Companies reexamine their lease accounting due to COVID
Companies have been rethinking their real estate strategy
|Wednesday, July 21, 2021|
By Michael Cohn for AccountingToday.com
Businesses are downsizing their office space and renegotiating leases as employees work from home, and they need to look at how they’re accounting for the leases under the new rules.
A recent poll from Deloitte found that two-thirds (66.9%) of companies surveyed have launched or plan to initiate a study looking at how they use real estate in the post-pandemic world. Deloitte’s recent report, Reevaluating your real estate footprint and a related infographic, discuss the various considerations and issues of the leases standard from the Financial Accounting Standards Board, known as Topic 842 or ASC 842 for its number in FASB’s Accounting Standards Codification.
Since the pandemic spread across the U.S. last year and organizations responded by closing their offices and asking employees to work from home, companies have been rethinking their real estate strategy, exiting space before a lease ends, modifying their lease agreements to accommodate extra space for social distancing and increasing their real estate sale-leaseback transactions to improve liquidity while reducing unused space. The move coincided with the rollout of FASB’s leases standard, which public companies began implementing in 2019. Private companies and nonprofits were supposed to have started using it by now, but FASB pushed back the effective date until 2022 as a result of the pandemic. Even as the employees began returning to offices and the pandemic seemed to subside thanks to the wide availability of vaccines this year, many companies are still likely to reduce their office space, especially as the highly transmissible delta variant of the virus causes infection rates to go up again across the world.
The accounting implications can vary for companies that are rightsizing their real estate footprint. “If they formerly owned a space and then they’re selling it and leasing it back, there could be some implications from the standpoint of the transaction needs to be such that they can actually derecognize the property and only recognize the leaseback,” said Tim Kolber, a managing director of audit and assurance at Deloitte & Touche who co-authored the reports. “There are pressure points in ASC Topic 842 that address that. If the company is going in and modifying existing lease agreements, there are some accounting implications there, in particular as it relates to whether they are exiting an entire property or part of a property, because there are some discrete accounting consequences for each of those practices. Irrespective of whether a company is actually modifying a lease or not, or selling property and leasing it back, there can be some implications if a company makes the decision to vacate property early, without modifying the lease, and then that’s where the abandonment framework comes in as well as the impairment framework. Some of the challenges we’re seeing are that since the lease accounting standard from the 842 perspective pushes companies into the ASC 360 guidance for impairment, it’s a new model and companies have some growing pains in understanding how to apply that model.”
Companies may need to combine the leases standard with the impairment standard to come up with the right accounting treatment. “The knee jerk reaction of many organizations is I have this leased asset and I am vacating the space or I’m no longer using it as part of my operations so I will look at the right of use asset that was generated for that asset in isolation, in a vacuum,” said Kolber. “But oftentimes, that would not be appropriate according to the literature because you have to look at it at the asset group level, and the asset group is defined as the level where there are separately identifiable cash flows. Right of use assets oftentimes don’t have identifiable cash flows in particular, so the asset group is oftentimes at a level higher than a company may think it should be. And that’s causing some challenges.”
Companies are encountering other challenges with their accounting for an abandoned lease besides those considerations. “Then the second half of the equation is, even if they are outside of the impairment guidance, understanding whether an asset has been abandoned or will be abandoned is sometimes challenging because a company may be of the view that, well, I'm going to be vacating this floor in six months, so I'm going to be, quote unquote, ‘abandoning the floor,’” said Kolber. “And then they would apply the abandonment model. But in actuality, if they plan to have a future economic benefit from using that space, whether it be in a different part of the business or the assets temporarily idled until it’s redeployed, or whether they have the intent and ability to sublease it, that would put them outside of the abandonment framework and would not allow them to accelerate the right of use asset amortization. So for all of these attributes of the ASC 842 model and the ASC 360 model, not only is the accounting important to understand, but the operationalization of the accounting is important.”
The accounting can be extra complicated for multinational companies, which have to worry about not only FASB’s ASC 842 leases standard for U.S. GAAP, but the International Accounting Standards Board’s leases standard for International Financial Reporting Standards, IFRS 16. FASB and the IASB spent years trying to converge the two standards, but there remain important distinctions between them, although both standards put operating leases on the balance sheet of many companies for the first time.
“As you think of multinationals and you start to get into IFRS and the added complexity of having the dual GAAPs, there are nuanced differences,” said Matt Hurley, a senior manager in Deloitte’s advisory practice. “IFRS in particular, when you start getting into either terminations or modifications or impairments, there are some P&L impacts that can occur that are going to be a little bit different than what you see under U.S. GAAP. But I think operationally, this is an area where people are adopting the standard and implementing technology to deal with it. These types of modifications and changes, kind of the ‘day two accounting’ as we call it within the systems, that’s where the systems solutions have struggled the most just because of the complexity behind it. And so you’re seeing people identifying and needing to create workarounds now to get the accounting and reporting right.”
Besides technology challenges, decision making has become more complicated as everybody in an organization seems to want a say in how much office space is needed and where it should be located. The decisions are unprecedented for many companies.
