8.6 Lease Modifications
8.6.1 Setting the Stage
ASC 842-10
15-6 An entity shall reassess whether a contract is or contains a lease only if the terms and conditions of the
contract are changed.
This section addresses phase 6 of the lease “life cycle,” which discusses guidance that a lessee would evaluate when determining how to account for a modified lease.
Connecting the Dots
Rent Concessions Provided as a Result of COVID-19
In response to the COVID-19 pandemic, the FASB provided
both lessees and lessors with relief related to accounting for rent
concessions resulting from COVID-19. An entity that elects to apply the
relief to qualifying concessions may choose to account for the
concessions by either (1) applying the modification framework for these
concessions in accordance with ASC 840 or ASC 842, as applicable, or (2)
accounting for the concessions as if they were made under the
enforceable rights included in the original agreement and are thus
outside of the modification framework. See Section 17.3.4 for more
information.
8.6.1.1 Definition and Overview
A modification is a change in any of the terms and conditions of a contract. In accordance with ASC 842-10-15-6, when a contract is modified, the entity would need to reevaluate the contract to determine whether the modification affects its conclusions under ASC 842.
ASC 842-10-15-6 states, “An entity shall reassess whether a
contract is or contains a lease only if the terms and
conditions of the contract are changed” (emphasis added). In
contrast, the ASC master glossary defines a lease modification as
follows:
A change to the terms and conditions of a
contract that results in a change in the scope of or
the consideration for a lease (for example, a change to the
terms and conditions of the contract that adds or terminates the right
to use one or more underlying assets or extends or shortens the
contractual lease term). [Emphasis added]
This difference in wording has led some to question what
types of changes trigger a requirement to reassess whether a contract is or
contains a lease.
This question is particularly significant for entities that,
in making the transition to the new leasing standard, elected the practical
expedient package in ASC 842-10-65-1(f) that allowed them to (among other
things) not revisit whether a contract is or contains a lease under the
definition in ASC 842. Therefore, if an entity that has adopted the new
leasing standard is required to reassess whether such a “grandfathered”
contract is or contains a lease under the definition in ASC 842, a change in
that conclusion may be more likely than it would be if the initial
assessment had taken place under ASC 842.
We believe that an entity should reassess whether a contract
is or contains a lease whenever a substantive15 change is made to the terms and conditions of the contract. Such
changes are not limited to those that meet the definition of a lease
modification, which is a specific type of modification characterized by a
change in the scope of or consideration for a lease. When a modification
does not meet the definition of a lease modification, an entity should
reassess whether the contract is or contains a lease but would not apply the
lease modification framework (as discussed in the remainder of Section 8.6 and in
Section
9.3.4) if the conclusion regarding whether the contract is or
contains a lease is unchanged.
If a contract formerly did not contain a lease but, after a
modification, is deemed to contain one, the contract should be accounted for
under ASC 842 as if it were a newly originated lease (see Sections 8.4.2 and
9.3.2). If,
after a modification, a contract that formerly contained a lease is deemed
to no longer contain one, the change should be accounted for as a lease
termination (see Sections
8.7.2 and 9.3.5).
Example 8-19
Lessor and Lessee enter into a
contract that conveys to Lessee the right to use an
identified piece of equipment for five years. Both
parties conclude that the contract contains a lease
of the equipment. At the end of the third year, the
parties agree to modify the terms and conditions of
the contract to give Lessor a substitution right (no
other changes are made). Provided that this
modification has economic substance, both parties
should evaluate whether the contract still contains
a lease. If it does, the lease modification
framework should not be
applied since the scope of or consideration for the
lease has not changed. However, if the contract no
longer contains a lease, the modification should be
accounted for as the termination of the lease and
the parties should account for the modified contract
in accordance with other applicable GAAP.
The decision tree below illustrates the concepts discussed
above.
8.6.1.2 Decision Tree on Accounting for Modifications
8.6.2 Modifications Accounted for as a Separate Contract
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 (for example, the right to use an additional asset).
