Relief on Covid-19 Lease Accounting Burdens

Good news for financial reporting and corporate disclosure folks: the Financial Accounting Standards Board says companies do not need to go through a potentially mind-numbing examination of how the accounting for operating leases might change due to Covid-19.

The guidance came from FASB on Friday. It says that companies do not need to account for changes to lease agreements that might arise from Covid-19 — say, a landlord cutting or deferring rent payments for six months — because so many lease modifications are cropping up that corporate reporting teams could be overwhelmed. 

Under the standard accounting rules for operating leases (formally known as ASC Topic 842), companies are supposed to analyze and report changes to lease payments that aren’t stipulated in the original contract, because those modifications can affect the company’s income statement and balance sheet. 

For example, if a landlord lets you skip rent for two months, that’s two months’ worth of free money for your business. So the company needs to report that as a one-time gain on the income statement. Your liabilities fall (because you owe less rent) as do the landlord’s assets (because he’ll see less money). 

The crucial question is whether a lease includes enforceable rights that require lease concessions if certain circumstances are met. When such modifications happen, the company is supposed to study the contract and determine whether enforceable rights exist, either explicitly or implicitly. If they do exist, and the concession is within the terms of those rights, you don’t need to disclose any change. If they don’t exist, then you do need to disclose the change. 

In normal times, leasing concessions are fairly rare, so compliance with that part of ASC 842 isn’t terribly onerous. Covid-19, however, has led to leasing concessions all over the place. Tracking, analyzing, and reporting them could be a herculean task even for large companies with sophisticated financial reporting systems — and don’t die of surprise here, but many companies don’t have that sophistication anyway.

So FASB decided to cut filers some slack. Taken directly from the guidance:

While the lease modification guidance in Topic 842 addresses routine changes to lease terms resulting from negotiations between the lessee and the lessor, the FASB staff believes that this guidance did not contemplate concessions being so rapidly executed as a result of a major financial crisis arising from the COVID-19 pandemic. 

And so, therefore, if you’re in this lease modification predicament… 

[I]t would be acceptable for entities to make an election to account for lease concessions related to the effects of the COVID-19 pandemic consistent with how those concessions would be accounted … as though enforceable rights and obligations for those concessions existed (regardless of whether those enforceable rights and obligations for the concessions explicitly exist in the contract). 

Consequently, for concessions related to the effects of the COVID-19 pandemic, an entity will not have to analyze each contract to determine whether enforceable rights and obligations for concessions exist in the contract.

Moreover, the whole point of reporting a lease modification is to tell investors that the basic economics of a leasing agreement has changed. Well, that’s not necessarily the case with lease modifications arising from Covid-19. For example, if the economic damage of Covid-19 does turn out to be less than expected, and both parties agree to make good on that old rent money — would you need to report a lease modification again? 

The short answer is that nobody knows, and the practical one is that corporate accounting teams have more pressing things to do with their time right now than ponder that question. Hence FASB’s ruling.

Devil in the Leasing Details

There are, of course, caveats. First, companies can only decide to go this route “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.”

So, um, what does that mean? For example, this choice would be available only if the total amount of rent a company pays still equals the original lease amount or is less than that amount, but not more. Or if you’ve only agreed to defer rent payments, you could even just keep accounting for rental payment and income as usual, because eventually all that money will be paid. 

And while you don’t need to do the painstaking work of examining each lease agreement, you do still need to disclose to investors what’s going on:

An entity should provide disclosures about material concessions granted (lessors) or received (lessees) and the accounting effects to enable users to understand the nature and financial effect of the lease concessions related to the effects of the COVID-19 pandemic.

I do wonder where audit firms will land on this issue, since it’s theoretically possible that a company could abuse FASB’s generosity here to commit fraud. 

For example, one could envision a scenario where Tenant A wrangles a lease concession from Landlord B, claims that it’s related to Covid-19, and then books a one-time gain to earnings that miraculously gooses EPS to one cent above analyst expectations. The stock pops, everyone hits their bonus, and Tenant A quietly kicks back some of that one-time gain to the landlord. 

Granted, that’s never going to be Enron-level fraud, but somebody out there is shameless enough to try it. No wonder that the PCAOB just published its own guidance to audit firms about Covid-related financial reporting issues, and lease arrangements were one item on the priority list.