Throughout the life of a lease, both lessees and lessors may experience changes to the terms and conditions of the contract. Accounting for these changes in 2020 was a bit unique as accounting standards setters provided companies with options allowing for the application of existing lease guidance and/or practical expedients due to the impact of the pandemic.
In April and May, respectively, both the FASB and IASB issued accounting relief guidance for companies that experienced lease concessions directly related to the financial crisis caused by COVID-19. The relief allowed companies to elect accounting treatment outside of the existing modification framework to ease the number of resources necessary to process the unprecedented number of lease changes. The following criteria must be met to be eligible to apply the relief guidance:
- The total consideration of the changed contract has to be substantially the same as or less than the total consideration in the original contract.
- The concessions must be agreed upon by both the lessee and landlord; short pays are not eligible.
- The changes to the contact can only be as a result of COVID; no other substantive changes can be made to the lease.
In addition to lease concessions and the optional relief guidance mentioned above, organizations may have considered other business decisions to properly address their financial position. One consideration may have been the full or partial termination of rights to an underlying asset in a lease. If companies decided full access to a building was no longer necessary, a full termination results in derecognition of the lease liability and corresponding ROU asset.
However, if only a single floor (of a multi-floor lease) is vacated and the lessee’s right to the space is only partially terminated, the lease liability is reduced to the present value of the remaining payments, and the ROU asset is reduced by either the proportionate change in the lease liability or the proportionate change in the remaining ROU asset.
ASC 842 describes both approaches to calculate the new ROU asset whereas IFRS 16 only advises the latter approach, proportionate change in the remaining ROU asset. Detailed examples along with an explanation of the impacts of each approach can be found in the article “How to Account for Partial Terminations due to COVID-19“.
Full and partial terminations are agreed upon by both the tenant and landlord. Conversely, the lessee may decide to abandon a building without a contract for termination. In this approach, the lessee continues to pay the landlord although they are no longer using the asset. The accounting for an abandoned lease considers whether the asset is fully or partially abandoned and the timing of:
- When the determination was made, and
- The actual cease-use date
To determine whether a lease is abandoned, lessees must consider the future economic benefits of the lease. For instance, if the lessee ceases to use the space but intends to sublease the asset, then one could argue that it is not truly abandoned.
A sublease is an arrangement in which the original lessee enters into an agreement with a third party to use the underlying asset while the original lease is maintained by the original lessor. As a result, the original lessee also becomes a sublessor. Ultimately, the lease receipts from the sublessee indicate the original lessee is still receiving economic benefit from the use of the asset and has not abandoned it.
Abandonment guidance as outlined in ASC 420, Exit or Disposal Cost Obligations, applies to companies reporting under US GAAP that have not transitioned to the new lease accounting standard. However, companies that have transitioned to ASC 842 with ROU assets recorded must follow ASC 360, Property, Plant, and Equipment for impairment guidance. An impairment occurs if the fair value of the asset is lower than the carrying value of the asset.
Companies must evaluate their long-lived assets at least annually for impairment indicators. Examples of indicators include abandoning the ROU asset, an adverse change in the business climate, an adverse change in how the ROU asset is used, and legal factors. Subsequent to identifying impairment indicators, the lessee will review the expected recoverability of the ROU asset and then may estimate the decrease in fair value to calculate and record an impairment loss, if necessary.
In conclusion, organizations faced many significant changes to their lease portfolios in 2020. The subsequent effect of the COVID-19 pandemic was an extended adoption date for private and government entities, and accounting relief for lease concessions sought for companies reporting under both US GAAP and IFRS. While the relief efforts were optional, companies may have made other business decisions affecting their lease accounting, such as full and partial terminations, abandonments, subleases, and impairment of ROU assets.