You’ve set up your right-of-use (ROU) asset and a lease liability, there is an amendment to the payments, term, leased space, etc. — now what? With the adoption of Accounting Standards Update No. 2016-02 now effective for both public and private companies, questions have surfaced for day two accounting considerations, particularly, how to handle changes in lease terms after the initial implementation of the standard.
Background
ASC 842 requires all leases longer than 12 months to be recorded as assets and liabilities on the balance sheet. The lease liability is recorded on the balance sheet as the present value of future minimum lease payments, offset by an ROU asset. The ROU is calculated as the amount of the lease liability, plus initial direct costs and prepaid lease payments, less accrued lease payments and the remaining balance of lease incentives received. After initial recognition on the balance sheet, ASC 842 requires lessees to update the measurement of leases for modifications. The guidance defines a lease modification as a change to the terms and conditions of a contract that results in a change in the scope or the consideration for a lease. Ultimately, the nature of the modification impacts the accounting approach.
Accounting Guidance
Lease modifications are either accounted for as a separate contract or a change in the accounting for the original contract.
Modifications Deemed a Separate Contract
Per ASC 842-10-25-8, an entity shall account for a modification to a contract as a separate contract (that is, separate from the original contract) when both of the following conditions are present:
- The modification grants the lessee an additional right-of-use not included in the original lease.
- The lease payments increase commensurate with the standalone price for the additional right-of-use, adjusted for the circumstances of the particular contract.
Here is an example of a modification that is accounted for as a separate contract:
The right to use an additional asset via more square footage (i.e., modify the lease for the remaining ten years to include an additional 5,000 square feet of rental space in the same building, with an increase in the payments that is in line with market rates).
Modifications that are deemed to be a separate contract should be accounted for as any other new lease — determine the lease classification and calculate the lease liability and ROU asset.
Modifications Deemed a Change in the Accounting for the Original Contract
For lease modifications that require a change in the accounting for the original contract (i.e., a continuation of the existing contract), entities shall reassess the classification of the lease in accordance with paragraph 842-10-25-1 as of the effective date of the modification. These types of modifications change an element of the original ROU that the lessee already controls.
According to ASC 842-10-25-1, “An entity shall not reassess the lease classification after the commencement date unless the contract is modified and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8. In addition, a lessee also shall reassess the lease classification after the commencement date if there is a change in the lease term or the assessment of whether the lessee is reasonably certain to exercise an option to purchase the underlying asset. When an entity (that is, a lessee or lessor) is required to reassess lease classification, the entity shall reassess classification of the lease on the basis of the facts and circumstances (and the modified terms and conditions, if applicable) as of the date the reassessment is required (for example, on the basis of the fair value and the remaining economic life of the underlying asset as of the date there is a change in the lease term or in the assessment of a lessee option to purchase the underlying asset, or as of the effective date of a modification not accounted for as a separate contract in accordance with paragraph 842-10-25-8).”
Here are examples of modifications that are accounted for as a change in the accounting for the original contract:
A modification of the lease for the remaining ten years to include an additional 5,000 square feet of rental space in the same building, with an increase in the payments that is at a discount to market rates.
An extension or reduction of the term of an existing lease, other than through exercise of an option in the original contract (i.e., total lease term increases from 10 years to 20 years).
A change in payments (i.e., lessee and lessor agree to decrease the annual lease payments from $65,000 to $50,000).
Modifications that are deemed to be a change in the accounting for the original contract require the lessee to remeasure and adjust the lease liability and the ROU asset at the modification date. In addition, the lessee must reassess the following:
- Allocation of consideration in the contract
- The discount rate
- The lease classification
- The lease term and purchase options
Amortization of the ROU asset is adjusted prospectively from the date of remeasurement.
The adjustment to the ROU asset depends on the type of modification, as follows:
Entities will need processes and controls in place to quickly identify when a lease modification is made and evaluate the impact to the accounting treatment accordingly. If you have any questions about lease modifications, Wolf & Company is here to help.
