Authored by Brent Maier, David B. Jamiolkowski, Marsha Ackerman, Kevin Secrist, Nich Palkovic
Due to business disruptions caused by COVID-19 and the impact on the global economy, the real estate industry expects to see a substantial amount of lease modifications for lessors and lessees. Rent collection levels are a leading indicator of the need for lease modifications, given their direct relationship to tenants’ abilities to meet their contractual rent obligations. The following data, published by the National Association of Real Estate Investment Trusts (NAREIT) on April 20, 2020 , summarizes April 2020 rent collections by property sector as a percentage of the expected or typical amount of rent collected prior to the onset of the COVID-19 pandemic. This data was based upon a survey of real estate investment trusts (REITs) and highlights how COVID-19 is affecting rent collections, particularly for those industries most impacted by shutdowns and social distancing.
As tenants face financial pressure, significant accounting implications will arise – specifically with leases. Some repercussions are:
All of the above could lead to a need for lease accounting adjustments in connection with Accounting Standards Codification (ASC) Topic 842.
In response to the current environment, the Financial Accounting Standards Board (FASB) issued a Q&A for Topic 842 and Topic 840: Accounting for Lease Concessions Related to the Effects of the COVID-19 Pandemic. Regardless of which FASB standard a company follows for lease accounting, the guidance related to accounting for lease concessions remains similar.
Treating lease concessions
The treatment of lease concessions is dependent upon whether contractual terms provide enforceable rights and obligations for concessions (e.g., force majeure, co-tenancy clause or default provision). If a contract provides these rights and obligations, then the concession is generally not considered a lease modification; if it does not, then the concession is likely a lease modification, which requires an evaluation of the lease classification for the lessor and lessee. In many cases, this represents a significant burden to evaluate each lease contract for these provisions and perform an evaluation of lease classification for each lease that does not have these provisions.
In the Q&A, the FASB recognized the costs and complexities of accounting for lease modifications that arise due to stay-at-home orders and rent deferral requirements imposed by certain localities, including the challenge of addressing the sheer volume of anticipated lease concessions due to the COVID-19 pandemic.
As a result, the FASB determined it would be acceptable for an entity to make an election to account for lease concessions resulting from the effects of the COVID-19 pandemic under Topic 840 or 842 as though enforceable rights and obligations for such concessions existed in the original lease contract, as long as the concessions do not result in a substantial increase in the rights of the lessor or obligations of the lessee. If the election is made and the “substantial increase” criteria has not been met, an entity will not need to evaluate each lease contract for such clauses, and can avoid lease modification guidance that would require an evaluation of the lease classification for each lease.
Lease concessions in use
So what might this look like in practice? Let’s assume a lease concession provides for the deferral of payments, but there is no substantial increase to the overall consideration in the original lease contract. One option provided by the FASB would be to account for the lease concession as if no changes were made to the lease contract. The lessor would continue to recognize income and a lessee would continue to recognize expense during the deferral period as though the lease were unchanged. The lessor’s balance sheet would reflect an increase in the lease receivable and the lessee’s balance sheet would reflect an increase in the lease payable.
Another option provided by the FASB would be to account for the deferred payments as variable lease payments, in which case the lessor would recognize revenue and the lessee would recognize expense in the period in which such payments actually occur. In practice, the lessor would continue to recognize income and a lessee would continue to recognize expense during the deferral period as though the lease were unchanged. However, the lessor would also recognize the concession as negative variable rent in the period the concession relates, reducing income by the rent concession for the month. The lessee would recognize the concession as a reduction of recognized expense. Where fixed rent increases over the original lease term, there could be a difference between the straight-line rent recognized under the original lease agreement and the rent concession recognized as a negative variable lease payment.
More complex questions arise when a lessor agrees to grant current rent concessions by increasing lease payments later in the term, or create a deferent rent obligation (i.e., a balloon payment due at the end of the lease term). The critical question is whether these changes resulted in a “substantial increase” in the rights of the lessor or obligations of the lessee. Although the FASB did not give any bright-line tests to evaluate what is considered substantial, the use of substantial, as opposed to the “material in the context of the contract” language of ASC 606, Revenue from Contracts with Customers, indicates a lower threshold that would result in lease modification accounting. Further, the FASB gives entities the option to assume that all lease concessions granted are lease modifications, so significant care should be given where lease payments increase on an undiscounted basis.
Evaluating lease classification
If the entity concludes that the lease concessions have resulted in a lease modification, the entity must evaluate lease classification. There are a number of factors to consider in performing that evaluation. The fair market value of the asset is an important assumption required within that evaluation. Understanding the impact of COVID-19 and changing market conditions is essential to developing a reliable and supportable estimate of fair market value. There is significant evidence that asset values may already be declining as a result of changes in tenant credit quality as implied by the rent collection figures noted above. This is further evidenced by an elevated rate of canceled and re-traded deals. While the extent of the impact on fair market values is yet to be fully realized, more than 17% of commercial real estate deals that were scheduled to close in April were canceled in the first three weeks of the month. This is more than triple the previous full-quarter high of 5.6% in the first quarter of 2008 as the Great Recession was emerging. 
Another factor affecting assumptions within the evaluation of lease classification includes rapidly shifting market conditions that could affect an entity’s incremental borrowing rate when measuring the right-of-use asset for a modified lease under Topic 842. In addition, declining operational performance could affect an entity’s credit rating, and shifting capital markets could significantly change the cost of borrowing for both lessors and lessees.
These factors combined create significant challenges in completing an evaluation of lease classification. A reliable evaluation increases the usefulness of avoiding lease modification accounting.
Portfolios and disclosures
The FASB Q&A also addressed whether the accounting for lease concessions should be applied consistently across the entirety of a company’s lease portfolio. While there is no specific requirement, the FASB indicated that an entity should apply a consistent method to leases with similar characteristics and in similar circumstances.
Lastly, an entity should consider the impact to disclosures, making sure any material lease concessions, and the effects, are adequately described in the footnotes.
In conjunction to lease modifications, other things to consider that will influence lease treatments, include:
Lease or debt covenant violations
Changes in incremental borrowing rates (IBRs)
Changes in fair market value
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
 NAREIT survey of members and FTSE NAREIT All Equity REIT index equity market capitalization, FactSet, March 31, 2020
 Canceled Deals Surge During Pandemic, CoStar News, April 23, 2020