“A lot of these decisions that we're seeing about space and the whole rationalizing of what real estate we’re going to have are coming from groups potentially outside of accounting,” said Hurley. “Maybe it’s a local sales office or something else. And having those controls in place to make sure that the changes are timely, that the people that need to know are notified in a timely manner and that it’s accounted for timely and that they’re all captured, and you’re not caught by surprise on things, I think it's adding to the complexity of some of the new processes that were put in place. Maybe these types of transactions weren’t contemplated because the organization didn’t have a history of closing locations or changing their footprint or exiting leases. They hadn’t done it in the past. They didn’t contemplate it in their future state process. And so now we’re adding strain to both process and system because they’re doing things that they may not have been doing historically.”
Landlords and lessors will be facing their own accounting issues from all the changes. "From the landlord perspective, if there is a question about the collectibility from their tenants on the rent or if there are questions about the ability to rent out the space, they too would be under the ASC Topic 360 guidance, but from the standpoint of an owned asset versus a leased asset,” said Kolber. “And that is something that would be outside of ASC Topic 842 altogether, unless they are leasing a property and then subleasing it to a third party. But it’s no different than the legacy requirements where if I am a company whose business is to own and rent out space in buildings, if there is any question surrounding my ability to lease out the space, and that could impact the overall long-term value of the property, then they would be subject to the ASC 360 requirements and would evaluate the property for impairment if it’s a standalone asset group or at the asset group level.”
When the lease has to be renegotiated between the lessor and lessee, various rules can come into play if they decide the terms of the original lease don't really apply anymore, but they can work out a deal between them short of abandonment.
“From both the lessee and lessor perspective, ASC Topic 842 includes a modification framework that, as of the effective date of the modification, from the lessee perspective, the lessee would remeasure the lease based on the revised lease term,” said Kolber. “In a similar manner, the lessor, if it is going to accept less from its tenant or if it’s going to change the terms of the arrangement or change the terms of specific aspects of the arrangement, ASC Topic 842 includes the modification framework that says how the lease would be remeasured. From the lessor perspective, most leases will be an operating lease, so it would just be a matter of revising the straight-line lease income that's associated with the property. If it’s a sales type or direct financing lease, then it gets a little more complicated. From the lessee perspective, so from the tenant’s perspective, the lease would be remeasured on the basis of the changed lease terms.”
But it can get a lot more complicated than that in the real estate industry. “Now where it gets challenging is if there are multiple changes to the same lease agreement,” said Kolber. “So, for example, if the lessee and lessor, the tenant and the landlord, negotiate a change to where, for instance, a four-story building, for one floor the lease term will be shortened by 50%, but the other three floors, the lease term will be extended. That is where we see companies having some challenges because what they need to do is identify the fact that they need to first bifurcate the asset liability into the respective components — the component that’s the shorter lease term and the component that's the longer lease term — and then they have to apply the modification framework to each change separately. That's a learning curve, and companies have been learning and applying the accounting based on the model.”
Subleases and sublets add an extra complicating factor. As companies scale back the space they need in their offices, but have a lease that goes on for a number of years, many will be subletting their space and that’s going to affect the accounting.
“What we have seen and expect to continue to see in scenarios where there is a longer lease term remaining, but part of the property is being vacated, we are expecting to see lessees or tenants try to find subtenants in order to recover some of the costs that are still required to be paid related to the existing lease agreement,” said Kolber. “And the accounting implications there are if the property is being actively marketed and the tenant has the intent and ability to sublease it, then that property would be subject to really no accounting consequences until a sublease is executed. And then once a sublease is executed, then you may have to apply the impairment framework to see if the right of use asset is properly valued. And if not, you would have to impair the right of use asset. Since there are now separately identifiable cash inflows and outflows, that subleased property would be subject to different accounting. And that goes from the accounting perspective. Many organizations are now understanding the nuances, but where they continue to struggle is because it’s something outside of the box and our system to apply the accounting may not fully be able to handle it, operationalizing this from the tenant’s perspective is often challenging.”
Landlords and tenants, as well as lessees and sublesses, have to negotiate the details.
“I think it’s pretty safe to say that we’re seeing all sorts of new methods of negotiation and timing on negotiations, different types of incentives and givebacks and things, as organizations look to create mutually beneficial structures on their leases,” said Hurley. “Things haven’t been done before, and so now organizations are having to figure out. If we've never done this before, maybe someone else has and they know how to deal with it, but they may not or it may be a totally new way of contracting. And then they’re having to take it in and really dig through the standard to figure out what is appropriate. Multiple ASCs have to be looked at to get the accounting right, and for a lot of organizations, that's not something that they are necessarily familiar with or have had to do in the past. But there are a lot of legs on this thing, and that’s before you even get to when we renegotiate something or we have these different payment streams or incentives given to a lessee.”
Taxes can also be affected by changes in the leases, including property taxes, deductions and expenses for the lease payments.
