Financial Reporting Challenges for Real Estate & Construction Entities in the COVID-19 World
By: Kristie Liberatore
The coronavirus pandemic outbreak (COVID-19) has left the entire world in an unprecedented time of change. The uncertainties relating to the duration of the outbreak, stay-at-home orders, terminated or restructured construction projects, keeping tenants and visitors safe, rent concessions and lease renegotiations, halting of business and leisure travel, deteriorating credit, liquidity concerns, and complying with governmental agency requirements have had a significant impact on real estate and construction companies. Additionally, COVID-19 has imposed a burden on some companies by affecting the wellness of employees, disrupting talent and workforce models, and interrupting normal business operations. The effect on the overall economy and financial markets have created volatility and unforeseen challenges for these industries. As if that isn’t enough to keep leaders up at night, there are also several accounting considerations stemming from COVID-19 that will need to be analyzed during the remainder of the year.
Impairment of Long-lived Assets and Goodwill
Real estate and construction entities will need to evaluate and consider the impacts of COVID-19, including any tenant-related changes or disruptions and anticipated future cash flows to identify indicators of impairment. This is arguably the biggest accounting issue that real estate and construction companies will face. Entities are required to perform impairment tests annually or when a triggering event has occurred. A few key examples of external and internal impairment triggers include:
- Significant decreases in the market value of assets;
- Decrease in the extent or manner the asset is being used (such as, idle facility or office space and reduced capacity due to ‘social distancing’ and fear of tenant/visitor safety);
- Current period operating loss coupled with a history of losses;
- Decrease in customer demand;
- Supply disruptions leading to inability to meet demand; and
Unfortunately, a decline in market capitalization that is consistent with declines experienced by others within its industry is not a sufficient argument against the existence of a triggering event.
The effects of the pandemic on the real estate market have not been uniform. We expect that the retail and hospitality market sectors will have the highest impairment impact. We have all seen significant store closures in 2020 as retailers are forced to shut physical locations down and file for bankruptcy. The hospitality industry is facing similar difficulties as travel continues to be minimal and venues for large gatherings experience low utilization. Office and health care sectors will have moderate impairment effects due to COVID-19. Many companies have shifted to a work-from-home environment since the outbreak began and some healthcare systems are looking to consolidate office strategies. Conversely, industrial, storage, and data center sectors are expected to continue to perform well with little impairment impact.
Rent Concessions & Collectability
The pandemic has decreased rent collections significantly for many real estate entities. In order to help alleviate some of the financial burden on tenants, many landlords have offered rent concessions. These can take the form of rent reductions, rent waivers, and payment deferrals. Some lessees with businesses less resilient to the pandemic have been forced into short-paying their landlords.
The Financial Accounting Standards Board (FASB) has acknowledged that the lease modification guidance did not contemplate concessions occurring so rapidly as a result of the COVID-19 pandemic. As such, the FASB issued relief during the second quarter of 2020 by allowing entities to elect to apply or not apply the lease modification guidance for concessions related to the pandemic disruption that do not result in a substantial increase to the rights of the lessor or the obligations of the lessee. Companies will need to elect to account for qualifying concessions in either of the following ways:
- As if they are a part of the enforceable rights and obligations of the parties under the existing lease contract
- As a lease modification in accordance with the full lease modification requirements.
The accounting treatment for these concessions will vary based on the policy election. Lessors should think beyond the accounting implications when granting concessions. Rent concessions impact cash flows for impairment testing, cash flows for distributions, creation of receivable balances with collectability concerns, fair value reporting issues, etc.
Lessors must monitor changes in collectability from tenants that miss lease payments. Material rent deferrals or short payments may call into question whether the lessee will be able to catch up on rent payments. The lessor must adjust the accounting for such leases even if a formal modification is never discussed or approved.
For operating leases, collectability is an ongoing assessment and when receipt of payment is less than probable, revenue is constrained to cash collected and receivables should be reserved for. This could have a material impact on long-term leases if a tenant is in distress or filing for bankruptcy.
Accounting for Income Taxes
Real estate and construction entities experiencing downturns in their business that have significant deferred tax assets (“DTA”) recorded may need to reassess their valuation allowance. Business projections used for DTA analysis should be consistent with those used for other operational or accounting purposes (goodwill and long-lived asset impairment discussed above), so close communication of the financial model assumptions is important across management teams. ASC 740 requires entities to consider all currently available information for DTA valuation purposes (including data subsequent to the balance sheet period end).
Many jurisdictions have proposed or enacted changes in tax law to help provide relief to businesses and individuals during these challenging times. Rates used in the provision for income taxes must be based on rates enacted during the reporting period, and not based on mere proposals or laws enacted subsequent to period end.
Industry leaders should be mindful of the classification of government relief to ensure any assistance is appropriately classified as income tax, other tax or a government grant.
Debt Covenant Violations and Waivers
Real estate and construction companies experiencing liquidity concerns as a result of granting rent concessions or a slowdown in construction could fail to meet contractual debt covenants and should proactively try to renegotiate when possible. Companies that violate their debt covenants within a reporting period should reclassify any outstanding long-term balance to a current liability. Entities can continue the long-term classification if a debt covenant violation waiver is received and valid for at least one year after the period end, and if the entity can conclude that it is not probable of violating the same or another covenant within one year of the period end balance sheet date.
Management may also consider long term modifications to current financing to avoid tense negotiations with lenders in the future. Accounting for loan modifications is complex and can impact the income statement. Lessors should be cognizant of the potential domino effect of tenants’ liquidity positions in analyzing the ability to meet their own debt-servicing requirements. Construction companies should consider similar effects of their clients’ liquidity management.
Under accounting guidance, a sales contract does not exist unless customer collectability is probable. Construction contractors may need to evaluate whether its current and new customers have sufficient access to liquidity. When receipt of payment is in question at the time of or close to a transaction, revenue should not be recognized until all performance obligations have been fulfilled by the entity and the concern over collectability has been lifted, or the agreement is terminated, and any consideration received to date is nonrefundable.
Customers facing financial difficulties may seek concessions with pricing or discounts from prior balances. Such concessions should be treated as variable consideration and may have a significant impact on revenue recognition under current standards.
Current accounting guidance requires management to evaluate whether there are conditions that raise substantial doubt about the entity’s ability to continue as a going concern. The COVID-19 pandemic outbreak presents numerous potential indicators (discussed throughout this article) along with ongoing uncertainty of the general economic outlook coupled with individual entities’ financial position and liquidity. Management’s evaluation should consider all information available through the date the financial statements are to be issued, and not just as of the reporting period end balance sheet date.
The forward-looking period for this purpose is one year after the date the financial statements are to be issued or are ready to be issued. It is important to ensure that cash flow projections, closures, cost cutting measures, asset sales and other data points are consistent with other liquidity analyses as these types of plans may trigger additional accounting considerations.
If negative conditions are identified, additional disclosures may be required, regardless of whether those conditions are mitigated by management’s analysis.
How Cherry Bekaert real estate and construction experts can help you navigate these complexities
Cherry Bekaert and our leading professionals in Real Estate and Construction can help organizations navigate complex accounting and financial reporting issues brought on by COVID-19 and adapt to the constant changes. We have a strong understanding of how real estate and construction companies are likely to be affected and the appropriate measures they can take to meet financial reporting, operational, and strategic objectives. Please contact Mark Cooter or Chase Wright to discuss these and related topics further.