-
The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract. For example, the standalone price for the lease of one floor of an office building in which the lessee already leases other floors in that building may be different from the standalone price of a similar floor in a different office building, because it was not necessary for a lessor to incur costs that it would have incurred for a new lessee.
When the modification is considered a separate contract on the
basis of the guidance in ASC 842-10-25-8, the lessee would account for the
modified lease as if it were a stand-alone lease and apply the new requirements
to the separate contract. Therefore, after the modification, the lessee would
account for the agreement as two separate contracts: (1) the original,
unmodified contract and (2) a separate contract for the additional right of use
that is accounted for in a manner similar to the accounting for a new lease.
Connecting the Dots
Accounting for a Modification as a Separate Contract
One of the conditions in ASC 842-10-25-8 for accounting
for a modification as a separate contract is that “[t]he modification
grants the lessee an additional right of use not included in the
original lease (for example, the right to use an additional asset).” The
“additional right of use” needs to be an additional asset or lease
component that differs from that included in the original contract
(i.e., extension of the lease term for an asset already subject to the
lease would not be considered an additional
right of use).
This view is consistent with the discussion in paragraph
BC176(b) of ASU 2016-02, which states, in part:
A
modification of the type [that extends or reduces the term of an
existing lease] does not grant an additional right of use. Rather,
it merely changes an attribute of the lessee’s existing right to use
the underlying asset that it already controls. That is because the
duration of the lessee’s right of use (for example, 2, 5, or 10
years) is merely an attribute of that right of use in the same way
that the specifications of a piece of equipment (for example, its
color or functioning speed) are attributes of that tangible asset.
8.6.2.1 Lease Modification With Additional Right of Use and Changes to Existing Right of Use
A lessee and lessor may agree to modify a lease to both (1)
include an additional right of use at its stand-alone price and (2) change
the scope of or consideration for the existing right of use. In such cases,
the parties to the lease cannot account for the additional right of use as a
separate contract.
For an entity to be able to apply the guidance in ASC
842-10-25-8, the only change to the lease contract can be the addition of a
right of use not included in the original contract, with a corresponding
increase in the lease payments commensurate with the stand-alone price for
the additional right of use. If there are any changes to the scope of or
consideration for the existing right of use, the entity should apply the
modification guidance discussed in Section 8.6.3 (for lessees) or
Section
9.3.4 (for lessors). This view is consistent with the
discussion in paragraph BC172 of ASU 2016-02.
8.6.2.2 Forward-Starting Lease for an Asset Subject to an Existing Lease
A lessee may have an existing lease and sign a separate
lease contract for the same asset with the same lessor, which will commence
when the existing lease expires (i.e., a “forward-starting lease”). In such
cases, the lessee and lessor cannot account for the forward-starting lease
as a separate contract.
An extension of the duration of the right to use the same
asset by definition cannot be an “additional asset” as that phrase is used
in ASC 842-10-25-8. Therefore, any extension of the period of use of an
asset subject to an existing lease, even if written as a separate contract,
must be accounted for as a lease modification that extends the term of the
existing lease rather than as a separate contract. A lessee effectively
treats a modification that extends the term of an existing lease as a new
lease that commences on the date of the modification (see Section 8.6.3.4 for
additional information). See the Connecting the Dots in Section 9.3.4 for
considerations related to how a lessor evaluates the extension of the term
of an existing lease.
Example 8-20
Company Z signs a five-year lease
for the right to use office space, with a
commencement date of January 1, 2020. On January 1,
2024, Z signs a new three-year lease for the right
to use the same office space with different payment
terms and a commencement date of January 1, 2025
(i.e., the day after the expiration of the original
five-year contract). Company Z does not treat the
three-year forward-starting lease as a separate
contract in accordance with ASC 842-10-25-8
(irrespective of whether the payments are at
market). Rather, Z accounts for the forward-starting
lease as an extension of the term of the original
lease, which creates a “new” four-year lease that
includes the last year of the first contract plus
the additional three years in the extension.
