Looking Back on 2020 – What Were the Accounting Implications of COVID-19 on Real Estate Companies?
“2020 was a year like no other.” That was a statement we heard over and over again. COVID-19 had a significant impact on real estate companies from both the financial and operational perspectives. The impacts were not just limited to real estate operators but also to entities that provided financing to these companies. Real estate operators and lenders had to adapt to the social and economic impact of COVID-19, including offering concession to tenants and modifying loan terms. There was a lot of uncertainty as we prepared for our 2020 audits but the primary areas that we found that had an accounting impact were revenue, debt and going concern.
- Adjustments to Base Rent
The impacts of COVID-19 stretched far beyond temporary occupancy challenges, as many landlords agreed to provide their tenants with rent concessions that were not originally agreed upon in order to ease their economic burden and avoid a liquidity crunch. Under Accounting Standards Codifications (“ASC”) 842 and 840, these changes would generally be accounted for as lease modifications as of the effective date of modification. However, in April 2020 the Financial Accounting Standards Board (“FASB”) issued a Q&A stating that if certain qualifications are met, an entity may make an election to account for a lease concession related to COVID-19 in the current period. The Q&A also stated that two approaches may be taken to COVID-19 related rent deferrals with no substantive changes in consideration: 1) account for the lease concession if no changes were made to the lease contract, and 2) account for the deferred payments as variable lease payments. Disclosures should be provided about material concessions, regardless of treatment. For further details, see Accounting for Rent Concessions Due to COVID-19.
- Impacts on CAM Escalation Revenue
As a majority of commercial tenants have net leases, typically variable additional rental payments based on actual landlord common area maintenance (“CAM”) expenses over the tenants defined base year, are paid. As physical occupancy dramatically decreased as a result of COVID-19, it was likely that many real estate owners saw a decrease in their CAM expenses. However, these commercial tenants should be prepared that landlords may utilize their gross-up provisions in their lease with respect to certain variable expenses in order to restore their CAM revenues closer to pre-pandemic levels. It could prove greatly beneficial for commercial building owners to review each of their leases to verify the ability to gross-up CAM expenses, along with having a gross-up policy clearly documented. Conversely, tenants should review their lease provisions and gain an understanding as to what is and is not allowable for gross-up. For further details, see How the Pandemic Could Impact CAM Expenses for Commercial Tenants.
- Collectability of Rent
The spread of COVID-19 across the global economy forced many businesses to cease operations both temporarily and permanently. As a result, rental collectability for landlords has been a great challenge. In accordance with ASC 842, when collectability of rent is no longer probable, revenue recognition comes into question. Lessors will need to carefully evaluate the collectability of their rent receivables in light of these circumstances. For further details, see Financial Reporting for Real Estate Under COVID-19.
The COVID-19 pandemic created a financial burden for many borrowers. Borrowers have been forced to ask lenders for temporary payment deferrals, additional funding, negotiation of existing debt terms, or relaxation of covenants, in order to not default on their debt. Amendments to debt terms can fall under a modification or extinguishment, each of which has different accounting implications.
Whenever debt terms are renegotiated, borrowers need to analyze the terms carefully to determine the appropriate accounting treatment. When preparing financial statements in accordance with Generally Accepted Accounting Principles (“GAAP”), the main question should be is the amendment a modification or extinguishment? The answer will depend on whether there was a substantial modification of terms. Under ASC 470-50, a modification is substantial if the present value of future cash flows under the terms of the modified agreement is at least 10% different from the present value of future cash flows under the terms of the original agreement.
Effects on the financial statement:
Debt Extinguishment - If an entity concludes that the amended terms are substantial this would constitute an extinguishment resulting in:
- Writing off the existing debt and recognizing the new debt is recognized - any difference is recognized as a gain/loss on extinguishment.
- Fees paid to the lender are expensed as part of the gain/loss noted above but fees paid to third parties (e.g., attorneys) would be capitalized and amortized over the term of the new debt.
Debt Modification - If an entity concludes that the amended terms are not substantial this would constitute a modification resulting in:
- Changes applied prospectively and any existing loan costs would be maintained but the amortization may be adjusted if the term of the loan is extended.
- Fees paid to the lender would be capitalized and amortized over the remaining term of the loan (not expensed as in the extinguishment) and fees paid to third parties (e.g., attorneys) would be expensed as incurred.
On October 28, 2020 the FASB released FASB Staff Educational Paper, Topic 470 (Debt): Borrower’s Accounting for Debt Modifications to provide educational resources to entities and examples of specific facts and circumstances to help navigate the application of guidance on debt restructurings and modifications. Please see FASB Staff Educational Paper—Topic 470 (Debt): Borrower’s Accounting for Debt Modifications.
Going Concern Considerations
Each reporting period, an entity’s management must assess whether there is substantial doubt about the entity’s ability to continue as a going concern. Management’s assessment is a two-step process that requires determining whether it is probable the entity will be unable to meet its obligations over a defined period. Many of the impacts of COVID-19 that were discussed above led to adverse conditions and events that could raise substantial doubt about the ability of an entity to continue as a going concern. Some of these conditions include lost revenue from providing concessions to tenants, high vacancies or working capital deficiencies. This resulted in management having to spend more time on forecasts and analyses this year to critically assess if substantial doubt existed and how to potentially mitigate that doubt. For a more in depth look on this topic, see Going Concern for Real Estate and Hospitality Companies Under COVID-19.
There are two parts to determining if an impairment loss on long lived assets should be recorded by an entity. The first relates to identifying if the impairment condition exists, whereby the carrying amount of a long-lived asset (or asset group) exceeds its fair value, and the second is to determine if the carrying amount of the asset is recoverable. Until the COVID-19 pandemic, management of real estate companies did not spend a significant amount on this analysis based on the stable nature of the appreciation in the real estate market. Under GAAP, management is required to test long-lived assets for recoverability whenever events or changes in circumstances indicate that its carrying value may not be recoverable. Some of the specific examples provided in the guidance of when the need arises to test the recoverability of long-lived assets include when there’s a significant decrease in the market price of a long-lived asset or a significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition. The market conditions created by the pandemic necessitated management to critically analyze whether an impairment loss had to be recorded. For further guidance on this topic, see Real Estate Impairment Considerations.
As the economic recovery from COVID-19 progresses and real estate companies continue to adapt to a new world, some of the considerations noted above may be encountered in 2021 and beyond. Real estate operators should make sure to reach out to their accounting professionals before undertaking transactions to make sure that the accounting implications are fully understood.
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