As defined by ASU 2016-02, a lease modification is a change to the terms of a contract that results in a change in the scope of, or consideration for, a lease. An example would be a change to the terms and conditions of a contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term. A modification must be evaluated to determine the requisite application of lease accounting.
Both the lessee and lessor may account for lease modifications as either one lease or two separate leases. If accounted for as one lease, you must reassess the lease classification (capital or operating) by assessing the criteria for the classification and adjust the lease contract. The lessee should determine the lease liability, and adjust the right-of-use asset when the following events occur:
- An event that changes the certainty of a lessee exercising an option to renew, terminate, or purchase the underlying right-of-use asset
- An event that changes the amount owed by the lessee under the residual value guarantee
- An event fixing variable lease payments based on the resolution of a contingency
If accounted for as two separate leases, you would treat the modification as a new lease. Lease modifications may include any of the following:
- Changes in the timing of lease payments
- Leasing additional space in the same building
- Direct costs, incentives, or other payments that should be accounted for in the same manner as those items would be accounted for as part of a new lease
A company should account for lease modifications as a separate contract when both of these circumstances occur: the modification gives the lessee right of use to an asset not included in the original contract, and the lease payments increase with the standalone price for the additional right of use.
When both conditions are met, the lease modification results in two separate contracts: the unmodified original contract and a separate new contract. If both conditions are not met, the modified lease will not be accounted for as a separate contract.
The lessee accounts for the original lease as if it is a new lease contract. A lessee should look at the consideration between the lease and nonlease components, remeasure the lease, and change the right-of-use asset.
A lease liability should be remeasured on the date of the event of the modification as if the lease were a new lease contract. The discount rate should not be changed if there is a modification due to a change in the lease term or purchase option if the discount rate at the lease inception already reflects these facts. The right-of-use asset should be adjusted if there is a full or partial termination of the lease. Other changes will result in the right-of-use asset being adjusted by the lease liability. There is no gain or loss due to the adjustment unless the right-of-use asset is reduced to zero, and then any excess is added to net income.
If a lease is classified as a finance lease (regardless of its original classification), a lessee should calculate interest expense on the lease liability based on the discount rate on the date of modification. The right-of-use asset should be calculated based on the revised asset values and lease term, done prospectively.
If a finance lease is modified, and the modified lease will be classified as an operating lease, the difference (if any) between the carrying amount of the right-of-use asset after the required adjustment and the right-of-use asset that would result from applying the initial operating right-of-use measurement guidance to the modified lease should be accounted for in the same manner as a lease incentive or prepayments.
When a lease is terminated, there should be no lease liability or right-of-use asset. Any difference between the two amounts should be run through net income. Professional judgment may be required to determine whether the termination of one lease and subsequent replacement of another lease is actually a continuation of the original terminated lease. Partial terminations require the adjustment of the lease liability and the right-of-use asset, which is decreased proportionally to the partial termination of the existing lease with any difference charged against income.
John D. Rossi III, CPA, is associate professor of accounting for Moravian College in Bethlehem and a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at email@example.com.