By Denise Lugo
Companies seeking to renegotiate or end equipment or real estate lease terms over lack of use will gain better outcomes if their accounting and legal teams work closely together, accounting professionals said.
The COVID-19 pandemic has caused companies to consider modifying or ending some of the leases they carry, and there are new FASB accounting rules in the pipeline to be mindful of.
“The advice that an accountant is giving is going to be different than the advice a lawyer might give, Patrick McCarney, an attorney at Indiana-based law firm Riley Bennett Egloff LLP, said. “The accountants are going to be more focused on how to treat this now, how to maximize the economic benefit for the clients, or if it’s in house for the company itself, and the lawyer is going to be more concerned about what happens next – what are the future ramifications,” he said.
McCarney said it is important for lawyers, whether a litigator or a transaction lawyer, be aware of changes in GAAP that can influence client behavior.
He pointed to W.H. Paige & Co. v. State Board of Tax Commissioners, a case whereby the business thought it was selling musical instruments with a security interest – meaning the business could repossess the property if the contract was breached. But Indiana’s tax court ruled that the musical instrument contracts were not sales but were in fact leases. And because they were leases, this meant that the business had title to all of those pieces of property all along and therefore was hit with hefty back taxes and a delinquent penalty.
“In both accounting and the law leases are very interesting and far more complicated than most people would realize,” McCarney said.
And this year lease contracts might prove more significant than ever before. Market watchers said billion-dollar bankruptcy filings are trending higher this year than any other year on record.
The industries topping the list of bankruptcies to date: restaurants with 670 filings; oil and gas with 621; real estate with 609; construction and supplies with 603; and retail with 553, according to BankruptcyData.com, a division of New Generation Research, Inc., based in Boston. The figures include both public and private companies, Ben Schlafman, the company’s chief operating officer, said.
Some Contracts Include Incentives
The FASB in 2016 published Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), to require companies to report on the balance sheet the full magnitude of the long-term leases these carry. Specifically, it requires the company that obtains the lease to recognize assets and liabilities for leases with terms of more than 12 months. Previously those figures were in footnotes.
The rules took effect in 2019 for public companies; for private companies, it goes into effect in 2022.
One example of a pure accounting area that lawyers might want to know about when renegotiating a lease relates to the discount rate a company used to initially record the lease agreement. This discount rate will change on modification and the results may be counter-intuitive, accounting practitioners said.
“As companies are changing these leases, they may enter into a rent abatement. Their lessor may agree to reduce their rent, and if they’re accounting for that as a modification, they have to use a new discount rate,” said Jennifer Booth, vice president of accounting at LeaseQuery, a Georgia-based accounting software firm. “What’s been interesting is you could actually get to a situation where your asset and liability recorded are going to now be higher than they were before the modification, even though you have lower cash payments. If you entered into this agreement at a point in the past when you had a higher discount rate, now when you modify this lease in the current economic environment, interest rates are so low. Even though you actually now have lower cash payments, you have a lower discount rate, which may end up increasing the asset and liability recorded on your books,” she said.
Booth, formerly of Ernst & Young LLP, agreed with the caution that companies need to tap their accounting teams early to look for nuances of the rules.
“There is a premise within the accounting guidance that says if two or multiple contracts are negotiated at the same time, even if they are separately papered, they need to be considered as one for accounting, and so that often means when you’re entering into a negotiated agreement you need to consider that,” said Booth. “That also would be important here, as agreements that might have been accounted for together are being changed that could impact others,” she said.
There are limitations about what can and what cannot actually take place in lease negotiations, Booth also pointed out. Companies, for example, do not just have to worry about future rent payments when modifying or ending leases, they also have to consider incentives that were provided at the start of the lease, she said. Incentives can include moving costs, money advanced to customize a location, or other big dollar perks.
Leases Rules Under Review
The FASB this year placed the leases standard under post-implementation review (PIR), its process for vetting a new standard to determine whether it achieved its objective to provide financial statement users with relevant information.
And the board late July voted to issue a proposal in September that amends the standard in three targeted areas companies flagged as causing negative outcomes.(See FASB Agrees to Propose More Amendments to Lease Accounting Rules in the July 30, 2020 edition of Accounting & Compliance Alert.)
Two FASB public roundtables are also set for September 18 to enable the board to identify and understand broad technical lease accounting issues that need to be addressed.
For in-depth analysis of the FASB’s standard for lease accounting, please see Catalyst: US GAAP — Leases , also on Checkpoint.
Additional analysis of the lease standard can be found in the Accounting and Auditing Update Service [AAUS] No. 2016-15 and SEC Accounting and Reporting Update Service [SARU] No. 2016-13 (March 2016): Special Report: Accounting for Leases—an Explanation and Analysis of Accounting Standards Update No. 2016-02.
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