Financial Reporting for Real Estate Under COVID-19
May 06, 2020
By Isaac Mansoura
Due to the spread of the coronavirus, many businesses were forced to shut their doors for a predetermined period of time which, depending on their geographic location, may get extended. This situation has created a severe liquidity crunch for landlords, the likes of which we’ve never seen. For real estate entities and their tenants, there are accounting implications and other financial reporting considerations.
Lessee Accounting for the Effects of COVID-19
Tenants en masse have sought rent reductions, deferrals or forgiveness from landlords. As such, the Financial Accounting Standards Board (“FASB”) has received a number of inquiries related to the treatment of rent relief and recently released a staff Q&A concerning such inquiries.
Generally, under Accounting Standards Codification (“ASC”) 842 Leases and 840 Leases, changes to the contractual terms and obligations during the lease period are deemed to be and accounted for as a lease modification as of the effective date of the modification. This would require a re-measurement of the lease liability and adjustment of the right-of-use asset. However, to alleviate the challenges of applying the modification guidance, on what could be a large volume of leases in an entity’s lease portfolio, the FASB offered some reprieve.
The FASB’s position is that the lessee could elect to account for the rent relief provided to lessees related to the effects of COVID-19 as if the enforceable rights and obligations of such rent relief were preexisting in the lease contract, alleviating the requirement for lease modification accounting. As such, a lessee may elect to not account for COVID-19 relief offered by the lessor as a lease modification. However, they are not precluded from doing so. The rent relief could be accounted for as a variable lease payment (i.e., those that would not be includable in the measurement of the lease liability). As stated in the FASB staff Q&A: “This election is available for concessions related to the effects of 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, this election is available for concessions that result in the total payments required by the modified contract being substantially the same as or less than total payments required by the original contract.” The election should be consistently applied to leases with similar characteristics.
Disclosure should be made as to the facts and circumstances of material relief provided by lessors or received by lessees related to COVID-19 and the accounting implications thereof. See FASB staff Q&A for the full details.
COVID-19 has and may continue take its toll on real estate values. As such, it is important for real estate entities to consider impairment relative to financial reporting. In accordance with ASC 360-10-35, an asset group is tested for recoverability whenever “triggering” events or changes in circumstances indicate the carrying value of such asset group may not be recoverable. COVID-19 and the effects thereof—the interruption of cash flows, for example—may be considered a triggering event.
The carrying amount of an asset group is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group. An asset group is defined as the unit of account for a long-lived asset or assets to be held and used, which represents the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. If the asset group is not recoverable, an impairment loss is recognized representing the excess of the net carrying value of the asset group over its fair value. Assessing fair value will likely be a challenge during this time.
A long-lived asset (disposal group) that meets the criteria of and is classified as held for sale is measured at the lower of its carrying amount or fair value less costs to sell.
Continuing with real estate and its related operations, under ASC 842 a lessee’s right-of-use (“ROU”) asset in connection with an operating lease is subject to the asset impairment guidance of ASC 360 Property, Plant and Equipment. The ROU asset is susceptible to impairment as a result of the computation of its amortization, which is computed as the difference between the total straight-line lease expense and the accreted interest of the lease liability. The result is a back-loaded amortization, which, in turn, results in an inflated net book value of the ROU asset early in the lease term. Lessee reporting entities should refer to ASC 360 and ASC 842 for further details.
Impact on Tenant Accounts Receivables
With local governments imposing stay-at-home orders across the country and the involuntary closure of non-essential businesses, lessors will have to evaluate the collectability of rent. In accordance with ASC 842, if the collectability of rent is no longer probable, recognition of rental income related to that troubled lease may be problematic. The lessor also needs to carefully evaluate the collectability of existing rents receivable. For those entities reporting on the income tax basis, a deduction is appropriate only after all efforts to collect from the tenant are fully exhausted and the receivable is deemed uncollectable; an allowance for uncollectible accounts is not appropriate.
Reporting entities never want to hear the words “substantial doubt” or “going concern.” The unfortunate reality is with every passing day, due to COVID-19, available cash may continue to dwindle and cash collections may diminish. For the moment, there’s no end of the economic downturn in sight. The effects of COVID-19 create conditions that could raise substantial doubt about an entity’s ability to continue as a going concern. Defined by GAAP, this “exists when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued or within one year after the date that the financial statements are available to be issued.” Reporting entities should vigilantly evaluate the effects of COVID-19 on their current and future real estate operations in order properly analyze their ability to continue as a going concern.