Accounting for real estate owners has become more difficult since the pandemic broke out last year as tenants stopped paying rent, rules changed for leases, and unused office space proliferated.
Even as businesses reopen across the country thanks to the widening availability of COVID-19 vaccines, those challenges are likely to linger. In preparing their 2020 year-end financial statements, more companies that own real estate property will need to deal with questions of asset impairment, going concern evaluations, tenant receivables, the new leases standard, and accounting for Paycheck Protection Program loans.
In terms of asset impairment, the novel coronavirus pandemic would seem to qualify as a triggering event as it led to widespread losses and business closures last year across the country. A triggering event can be an event or set of circumstances resulting in losses, decreased cash flow, decreased occupancy, expiring leases or a deterioration in the environment in which an entity operates. For many businesses last year, an impairment assessment would seem to be required and there’s potential for an asset write-down.
“Asset impairment wise, we have got a standard that says that property that’s held and used should be assessed for impairment if there is some type of triggering event,” said Nancy Cox, a partner at the Bonadio Group. “In a normal year, if we’re dealing with residential real estate and commercial real estate, it’s obviously something we have to think about. This year, because of COVID, triggering events can include stuff like adverse changes in business climate, continuing losses like insufficient rental demand, cash flows that don’t meet debt service requirements, even major tenants that are experiencing losses. If you're a commercial property and you have major tenants that are experiencing losses, that’s how deep you have to go into consideration. It’s not just your clients, but it’s their tenants also. All of those things could be potential triggering events. In my mind, it’s almost like the norm this year that there’s going to be a triggering event.”
To do the impairment assessment, businesses will need to compare the carrying amount of the asset to the total net future cash flow. “That in and of itself is a process that we're working with our clients to do,” said Cox.
Bonadio has developed a model that’s specific to income-producing real estate entities for residential and commercial industrial property. “They have tenants and are getting rental income every month,” said Cox. “We’ve developed a tool for that. It takes a lot of conversations with clients to be able to populate the tool and make sure that they're looking at their future cash flow, looking at different budgets for the upcoming year. Basically, as we go through this process, management fills out the tool for us and then we go back and audit it. We look at it to say, ‘OK, does this make sense? And then is there or is there not an impairment based on the carrying value versus the future net cash flow?’”
In case it identifies that there was an impairment, the business needs to recognize the loss and report it as a current net income item. “It’s not something that you want to occur, but unfortunately, it is something that is happening,” said Cox.
The circumstances may vary by region. “In the market that I’m in, in Western New York, we don’t have a tumultuous market where it's very volatile, like in New York City, for example,” said Cox. “We weren't impacted to the extent that perhaps New York City was. But that being said, at the end of the year, at 12/30/20, a lot of them have bounced back or are showing that they will be bouncing back by 2021. Now, we still have to do the consideration because the triggering event is at a point in time.”
Auditors and reviewers of financial statements will probably need to do many such assessments for their 2020 audits and reviews.
The Paycheck Protection Program adds another level of complication, and it helps to have experts at a firm who can help with how to account for the loans, which may or may not be considered forgivable by the Small Business Administration. “With the PPP, we have a CARES Act team, so any questions that I have on the PPP or anything else related to the CARES Act, I usually make sure that we’re working with that team,” said Cox. “But in general, for the Paycheck Protection Program loans, there are several different ways that you are allowed to account for it. Most businesses will likely choose one of two, which is a debt method or a grant method. The debt method is just like debt would be presented on a normal for-profit company’s balance sheet where you have debt and then it’s recorded as income when it’s actually forgiven. The grant method is basically if you can go through an analysis to say it’s probable that the loan will be forgiven, partially or in full, you can use this method. It’s initially recognized as deferred income and then you recognize the gain in the period over which the related expenses are made, which typically would be 2020, so in general, you would be not having a balance sheet impact. It would really be all income statement impact.”
Tax teams at firms should also play a role because there could be tax implications. “One thing that we run into when determining the best method with management as to how to record the PPP loan, is number one, so far, for most of them, it’s likely that they will be forgiven,” said Cox. “They've been able to demonstrate that. So they really do have a choice. For pass-through entities, there are tax considerations. We have been making sure that we are communicating and working with our tax team every time we look at how to record this. For pass-through entities, there are implications of determining when an entity may need some basis or not, and that could have an impact on the way that it’s recorded on the financial statement. We advise companies to work with their accounting and tax people together.”
For many businesses, the PPP is the first time they have participated in a government incentive program and have never had to account for it. According to a survey released Tuesday by tax technology provider Clarus and Zogby Analytics, nearly 40 percent of the businesses polled never participated in government incentive programs prior to the PPP.
Many PPP loans will qualify for full or partial forgiveness. If the loan has not yet been forgiven, real estate professionals and their accountants will need to consider the interplay of costs used for forgiveness with employee retention credits prior to filing for forgiveness.
“In general, for my clients, we've been pretty much using the debt method just because the ones that we’ve been working through, there have been no basis issues that we've needed to really worry about,” said Cox. “Some of them have already been forgiven, and some were forgiven in 2021, so we just add that as a disclosure. But we've been leaning toward that for my client base. I think that across the board a lot of businesses will be choosing the grant method.”
Real estate accountants have also been dealing with the new leases standard, ASC 842, from the Financial Accounting Standards Board, especially public companies, for whom the new standard took effect already. In response to the pandemic, FASB deferred the adoption of the new leases standard for private companies and not-for-profits until fiscal years beginning after Dec. 15, 2021, and interim periods within fiscal years starting after Dec. 15, 2022, but companies still need to get ready to implement the new rules.