“There are cases where you have different treatment for book tax on leases, even under the new standard,” said Hurley. “When you make these changes, you might get one accounting treatment, but have a different tax treatment. And so we’re seeing a lot of organizations having to revisit how they’re classifying certain leases for tax purposes to make sure they’re doing it correctly and then having to track that information separately, because it could be a very different recognition pattern for tax purposes. Then you’re talking about different processes and systems. Each one of these changes has this ripple effect. It’s not just, ‘oh, we’re paying different rent rates,’ or ‘oh, we’ve got different square footage that we’re releasing.’ It’s adding complexity to the processes and systems that were probably established to handle one set of facts and circumstances, and now you have another one that you need to make sure you understand what the guidance says on how to treat something. And then you also have to think about all the downstream impacts of using taxes. For example, does this give me different tax treatment? Does this qualify as a modification for tax purposes? What does it do and how do I track any book tax differences?”
Take the scenario where a tenant renegotiates an expanded footprint because they want to allow better social distancing. “So rather than contracting space, they are asking for more space and they ask the landlord for a tenant incentive allowance to build out the space,” said Kolber. “Well, for book purposes, you will have the right of the asset inclusive of that tenant incentive allowance recognized on the balance sheet. But for tax purposes, there is a different tax treatment for the piece of the right of use assets related to the property and the piece related to the tenant incentive allowance. So understanding the attributes that make up the right of use asset after modifying the lease or negotiating a new lease is vital.”
Deloitte has released a separate report on the tax implications of the leases standard.
Guidance from accounting firms
While both FASB and the IRS have provided some helpful guidance, firms such as Deloitte have also been offering their own perspectives to help clients and accountants sort out the details.
“From the FASB perspective, meaning from the U.S. accounting requirements that are out there, the guidance, as currently drafted, I believe, provides enough support and enough guidance in order to allow companies to account for their leases,” said Kolber. “That coupled with the publications that each of the large firms has out there, including Deloitte — we have an 850-plus page lease accounting roadmap, which is phenomenal, but every firm has that — that should provide sufficient information for companies to properly apply the accounting requirements.”
Accountants and their firms can play a role in advising clients on how to deal with all the complexities.
“For our non-audit clients, we oftentimes help explain the guidance, provide thoughts and perspectives about the application of the guidance and assist with our clients’ understanding of the guidance,” said Kolber. “And the large firms, the mid-sized firms and even the regional firms, all of the firms are out there to support anyone who has questions about how to apply the requirements. Ultimately, it’s management’s decision on how to apply the requirements, but they can at least hear from the accounting firms on the interpretive views that are out there for them to make an informed decision on how to apply the requirements.”
Auditors will also need to deal with auditing how clients account for the leases in companies that modify their office space arrangements.
“From the real estate rationalization perspective, audit firms, as they’re doing their procedures, need to get comfortable with the assumptions used to measure, for instance, the fair value of the right of use asset, all of the assumptions that are used to conclude that a right of this asset was either impaired or abandoned, and understanding the application of the requirements related to certain attributes, whether it be an impairment, an abandonment or a lease modification,” said Kolber. “So what the company does in applying the requirements, we have to do the audit work, and doing the audit work, we will look toward the same framework to make sure that the requirements are properly applied. And we’ll audit it based on the appropriate level of scrutiny that we believe necessary to get comfortable that the companies are doing the right thing when it comes to applying the requirements.”
Accountants and auditors need to help their clients familiarize themselves with the lease standards to save time and headaches later. “You want to make sure that you're doing it right on the front end and being out in front of it,” said Hurley. “I've got several examples and several clients right now that I’m working with where they underestimated the complexity of what they were trying to do or the new contract they were signing and what the accounting for it would look like. And now they’re under the scrutiny of the audit and they’re trying to get through that, and they’re spending way more time and effort in a compressed timeline because they underestimated some of the complexity or they misinterpreted the guidance on the front end. And it’s really emphasized to me even more so now that spending the time to make sure you're doing it right on the front end, establishing those processes, controls and systems to be able to handle it, and seeking that guidance that any number of firms can provide and, whoever your advisors are, get that guidance. It may feel like added effort on the front end or added costs on the front end, but on the back end, it saves so much time and expense when you’re not caught off guard, you're not trying to meet some sort of deadline for an SEC filing or for a debt covenant or you may have a SPAC transaction or any number of things where you're caught by surprise from this and having to scramble to fix things.”
Auditors need to understand the requirements as well as the people preparing the financial statements when a company adjusts its leases to rightsize its office space.
“I would strongly encourage any organization that’s contemplating any one of these real estate rationalization initiatives to also get their auditors involved in the discussion upfront,” said Kolber. “It makes it so much easier if the auditor understands what the nature of the transaction is going to be, some of the critical provisions, etc., because they will at least be able to absorb and understand what the company is doing and the accounting implications. And before the contract’s even signed, the auditor may be able to weigh in and provide thoughts and perspectives on the accounting literature, not on the transaction itself, because that may impact things from the independence perspective. But they can at least share thoughts and perspectives about the nature and the types of things that the company should consider and allow them to make a more informed decision and have their auditors along the way.”