The COVID-19 pandemic and subsequent lockdowns significantly impacted the global economy, with shockwaves still being felt around the world. Some of the most affected organizations are in real estate, with potentially long-term consequences due to their geographical region or asset class.
This article will guide you through the main accounting implications for real estate companies in light of COVID-19. However, it is not an exhaustive list as the situation is continuously evolving.
Impact of COVID-19 on the valuation of investment properties
The fair value measurement of real estate properties is categorized as Level 2 or Level 3, due to assets often being unique, irregularly traded and a lack of observable data for identical assets. As such, using unobservable inputs for valuations — already a complex and judgmental area — has become even more challenging with COVID-19.
Due to the unprecedented nature of the pandemic, valuers will need to consider many factors more carefully for 2020 valuations — especially since the pandemic’s effects are unevenly spread across property types, tenancy, geographical areas, etc. This may lead to valuation reports containing some uncertainty or qualifying clauses.
Entities must make sure to provide any relevant sensitivity disclosures to help users understand how fair value was determined, as well as the key assumptions and judgments made by management. Where properties are classified as Level 2 fair value, entities should consider whether unobservable inputs have become significant, which would result in a Level 3 categorization and require additional disclosures.
Accounting for lease concessions
Due to the COVID-19 pandemic, many lessors have granted rent concessions to their lessees.
Previously under IFRS 16, rent concessions usually met the definition of a lease modification, unless foreseen in the original lease agreement. Since the accounting for lease modifications can be complex, the International Accounting Standards Board (the Board) has amended IFRS 16 to include an optional practical expedient not to follow the lease modification accounting that simplifies how a lessee can account for rent concessions due to COVID-19.
The Board did not provide a practical expedient for lessors, who must continue to assess whether the rent concessions are lease modifications, and account for them accordingly. However, KPMG has put together practical guidance and examples to help lessors account for rent concessions treated as lease modifications in our publication Leases – Rent concessions.
Recognition of lease income
Some industries were hit harder by the pandemic than others. For example, the hospitality industry was confronted with an unprecedented challenge and is still struggling to deal with the effects of lockdown. Therefore, the collectability of operating leases from these types of tenants is still uncertain.
The issue is whether a lessor should continue to recognize lease income when it has been assessed that some rents on operating leases cannot be collected.
Paragraph 81 of the IFRS 16 states that: “A lessor shall recognize lease payments from operating leases as income on either a straight-line basis or another systematic basis.” The standard does not mention any collectability conditions that must be met to recognize operating lease income by a lessor. Therefore, they can continue to recognize this income.
However, the impairment of the respective lease receivable must be accounted for.
Impact on the expected credit losses on lease receivables
Lease receivables fall within the scope of the IFRS 9 expected credit loss (ECL) model. So, real estate companies must consider how the COVID-19 outbreak has impacted the ECL estimate.
Generally, lease receivables don’t have significant financing components and are measured on initial recognition at the transaction price determined under IFRS 15 Revenue from Contracts with Customers. And they normally don’t have a contractual interest rate either, which implies the effective interest rate for these receivables is zero. As a result, discounting cash shortfalls to reflect the time value of money when measuring ECLs for lease receivables is generally not required.
However, due to the pandemic, lessees can delay payments. Even if the lessor expects to receive all amounts due after the contractual due date, an ECL will still arise — unless the lessor is compensated for the lost time value of money, i.e. the lessor charges interest for the late payments.
Other revenue recognition implications
In the real estate sector, it’s common for some companies to recognize revenue over time under paragraph 35(c) of IFRS 15: “The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.” This approach is not a choice and is only available when the company has an enforceable right to payment.
Under the conditions of COVID-19, entities should consider whether the right to payment can still be enforced, especially when contracts include force majeure or similar clauses that are being invoked. This assessment involves significant judgment. The companies must disclose the judgment made, as well as disclose or update disclosures when the contract existence criteria are met and whether the revenue is recognized over time under paragraph 35(c).
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This article has been written by Loredana Plesca.