Lease Modifications Rising Due to Economic Uncertainty
Covid-19 has led many companies to renegotiate certain aspects of their leases on long-lived assets; accounting for those changes may be challenging.
CFOs and treasurers around the world are laser-focused on conserving cash, as the economy looks poised to decline into a crippling recession. Many businesses’ survival of the next few years will depend on executives’ management of their liquidity. As McKinsey & Company put it in March:
“For some organizations, near-term survival is the only agenda item. Others are peering through the fog of uncertainty, thinking about how to position themselves once the crisis has passed and things return to normal. The question is, ‘What will normal look like?’ While no one can say how long the crisis will last, what we find on the other side will not look like the normal of recent years.”
The focus on liquidity makes equipment leasing a more attractive option than ever before. That’s because leasing, in place of large capital expenditures, enables businesses to obtain long-lived assets without decreasing their current cash position. Thus, many organizations are now exploring leasing options to finance new equipment, as well as opportunities to leverage sale-and-leaseback transactions on equipment they’ve already purchased.
Moreover, businesses are re-examining their existing lease contracts—for both equipment and real estate—looking for clauses that may contain hidden opportunities for cash flow. For example, a lessor may be able to request the early use of lease incentives; exercise an early-termination option; reduce, assign, or sublet a leased space; or even bring on co-tenants. Early application of a portion of a security deposit to a rent payment is another approach for reducing current negative cash flow.
Lease Accounting Considerations
The volume of prospective changes and revisions to corporate leases presents a significant challenge for lease accountants, corporate controllers, treasurers, CFOs, and their financial reporting teams. Compliance with U.S. Generally Accepted Accounting Principles (GAAP) and/or International Financial Reporting Standards (IFRS) lease-accounting rules will be challenging for organizations that do not have robust systems and controls for managing leases.
Many companies are developing a transparent action plan that focuses on renegotiating with lessors the terms of existing leases, utilizing one or more of the following approaches. Each of these approaches is generally accounted for as a deal modification that requires a remeasurement of the lease liability and right-of-use (ROU) asset using the most recent and appropriate incremental borrowing rate (IBR).
1. Seeking out abatements. Many businesses impacted by Covid-19 are seeking to defer rent or lease payments for a period of time via abatements, also referred to as “rent holidays.” Some entities have been able to defer rent for a period of months and then catch up over the remainder of the lease term, while other entities have been able to renegotiate their leases and obtain some free periods of rent up front to ease their current cash flow burden.
2. Requesting payment forgiveness. Some businesses have successfully negotiated with their lessor to have certain payments forgiven, which obviously increases cash flow. In particular, some entities have asked for, and been able to receive, a month or two of free rent during the pandemic crisis. This has primarily worked for businesses that have had to temporarily close operations.
3. Asking for interest rate reductions on leases. A reduction in the interest rate built into a lease will reduce payments and enhance cash flow. With interest rates at historical lows, many lessors are refinancing with their lenders to reduce their cost of carry. A lessee should be able to share in part of that interest rate reduction.
4. Changing the length of the lease term. Shortening the term of a lease may enable a business to reduce payments and enhance cash flow. We are seeing lessees terminate certain leases early, and at times without penalty, to enhance cash flow.
5. Full and partial lease restructurings. Lessors want to see lessees succeed. At times, they are willing to renegotiate a lease to the benefit of both parties in order to help support the lessee’s business. When a lease is restructured to extend the lease term and lock in future cash flows, the changes benefit the lessor. When restructurings reduce the lessee’s payment amounts or defer payments, the changes preserve cash in the short term for the lessee. Lease restructurings usually inure to the benefit of both parties.
6. Obtaining current and future lease incentives. Companies can pursue lease modifications that add incentives to the contract to shift responsibility for leasehold improvements to the lessor. Obtaining such incentives can reduce the lessee’s outflows directed toward improvements, resulting in reduced spending in the short term and enhanced cash flow. When accounting for these changes, the lessee must appropriately discount multiple incentives or future-dated incentives.
7. Changing fixed payments to variable payments. By changing fixed payments to variable payments—based on asset utilization or a percentage of revenues, for example—a lessee can better match its lease-related outflows to its cash inflows. Note that variable payments are generally accounted for as period costs.
8. Seeking loyalty payments. Loyalty payments obtained from the lessor also enhance the lessee’s cash inflows. A company would typically seek out loyalty payments under master leases in which it is leasing multiple assets from a single lessor or funder, or in long-term leases such as many real estate deals. Multiple loyalty payments or future-dated loyalty payments must be discounted appropriately.
Each of these lease modifications requires remeasurement of the lease’s value. As the economic picture comes into better focus over time, so too will the needed revisions to initial impairment estimates. In addition, some leased and other long-lived assets will, for the first time, be reviewed and tested for impairment. This will undoubtedly result in some previously unexpected partial and full impairments in Q1/2020 and Q2/2020.
In addition to the eight lease modifications described above, lessees may seek to simply terminate their leases. By returning an entire leased asset early, and terminating the entire lease, a company can eliminate the cash flows associated with that lease. Full lease terminations are generally accounted for as early terminations of the lease.
The early return of a portion of a leased asset, such as one floor of a building or a certain model of vehicle within a fleet lease, reduces the lessee’s outflows of cash. Like the other types of lease modifications, partial lease terminations are generally accounted for as a deal modification requiring a remeasurement of the remaining lease liability and ROU asset using the most recent and appropriate IBR. A gain or loss may be generated for the lessee due to the early termination of a portion of the lease, as the lease’s original accounting entry assumed a longer holding period for the asset than what actually came to be.
Looking Forward
Lease accounting will become increasingly complicated and transaction-heavy as the full impact of Covid-19 on the world economy becomes apparent. Deals are already changing rapidly, estimates are being revised, renegotiations are ongoing, and consolidations and retrenchments are happening. Marc Holliday, the chairman and CEO of SL Green Realty Corp., a large real estate investment trust (REIT), recently stated that more than 60 percent of retailers are not currently paying for their rental space.
Businesses tackling the added complexity and velocity of changes to lease portfolios and revised estimates, including impairments of the carrying value of leased assets, will ultimately require robust lease accounting subject matter expertise for compliance with accounting standards and corporate policy. External advisers can provide guidance to the controllership, treasury, financial planning and analysis (FP&A), procurement, legal, and other functions, as well as to the business.
See also:
- Equipment Leasing: The Good, The Bad, and the Ugly
- A Tsunami of Loan Modifications Is on the Horizon
- How to Ride High on the Loan-Modification Wave
It is also important for finance teams to find processes and technologies that remove some of the human intervention in lease management. Automating routine processes can free up treasury and finance staff to spend more time on analysis, as well as creating a repeatable result for each new lease or lease modification.
In the current business environment, where cash is king, every entity that needs a new capital asset should look at a lease-vs.-buy scenario to determine the best way to finance it. Leasing provides a well-established method of using other people’s money to obtain needed assets—a longstanding arrow in a treasurer’s quiver for enhancing cash flow. And as leases come up for renewal and extension, lessees can negotiate with the lessors to reduce their payments for non-real estate assets. After all, the lease on a used asset should cost less than when the asset was new.