It would be nice if a lease concession was a treat you got from a concession stand at your favorite sporting event.
Instead, in the accounting world, a lease concession occurs when a lessor makes a revision to its agreement —either voluntarily or as a result of current lease provisions— with a lessee that causes a change in the present rights and obligations of the lessor/lessee relationship.
Lease concessions include items like deferral of lease payments, reduction in or forgiveness of amounts due under required lease payments, or a cash payment from the lessor to the lessee. Lease concessions like these became more common over the past two years than they had been in the past as lessors tried to help lessees impacted by the COVID-19 pandemic.
Prior to the COVID-19 accounting election provided by the Financial Accounting Standards Board (FASB) entities applying Accounting Standards Codification (ASC) 840 or ASC 842 were required to evaluate changes in lease payments on a contract-by-contract basis to determine the appropriate accounting treatment for a lease concession. Leases may contain explicit or implicit enforceable rights and obligations that require lease concessions if certain circumstances arise that are beyond the control of the parties to the lease agreement, such as force majeure clauses for things like a natural disaster or a pandemic.
If a lease concession is provided in accordance with the enforceable rights and obligations already included in the lease agreement — and no additional changes are made to the lease contract — then the concession is not considered a change in the provisions of the lease and is not accounted for under the lease modification guidance of ASC 840 and ASC 842.
This is applicable even if the amount, timing or type of concession is contemplated but not stipulated in the lease agreement and the lessor and the lessee must negotiate the terms of the concession.
However, if the lease concession provided by the lessor is beyond the enforceable rights and obligations in the current lease contract, entities are generally required to account for the lease concession in accordance with the lease modification guidance provided in ASC 840 and ASC 842.
How to apply lease modification under ASC 840
Under ASC 840, a change in a lease other than to extend the lease terms requires that a test be performed to determine if a new lease has been created and, if so, a second test determines the accounting for that new lease.
The first test is performed to determine whether the classification of the lease at inception would have been different had the concession been in force and all other factors, like interest rate or fair value, remained the same.
If the first test changes the lease classification, then the lease is accounted for as a new lease and the entity moves forward to the second test.
The second test is made as of the date of the change in the lease terms and uses the revised terms of the lease, including its remaining life and other factors (interest rate, fair value, etc.), as they exist at the date of the change to determine the required accounting for the new lease.
Accounting implications of lease modification under ASC 840
If you do modify the lease under ASC 840, here is a high-level summary of the accounting implications:
Lessee (new lease created under step 1)
- If it is determined that a capital lease would remain a capital lease under the first test, then the recorded asset and obligation balances are adjusted by the difference between the outstanding obligation balance and the present value of the future minimum lease payments (using the rate of interest used to record the lease initially).
- If an existing lease remains an operating lease, then the concession is generally recognized prospectively over the remaining term of the lease, usually on a straight-line basis.
- If an operating lease replaces a capital lease, then the transaction is accounted for as a sale-leaseback transaction pursuant to ASC 840-40.
- If a capital lease replaces an operating lease, then the new lease is accounted for as an operating lease at the date of the change in the lease terms.
Lessee (no new lease created) – at the option of the lessee depending on the nature of the concession
- Lease concession is accounted for as a deferral of payment, whereby the lessee continues to account for the lease using the rights and obligations of the current lease and recognizes a short-term lease payable during the period in which payments are owed.
- Lease concession is accounted for as a contingent rental payment where the lessee recognizes the contingent rent in the period when the rent concession becomes accruable (ie. when changes occur in the factors on which the contingent rental payments are based).
Lessor (new lease created)
- If the existing lease remains an operating lease, the lease continues to be accounted for as an operating lease and any accrued or deferred rents are amortized over the remaining lease term.
- If the classification of an existing sales-type or direct financing lease does not change or if the classification changes from a sales-type lease to a direct financing lease, the remaining balance of the minimum lease payments (and estimated residual value, if applicable) are adjusted for the impact of the lease concession with the net adjustment being recorded as a charge or credit to unearned income.
- If an agreement that was previously classified as a sales-type or direct financing lease is changed to an operating lease, then the remaining net investment in the sales-type or direct financing lease is eliminated, and the leased property is recorded as an asset at the lower of:
- Original cost
- Present fair value
- Present carrying amount, with the net adjustment being charged to income
Lessor (no new lease created) – at the option of the lessor depending on the nature of the concession
- Lease concession is accounted for as a deferral of payment, whereby the lessor continues to account for the lease using the rights and obligations of the current lease and recognizes a short-term lease receivable during the period in which payments are owed.
- Lease concession is accounted for as a negative contingent rental payment where the lessor recognizes the contingent rent in the period in which the achievement of the specified target that triggers the payment becomes probable (i.e. when it becomes probable that the future event will occur), except in the case of an operating lease where lease payments are forgiven and the negative contingent rental payment should be recognized in the period the forgiven payment would have been recognized as a receivable.
FASB accounting election – COVID-19
The FASB staff has provided an accounting election for entities that provided or received lease concessions due to the COVID-19 pandemic. The election is designed to help reduce the accounting complexities at a time when many businesses may have been ordered to close or have seen a significant reduction in their revenues.
This accounting election allows entities (both lessors and lessees) to not evaluate whether a lease concession provided by a lessor due to COVID-19 is a change to the lease provisions.
Instead, entities can elect whether to apply to guidance on accounting for a change in a lease provision, allowing entities to either:
- Assume that the concession was always contemplated by the agreement (no new lease is created)
- Assume that the concession was not contemplated by the lease agreement (new lease has been created)
This accounting election is available for any lessor-provided COVID-19 related concession that does not result in a substantial increase in the rights of the lessor or the obligation of the lessee and should be applied consistently to all leases with similar characteristics and in similar circumstances.
Recognizing that judgment calls will lead to diverse applications of ASC 842, the FASB has stressed the importance of disclosures surrounding any material lease concessions that relate to COVID-19, including disclosing the entity’s policies related to accounting for such concessions.
Lease modifications under ASC 842
Many private companies will be transitioning to ASC 842 over the next year as it is applicable to periods beginning after December 15, 2021 for private companies. As a result, it is important to also understand the implications of lease modifications under the new accounting model.
Under ASC 842, if a lease modification creates a separate lease, the lessee makes no adjustments to the original lease and accounts for the separate lease the same way it accounts for any new lease.
A separate lease is created when the modification grants the lessee the right to use an additional asset not included in the original contract that is priced in a manner consistent with the standalone price of the additional right to use.
If a separate lease is not created, then the lessee’s accounting will depend on the nature of the modification to the lease agreement.
If the lease modification reduces the scope of the lease through a full or partial termination, the lease classification is reassessed on the effective date of the lease modification and the related consideration is remeasured and reallocated.
As a part of this process, the revised lease payments and discount rate is used to revise the lease liability with the right of use asset being adjusted in a proportional manner, with the difference between the proportionate adjustment to the right of use asset and the lease liability being recognized in the income statement as a gain or loss.
For other lease modifications, the lease classification is also reassessed on the effective date and the related consideration is remeasured and reallocated; however, the lease liability and right of use asset are adjusted by the same amount, resulting in no income statement impact.