“Most of my clients are developers, so they’re lessors, and we were getting prepared to roll out the leasing standard when it first came out,” said Cox. “The good thing is that, by and large, it's not going to have a huge impact for the lessor. This is just my opinion, but I think that where it will have an impact on the lessor — the developers, the property managers and the property holders — is the fact that all the leases have to be on the balance sheet of their tenant. Will it change tenant behavior? Maybe, maybe not. Would they buy instead of lease if it has to be on their balance sheets anyway? Will it impact them if they have debt covenants that they have to be meeting? It remains to be seen. The really great thing is that the FASB did defer the adoption of the leasing standard for calendar year entities to 2022, which is allowing companies to deal with the pandemic and all of the implications that came out of that and not have to worry about this yet because it will obviously have a huge impact on the lessees. For individuals who are leasing space where they used to have an operating lease, it will now be on the balance sheet, so it will be a big impact. Depending on the type of business, if they have leased equipment, it could have a huge impact. Giving companies time to digest everything else going on in their business, and putting this one off for a while, is a really great thing. It definitely is for my clients.”
Public companies were required to begin implementing the leases standard prior to the outbreak of the pandemic, and some have already been receiving comment letters from the Securities and Exchange Commission. The top concerns, according to a
“The SEC is pushing for them to give really good information to financial statement users on how they were impacted or how they might continue to be impacted,” said Sarah O’Sullivan, accounting director at LeaseQuery. “One of the things that relates to leases that we’ve seen is that some companies are thinking about rent concessions. They’ve asked for rent concessions, or possibly reducing their real estate footprint in the future as they consider whether they can have more of their workforce be remote, or on a flex schedule. There’s probably been more modifications or terminations and lease contract changes, a higher frequency of them lately, and some companies may not be as used to doing the accounting for those. It’s a complex aspect of the 842 accounting. There are some comments in the SEC comment letters about making sure they’re applying the accounting correctly, especially with some of the relief that FASB came out with for COVID-specific rent and lease impacts. Make sure that they’re being transparent and on top of it. Make sure that the auditors in the company are educated on that so it’s not a surprise when it happens.”
If too many tenants stop paying rent or ask for steep rent concessions, that could affect a landlord’s ability to continue operating as a going concern.
“Going concern assumption is a basic underlying accounting assumption,” said Cox. “A company is a going concern if it’s going to be able to meet its operations and obligations over the next year. We really do need to step back and say, ‘OK, if we're looking at an asset impairment, that means that they've had all these triggering events.’ They could have losses. They could have tenants that are terminating their leases earlier. They could have little demand for rents. All these things could also be an indication of a going concern. In general we found that is leading to more disclosures. It's not necessarily leading to a modification of our opinion, but it is leading to more disclosures. Maybe there are liquidity and capital resources issues, so that would become a disclosure.”
While private companies don’t have to worry about receiving a comment letter from the SEC, they do need to satisfy their lender. “A lot of our clients are private, so the reader of the financial statement is really the bank,” said Cox. “So it’s just to say, ‘Hey, bank, we've considered this. We do think they're going to be able to meet their obligations over the next year, or rather management does and we agree. And here's the reason that we think that.’ It's something that should be really called out on the financial statements, because if you're a banker looking at these financials, you're saying, ‘Oh, are they going to be able to pay down their loan over the next year?’”
Accountants can provide disclosures to reassure lenders that other sources of funds are available. “If operations are suffering, management has other entities where they are able to borrow from a related party and they would be able to fulfill their obligations over the next year,” said Cox. “That's one thing that we've definitely seen a lot more disclosure about.”
Other considerations relate to accounting for rent concessions, and FASB’s staff issued a
“A lot of our clients have been allowing their tenants concessions or perhaps deferrals,” said Cox. “You may see on the balance sheet where accounts receivable is higher, and then tenant receivables also becomes an issue because there have been moratoriums on evictions, so now you have tenants for residential property especially that are in there and not able to pay their lease payments, but you're not allowed to evict them. So now you have these high accounts receivable. Should there be a writedown on that? Do you need a big allowance? These are considerations that we’re going through. Some of our clients were able to get deferrals on principal and interest payments on their loans, and so we are looking at financial statements. How does that impact future maturities of long-term debt? When are those deferrals going to come due? Are they going to amortize the debt? There are all kinds of considerations as far as how that disclosure should be made.”
With the strong economic recovery underway this year, more landlords and tenants are now making overdue improvements as they reopen their businesses. “Now we have clients that are doing tenant improvements or that are doing big capital improvements,” said Cox. “They obviously had a break in them. If they were scheduled to be done in 2020, perhaps they're six months late. Because they had to stop what they were doing as far as construction goes, now at the end of the year, maybe some tenants are late in paying, so their receivables are up, and then they have all these construction costs, so now their accrued expenses are up, but they haven't actually paid for the capital expenditures yet. We've been seeing a lot of how this impacts cash flow because that's really a non-cash item if they have all of these construction costs but they haven't paid for them yet. You really need to consider that in your current year cash flow as well as next year.”
All of that can lead to debts piling up, which may or may not be repaid. “The other thing that I've seen that I hadn't seen for a long time is having to consider — because of principal and interest deferrals, consideration of impairment and all these other things, and perhaps going concern — does that then lead to troubled debt?” said Cox. “Do we need to start considering the gap related to a troubled debt? They all go hand in hand. Once you go down the impairment route and the going concern route, they all go together just like a family. You could end up going through a lot of considerations. Make sure you're giving a good quality set of statements that give the whole picture of what's going on with the company. There are a lot of subsequent events, follow-ups and footnotes types of things saying, “OK, here's how they're looking for 2021.’ It's a crazy year for a lot of things, accounting wise.”
