With at least two years post-implementation of the largest change to lease accounting, all of us have hopefully explained the nuances of FASB ASC 842 to our clients, have perfected Excel templates for computing right-of-use assets and liabilities, and explained to users of the financial statements that the recognition practices for both operating and finance leases “really have not changed much.”

However, the “fix-it and forget-it” Excel templates aren’t the end of the discussion. Times change, and leases change, and the changes to the terms and features of existing leases, called “lease modifications” remain.

Understanding the challenges of how to assess and account for lease modifications is crucial for companies to ensure compliance and accurate financial reporting. “Lease modification” can refer to any of the following changes:

• Extending or shortening the lease terms;

• Changing the lease payments; and/or

• Altering the leased asset’s scope.

ASC 842 categorizes lease modifications into two types: those that result in a separate contract and those that do not. The key is determining which modifications result in treating as a separate contract (e.g. a new lease) and which are treated as modifications to an existing lease (e.g. keep the old lease but recompute the ROU assets and liabilities).

The existence of both of the following two conditions gives rise to the separate contract (e.g. new lease) scenario:

• Increase in scope: The modification adds the rights to use one or more underlying assets that were not part of the original lease, and

• Commencement at market rate: The increase in lease payments reflects the standalone price of the additional right-of-use asset, adjusted for current circumstances.

If both conditions are met, the modification is treated as a new lease and the existing lease remains unaffected. Both the lessee and the lessor recognize a new lease contract, and the lessee recognizes a new right-of-use asset and a corresponding lease liability, while the lessor recognizes a new lease receivable or investment in the lease (depending on whether the lease is a finance or operating lease). Both lessee and lessor recognize a new lease component, without adjusting the original lease.

When there are modifications that are not treated as a separate lease, these are accounted for as a change to an existing lease. This requires the remeasurement of the existing lease liability and ROU asset. The accounting treatment depends on whether the modification is considered a change in the lease scope or a change in the lease payments. Examples include:

• Change in lease term (increase or decrease)

• Change in the consideration per the lease (e.g. variable payment becomes fixed)

• Partial or complete termination of the lease

• Change in assessment of purchase option being exercised

• Change in amount probable of being owed under a residual value guarantee

• Change in scope caused by addition or removal of assets

Generally, this reassessment occurs at the time of a triggering event, which is the date that the modifications are recorded. Examples of triggering events:

• Start of construction of significant leasehold improvements

• Business decisions that make renewal reasonably certain

• Subleasing into a renewal period

• Other renegotiation points in time (e.g. lease concession from landlord)

What You Need to do Depends on the Type of Modification

Partial or Full Termination: If the modification partially or fully terminates the lease, the lessee will reduce the carrying amount of the ROU asset and lease liability to reflect the revised lease term or scope. Any difference between net carrying amount reduced and the consideration paid (received) for termination is recognized on the income statement as a gain or loss on lease modification.

Change in Terms: For modifications that amend the lease term, payments or other terms without terminating the lease, the lessee must remeasure the lease liability using a revised discount rate as of the effective date of the modification. The revised lease liability reflects the present value of the remaining lease payments under the modified lease terms. The lessee adjusts the ROU asset by the difference between the previous lease liability and the remeasured lease liability.

Change in Scope Without a New Lease Component: If a modification changes the scope of the lease (e.g., adding or removing the right to use a portion of the leased asset) without adding a new lease component, the lessee must reallocate the consideration in the contract to the modified lease components. The lease liability is remeasured, and the ROU asset is adjusted accordingly. If the remeasurement results in a reduction of the ROU asset to zero, any excess is recognized in profit or loss.

The following chart illustrates what changes when the remeasurement or modification accounting is required:

Lessee vs. Lessor Accounting

The accounting treatment for lease modifications differs between lessees and lessors. Lessors must also consider whether the modification results in a separate lease or a continuation of the existing lease.

Operating Leases: For lessors with operating leases, if the modification is not accounted for as a separate lease, the lessor continues to recognize the lease income under the modified terms. The lessor will reassess the lease classification if the modification results in a substantial change to the lease.

Finance Leases: For lessors with finance leases, modifications that do not create a separate lease are accounted for by adjusting the net investment in the lease and recognizing any impact in profit or loss. The lessor must reassess the lease classification under the modified terms to determine if it remains a finance lease or should be reclassified.

ASC 842 requires companies to disclose the nature and financial impact of lease modifications in their financial statements.

When reassessing modifications, keep in mind:

• Lease modifications need to be identified and assessed promptly (e.g. on a triggering date).

• Discount rates need to be reassessed given current interest rate environment, credit profiles, collateral requirements and updated lease terms.

• Remeasuring and reallocating lease liabilities requires professional judgment, especially when there are multiple lease components or variable lease payments.

Evaluating lease modifications under FASB ASC 842 requires diligent assessment and evaluation of new lease accounting terms. Look to FASB ASC 842-10-55-159 through 254 for guidance on how to account for lease modifications.