Lease Modifications and COVID-19:: Accounting and Operational Concerns

Accounting for changes to lease contracts as a result of the COVID-19 pandemic was the subject of ELFA’s “Wednesday Webinar” on May 27. The hour-long presentation, “Lease and Loan Modifications and Restructurings in the COVID-19 Environment,” featured Shawn Halladay, Chief Financial and Operations Officer at The Pitney Bowes Bank; Tim Kolber, Managing Director, Accounting and Reporting Advisory Services at Deloitte, LLP; and Mamta Shori, Chief Financial Officer, Wells Fargo Equipment Finance. The panel covered a series of topics including:

• Common issues facing lessors navigating the accounting and reporting requirements for lease modifications,
• Application of the FASB staff’s relief related to the COVID-19 pandemic, and
• Operational considerations for lessors when they modify lease contracts.

What Is the Concern?

The widespread business disruptions stemming from the COVID-19 pandemic have caused many of our customers to request some form of relief from their contractual obligations under lease agreements. Many lessors are responding by changing the scheduled lease payments. Whenever there is a change in lease payments, there is always a question whether there is an accounting impact from the change that needs to be considered along with the business implications of the change in payments.

The accounting model for lease modifications is set out in ASC 842, Leases, but that model was predicated on the assumption that modifications would occur as they had in the past. The COVID-19 environment is more extreme than any standard setter imagined when ASC 842 was deliberated, and the volume of requests for modification and the speed with which they have been received is probably without precedent. The Financial Accounting Standards Board quickly became aware of the difficulties lessors and lessees were experiencing. They responded to issues that were raised and provided additional guidance on the application of the lease modification accounting to COVID-19 related lease changes.

The Core Model

Mamta Shori opened the webinar with a review of lease modifications under ASC 840, the old lease standard, and under ASC 842, the current standard, and described where difficulties might arise. ASC 842 defines, in part, a lease modification as a change in consideration or the term of a lease. Whether a change to the timing and/or amount of lease payments was allowed within the contract or not became a significant gating issue for lessors.

If a change met the definition of a lease modification, the lessor would need to rerun the lease classification tests and then flow a lease classification change through an accounting decision tree. This would not be an easy task. Lease classification is a process that lessors are not set up to do part-way through the lease. For example, lease classification requires current fair values for the present value of rent test and most lessors do not have a process for regularly updating this fair value data.

FASB’s COVID-10 Related Relief

The FASB recognized there were two broad areas of difficulty in applying the guidance in ASC 842:

1. Evaluating the legal framework for a lease change to determine whether there is a change to the contract or whether the modification was allowed within the contract, and
2. The potentially significant number of lease contracts that would be impacted.

The FASB’s solution was to publish guidance in the form of a Staff Q&A that allowed companies to elect whether or not to treat the concessions as accounting modifications. If a company takes advantage of the election, the change is not an accounting modification and there is no need to review lease classification or treat the lease as a new lease.

The coming months will be challenging as lessors work through
the many accounting issues created by the pandemic.

Tim Kolber reviewed the scope and application of the relief in detail. First, to be eligible for the relief, the rent concession needs to be related to the COVID-19 pandemic and, second, the concession must result in total payments that are substantially the same or less than the total payments in the original contract. There are some alternative points of view as to whether the total payments should be measured on nominal or present value basis, but either approach appears to be acceptable.

How the relief is applied by lessors will depend on whether the lease is an operating lease or sales-type/direct finance lease. The impact will depend upon the nature of the change and how the lessor was accounting for income prior to the event. For example, if an operating lessor elected to follow a variable rent approach with respect to accounting for the concession and deferred a month’s rent, the lessor would record negative variable lease income that offsets the straight-line rental income for the period. It should be noted, however, that other approaches for recognizing the concession exist. A lessor with a sales-type or direct financing lease will address concessions in a couple of different ways. For example, one approach would be for the lessor to continue to recognize lease income during the rent payment holiday, while adjusting the effective interest rate so that the remaining payment will cover the remaining lease receivable. A second approach would result in the lessor not recognizing any interest income during the concession period only to resume the recognition of interest income once the rent holiday has ended. An outright waiver of rent would, however, result in a current loss.

Operational Considerations

Whenever there is change to a contract, there are business implications to the changes. Some of the pitfalls and matters to consider when considering a rent change were addressed by Shawn Halladay. For example, there are factors that impact whether a lessor will consider granting a concession:

• The credit quality of the customer and its prospects during the remaining lease term,
• The customer’s payment status, and
• The overall history of the customer relationship

If a lessor grants a change to the contract there are a number of possible operational pitfalls that need to considered:

• The ability of the lease processes and systems to handle the change,
• How the changes flow through the lease management system,
• The documentation required to evidence the change,
• The impact of the change on lease pricing and economics, and
• The need to address possible ancillary effects, such as early buy out pricing and stipulated loss tables.

If this list were not enough to consider, a lessor may need to consider the impact of lease changes on its partners. If the lessor has assigned leases, entered into lease securitizations or residual sharing agreements, the implications of any lease changes on these arrangements will need to be reviewed.

Where to Next?

The coming months will be challenging as lessors work through the many issues created by the pandemic. There are a number of resources available to help navigate these issues, including:

• The archived recording of the webinar, available at www.elfaonline.org/events/elearning/web-seminars
• The FASB staff guidance on this and other COVID-19 related issues, available at www.fasb.org/COVID19.