COVID-19 and CARES Act Financial Statement Implications for Real Estate Businesses
April 03, 2020
By Eric Diamond
The current outbreak of COVID-19 and issuance of CARES Act have resulted in various financial statement implications that real estate companies need to consider as they operate in this changing environment.
Many companies may have annual or quarterly covenant compliance requirements. Although they may have been in compliance for calendar year 2019 and possibly even first quarter 2020, companies should still be projecting out their covenant calculations for future periods. If there is any expectation or possibility of not being in compliance, companies should start having discussions with their lenders-- immediately -- to determine any remediation steps. These could include issuing waivers or amending or modifying the loan agreement.
Some companies may have been fortunate enough to already have completed and finalized their 2019 year-end financial statements. Others may be in the middle of that process, or even in the middle of their financial statement audits (if required). Keep in mind that although the company may have been in compliance with financial covenants at year-end for 2019, if they were not in compliance or if they anticipate not being in compliance for any subsequent period in 2020 prior to finalizing and issuing the financial statements, certain disclosures in the footnotes to the financial statements may be required. In addition, companies may need to consider obtaining waivers for those future periods as well.
In order to accommodate borrowers, lenders may modify the terms of the loan agreements (granting concessions, reducing interest rates, deferring payments, etc.). Any modifications to the terms of the loan agreements may result in changes to the accounting, such as debt modification, debt extinguishment or troubled debt restructuring. This determination will impact how companies account for and record existing financing costs that were previously capitalized, as well as how new financing costs are accounted for. It’s recommended to consider these implications early on in the process so you can have those discussions with your lenders and accountants.
Some landlords may experience difficulty in collecting rent payments, and may need to consider modifications to lease agreements or rent abatements or concessions. There is also a possibility of future mandates issued by the government concerning rent deferral or forgiveness programs. For typical lease agreements in excess of one year, U.S. GAAP standards require the lessor to straight-line rent. This includes calculating total rent, with any rent escalations and any periods of rent abatement or concessions, and recognizing rental income evenly over the term of the lease. With the increased potential of rent abatements and concessions being granted to tenants, whether on new, renewed or existing leases, in addition to lease modifications, companies should assess the impact this may have on its straight-line rent calculation.
Depending on the specific property, landlords may be cutting back on various costs, including property management and common area maintenance, or actually may have increased certain costs due to additional cleaning services as a result of the outbreak. For leases that contain clauses whereby the landlord is able to recover all or a portion of certain operating expenses, this pool of expenses to be allocated to tenants may need to be analyzed more carefully to ensure it is in accordance with the terms of the lease agreements.
As a result of any potential reduction or lost rental income, companies may be able to claim business interruption losses under their insurance policy, which is going to be very specific based on the terms of these policies. The accounting for these insurance claims will vary depending on the nature of the claim, amount of proceeds, and timing of the actual loss and potential recovery. Any potential recoveries for business interruption are considered gain contingencies under U.S. GAAP and are therefore only recognized once the claim is resolved and finalized, which really means that either proceeds have been received or confirmation of these proceeds has been received from the insurer.
One of the biggest financial statement impacts of this outbreak is impairment consideration on long-lived assets -- specifically real estate properties. The impact of the outbreak has resulted in declines in occupancy and rent collections throughout many types of real estate asset classes. Companies are going to need to assess these and other impairment indicators. Some of the more prevalent impairment indicators right now affecting companies may include: a significant decrease in market value, a significant decline in revenue and cash flows, an adverse change in how a property is to be used, or a significant change in business environment that could adversely affect the value. Keep in mind that impairment consideration is used to assess if the current carrying value of a property may not be recoverable. While short-term periods of temporary declines may not necessarily indicate an impairment, the more long-term and permanent effects of the outbreak may result in impairment. This will pose a challenge to many companies as the extent of the impact is uncertain and hard to quantify and companies will need to do their best to understand what the short- and long-term effects will be on the company.
For companies that have audit or review requirements on their financial statements and have yet to finalize and issue those financial statements, management will need to evaluate going concern. I do want to highlight that the responsibility to assess going concern does not fall solely on the independent auditor; it is the responsibility of management as well. This evaluation is more than merely an assessment if the company will continue to be in existence; this assessment includes an analysis to determine if the company has sufficient cash and liquidity to be able to pay its obligations and liabilities when they become due for a period of 12 months from the date of issuance of the financial statements. Although the impact of the outbreak may be hard to predict and difficult to quantify, the company needs to carefully analyze their cash projections and potentially even consider a few different projection scenarios (a most likely scenario, a conservative scenario and even a worst case scenario). The result of this going concern analysis will determine the extent of any required disclosures in the footnotes to the financial statements. If no disclosures on the company’s ability to continue as a going concern are deemed necessary, there is still a high likelihood that some disclosures may be required on the potential impact of the outbreak on the company’s financial performance and liquidity in either a risk and uncertainty footnote or even a subsequent event footnote to the financial statements.
Considering how many companies are having employees working remotely, or are being forced to either layoff or furlough employees, companies also need to consider the challenges posed in this mode of operation in order to ensure the accounting records are being updated accurately on a day-to-day basis. Living and adapting to this new remote and virtual environment may result in the need to revise certain internal controls or procedures, implementing additional layers of supervision, and ensuring the IT systems are sufficient and secure to handle these remote capabilities.
There are many factors for real estate businesses to consider as the impacts of this pandemic continue to develop and change the way information is reported in financial statements moving forward.