As the COVID-19 pandemic continues to keep customers home and operations closed, many companies have not made rent payments on their unoccupied commercial properties, including retailers, restaurants, fitness centers and movie theaters. This list includes multimillion-dollar companies such as Old Navy, Cheesecake Factory, LA Fitness, Party City and Regal Cinemas, which either stopped payments entirely or paid only a fraction of their monthly fees.
Cash-strapped companies have made this decision while looking for immediate relief and ways to boost liquidity, but there may be other options available to them within the terms and conditions of commercial lease agreements. COVID-19 has added a new layer of complexity to navigating these leases and the related financial obligations. As a result, commercial tenants and their landlords are struggling to understand their respective rights and obligations, as well as any accounting implications for changes in payment or to the terms of their leases.
Understanding Leasing Obligations
The first step for any company is gathering its leases for assets impacted by COVID-19 and identifying all liabilities as well as areas of opportunity. Specifically, companies should:
1. Determine what is owed and when. While leased assets may remain unoccupied during the shutdown, most entities are still required to pay rent and other costs outlined in their lease agreements. Be sure you do not miss payments and important events during COVID-19 closures that could subject your company to late fees, non-payment penalties or evictions. Every lease will have different language, obligations and consequences for the lessee and lessor. Review and monitor specific lease language around:
- Timing and dates such as payment/default, vacate date, lease term options and audit rights
- Physical space such as co-tenancy, sublet, alteration/remodel and common area access
- Financial considerations such as default, late fees, security deposits, free rent and other concessions
2. Identify potential cost savings. As most parts of the country are still determining the timeline to resume normal operations, it is important to conserve cash wherever possible. Lessees should review the financial activity on each lease to get an overview of current expenditures, which could reveal unnecessary or optional charges they can cancel or put on hold. This could include additional rent for services they are no longer receiving such as lobby security, special janitorial services and supplemental air conditioning. Finally, lessees should explore any language around rent abatements and what happens when the space rented cannot be used due to circumstances beyond anyone’s control (i.e., force majeure).
3. Check clauses for hidden rights and obligations. There are a number of lease clauses that may address lessee/lessor responsibilities during COVID-19, with varying impacts. These include force majeure, casualty, interruption of essential services, condemnation, insurance, notice, gross-up, and percentage or profit-sharing rent provisions. Review these carefully to ensure you do not give up existing rights or miss opportunities to reduce risk.
Implications for Lease Accounting Requirements
As companies scour their lease agreements to identify their rights, obligations and opportunities for cost savings, many are wondering how one-time concessions or larger modifications to lease agreements will impact future lease accounting calculations.
If a company cannot secure agreement with a lessor and must abandon an asset, it will need to write down the asset’s value over a shorter period of time while still retaining the liability and making the payments. If the landlord will allow them to terminate their lease early, they will need to account for any termination fees paid, and note the asset and the liability on their balance sheet.
For organizations with large portfolios, evaluating their leases for rights and obligations in response to COVID-19 will be daunting, as will the impact of lease modifications on financial statements. Many companies were already struggling to manage their lease accounting responsibilities and now their lease portfolio may be upended.
In fact, this challenge has caught the attention of the Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB) and the Governmental Accounting Standards Board (GASB). Each of these policymaking bodies has proposed changes to its respective lease accounting standards to give some companies breathing room as they try to record leases and manage changing terms during the ongoing pandemic.
The FASB recently approved a one-year deferral of lease accounting standard ASC 842. Now slated to take effect in January 2021, this proposal allows private companies an additional year to adopt the lease accounting standard in their financial statements. Public not-for-profit companies that have not yet issued financial statements would also be granted an extension.
The IASB cleared amendments to its IFRS 16 Leases standard, making it easier for lessees to account for pandemic-related rent concessions such as temporary rent reductions. The amendment exempts lessees from having to consider individual lease contracts to determine whether rent concessions occurring as a direct consequence of the COVID-19 pandemic are lease modifications. Essentially, it allows lessees to account for such rent concessions as though they were not lease modifications. It applies to rent concessions related to COVID-19 that reduce lease payments due on or before June 30, 2021.
Due to state and local government offices closures and disruption, the GASB announced a delay to GASB Statement No. 87, Leases, which will give these municipalities an additional 18 months to comply with reporting regulations. The new deadline for compliance will be June 15, 2021.
Despite these new allowances, it remains critical for companies to arm themselves with the key details of their lease agreements and be prepared to accurately report any changes to their leases on their balance sheets. This information will play a critical role in managing tough conversations with landlords during the current crisis and, when the time comes, will ultimately make the reporting process more efficient.
As companies navigate these challenges, legal and accounting advisors can also offer insight on how lease provisions may pertain to COVID-19 and result in concessions and other accounting changes.