to COVID-19. Entities that apply the election can account for any such concession as if it was provided in the enforceable rights and obligations of the contract, even if the concession did not explicitly exist in the contract. What this means is that an entity can choose to apply or not apply the modification framework in Topic 840 or 842, as applicable to the entity, to the lease changes on a contract-by-contract basis.
This choice is allowed only for lease concessions that are specifically related to the COVID-19 pandemic that do not result in a substantial increase in the rights of the lessor or the obligations of the lessee (for example, if the cash flows in the modified lease are the same as or less than those specified in the original contract).
What lessees should do nowThis FASB’s actions will be particularly beneficial to retail establishments, restaurants, and other businesses that were hard hit by shutdown orders, and in which lease expense represents a large portion of their profit and loss statement. Ultimately, all entities that are party to a lease concession stemming from COVID-19 need to consider their approach under the available accounting policy election.
In response to the guidance, the first step many businesses should take is to confirm that adequate controls are in place to determine that 1) the tracking and administration of lease concessions is complete; 2) concessions qualify for the policy election; and 3) the policy election and resulting accounting approach is applied consistently for concessions with similar characteristics.
The various types of concessions – abatements, deferrals, reduced payments, or other changes – should be identified, quantified, and tracked. Lessees should maintain documentation showing that such concessions are directly related to COVID-19 and that these concessions do not ultimately lead to a substantial increase in the rights of the lessor or obligations of the lessee. The FASB staff Q&A did not specify whether an entity’s analysis of lease payments before and after the concession should be performed on a discounted or undiscounted basis, or whether it should be performed by comparing the total payments due for the entire lease term or only the remaining payments due for the remaining lease term. We believe an entity can perform its analysis using either discounted or undiscounted cash flows, and either the total payments over the entire lease term or the remaining payments for the remaining term, provided that the approach is consistently applied to all lease concessions.
Finally, in formulating the accounting policy election, the FASB staff acknowledged that judgment will be needed and that, depending on the type of concession, there might be some diversity in how organizations end up accounting for various types of concessions. For example, a mere deferral of lease payments with no substantive changes to the lease term or amount of consideration in the contract might be accounted for as if no changes to the lease contract were made, meaning a lessee (lessor) would continue to accrue for the deferred rental payments due under the original lease terms and recognize expense (income) during the deferral period. Alternatively, deferred payments could be accounted for as variable lease payments, meaning the modified rentals would be recognized by a lessee (lessor) as negative variable lease expense (income) in each period in which rent is deferred and additional variable lease expense (income) in each period in which the previously deferred rent becomes due. Anticipating diversity in practice, the FASB made it a point to reiterate that all entities should disclose any material lease concessions related to COVID-19 and should fully disclose their policies to account for such concessions.
The relief provided by the FASB guidance likely is welcome news for all types of organizations. Regardless of which lease accounting standard they are currently applying – Topic 840 or Topic 842 – the new policy election has the potential to significantly reduce the cost and complexity involved in accounting for lease concessions arising from the pandemic and its aftermath.