During a lease term, it is common to receive modifications to the contract between the lessee and lessor, which could result in a change in either scope or consideration for a lease. Whether these changes could change the accounting and the proper treatment for a lease modification depends on the nature of the modification. Under ASC 842, modifications are noted as the following:
- Additional rights
- Extended or reduced term of lease
- Change in consideration (rent payment)
- Partial or full termination of a lease by reducing the lessee’s right to use the underlying asset
Contract modifications may require a remeasurement of the lease liability and right-of-use (ROU) asset. Lease accounting under ASC 842 requires remeasurements when the event involves more than just a renegotiation of lease terms but also conditions including changes in the lessee’s facts, assumptions or other circumstances.
Companies should first evaluate if the contract modification contains a lease. If it does contain a lease, the next step is to evaluate if the modified contract should be a new lease or remain the original lease. Lease modifications can change a lease so drastically in scope or consideration that the modification creates a new lease. Under ASC 842, two criteria must be met to result in a separate contract:
- Modification grants additional rights of use (i.e. additional floors or square footage in the building)
- Lease payment for additional rights is at a standalone price.
If the modification does not create a separate contract as directed by the criteria above, the lessee remeasures the lease liability and ROU assets at the modification date and reassesses the following:
- Lease term and purchase options
- Discount rate
- Allocation of consideration in the contract
- Lease classification
If the lease modification removes the lessee’s rights to the asset, the lessee accounts for the modification as a full termination. At the time of termination, the lessee should remove any lease liability and ROU asset balance from the general ledger. If the ROU asset does not equal the lease liability, then the lessee should recognize a gain or loss in the income statement. A gain or loss is normally a result of finance lease accounting or operating leases with built-in payment escalations or free rent periods.
A partial termination is a result of a modification that reduces the lessee’s rights to the asset. An example includes a reduction in square footage. The lease liability is remeasured based on the new payment terms, and the ROU asset is reduced based on either the proportionate change in the lease liability or the proportionate change in the asset.
Modifications and reassessments both could result in the remeasurement of the lease liability; however, there are only certain types of events that will trigger an updated discount rate at the date of the change. Additionally, certain changes to the lease might trigger reassessment or considerations of lease classification (E.g. Operating vs Finance Lease).
Reassessment considerations:
- Change in circumstances within the control of the lessee in regard to exercising options to extend, renew or terminate the lease or asset
- The contract is amended to require the lessee to change considerations regarding the extension or termination of the lease
- Lessee reverses conclusion regarding the exercise of the options in the lease
The chart below summarizes the proper accounting treatments for both modifications and reassessments.
| Reassessment Events | |||||
| Lease Modification | Change in Lease Term | Change in Purchase Option Assessment | Change in Residual Value Guarantee |
Resolution of Contingency |
|
| Reallocation | √ | √ | √ | √ | √ |
| Reassessment | √ | √ | √ | X | X |
| Discount Rate Update | √ | √ | √ | X | X |
Common examples of restaurant leasing modifications based on the chart:
Example: Rent payment increases each year based on CPI index.
An operator leases a building with rent based on the CPI index that resets annually. Rent increases based on a CPI Index are considered a variable lease component. As such, the base fixed rent amount is used to calculate the lease obligation and ROU asset. Once the rent payment resets based on a CPI increase, a new base rent amount is determined and should be used to remeasure the future lease obligation and corresponding ROU asset. In this situation, there is a new floor to the rent payment going forward. The discount rate used would not change from the rate used at inception.
Example: Rent payments are renegotiated with the landlord in year 6 of a 10-year base term for the remainder of the base term.
An operator is leasing a building for a 10-year term. The lessee renegotiates the rent payments in year 6 for the remainder of the 10-year term of the lease. At the time of the modification, the lease liability is remeasured by calculating the present value of the remaining future lease payments at the discount rate at the date of the modification. This remeasurement of the lease obligation will also adjust the ROU asset when recorded.
Example: A lease renewal option is exercised in Year 9 of a 10-year base term for another 5 years due to a remodel of the premise.
An operator is leasing a building with a 10-year term. In year 9, the lessee renews the lease for an additional 5 years due to a remodel of the building. At the time of the modification, the lease liability is remeasured by calculating the present value of the remaining future lease payments at the discount rate at the date of the modification. This remeasurement of the lease obligation will also adjust the ROU asset when recorded.
Moving forward
As you can see, there are a lot of nuances with ASC 842 Leases that are new to lease accounting when making changes during the lease term. If you are using a lease accounting software, most have a remeasurement wizard to walk you through the process, and will also give you the journal entries to record. If you are not using a lease accounting software, the process becomes a bit more manual, so it is even more important to understand the details of ASC 842 such as when a new discount rate is used. We are here to help if you would like to talk through your questions – contact your GBQ team.
Article written by:
Kristin Romaker, CPA
Senior Manager, Assurance & Business Advisory Services