Accordingly, Z should remeasure the lease liability
for the “new” four-year lease, as discussed in
Section 8.6.3.4. Similarly, the lessor
in the arrangement would account for the
forward-starting lease as a modification of the
existing lease rather than as a separate
contract.
The example below from ASC 842-10-55-160 and 55-161
illustrates a scenario in which a modification is accounted for as a
separate contract.
ASC 842-10
55-160 Lessee enters into a
10-year lease for 10,000 square feet of office
space. At the beginning of Year 6, Lessee and Lessor
agree to modify the lease for the remaining 5 years
to include an additional 10,000 square feet of
office space in the same building. The increase in
the lease payments is commensurate with the market
rate at the date the modification is agreed for the
additional 10,000 square feet of office space.
55-161 Lessee accounts for
the modification as a new contract, separate from
the original contract. This is because the
modification grants Lessee an additional right of
use as compared with the original contract, and the
increase in the lease payments is commensurate with
the standalone price of the additional right of use.
Accordingly, from the effective date of the
modification, Lessee would have 2 separate
contracts, each of which contain a single lease
component — the original, unmodified contract for
10,000 square feet of office space and the new
contract for 10,000 additional square feet of office
space, respectively. Lessee would not make any
adjustments to the accounting for the original lease
as a result of this modification.
8.6.3 Modification Is Not Accounted for as a Separate Contract
ASC 842-10
25-9 If a lease is modified and
that modification is not accounted for as a separate
contract in accordance with paragraph 842-10-25-8, the
entity shall reassess the classification of the lease in
accordance with paragraph 842-10-25-1 as of the
effective date of the modification.
25-11 A lessee shall reallocate
the remaining consideration in the contract and
remeasure the lease liability using a discount rate for
the lease determined at the effective date of the
modification if a contract modification does any of the
following:
-
Grants the lessee an additional right of use not included in the original contract (and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8)
-
Extends or reduces the term of an existing lease (for example, changes the lease term from five to eight years or vice versa), other than through the exercise of a contractual option to extend or terminate the lease (as described in paragraph 842-20-35-5)
-
Fully or partially terminates an existing lease (for example, reduces the assets subject to the lease)
-
Changes the consideration in the contract only.
8.6.3.1 Accounting by Modification Type
The table below summarizes
the accounting for modifications that are not accounted for as a separate
contract.
|
Modification Type
|
Roadmap Section
|
Lessee Accounting
|
|---|---|---|
|
Modification that extends or reduces
the lease term of an existing lease (other than
through exercise of an option)
|
8.6.3.4
|
The three modification types to the
left will be accounted for in the following
manner:
|
|
Modification that grants the lessee
an additional right of use not included in the
original contract and that is not accounted for as a
separate contract
|
8.6.3.5
| |
|
Modification that only changes the
consideration in the contract
|
8.6.3.6
| |
|
Modification that decreases the
scope of the lease through a full or partial
termination
|
8.6.3.7
|
The modification type to the left
will be accounted for in the following manner:
|
8.6.3.2 Accounting for Initial Direct Costs, Lease Incentives, and Other Payments Made in Connection With a Modification
ASC 842-10
25-10 An entity shall account
for initial direct costs, lease incentives, and any
other payments made to or by the entity in
connection with a modification to a lease in the
same manner as those items would be accounted for in
connection with a new lease.
In a modification, as in a newly executed lease, a lessee
may (1) incur initial direct costs, (2) be required to prepay a portion of
the rent, or (3) receive an incentive from the lessor. In each of these
cases, the lessee would account for these amounts in the same manner as it
would account for them under a new lease.
Connecting the Dots
Considerations Related to
Premodification Initial Direct Costs and Lease
Incentives
The lessee modification guidance in ASC 842 has no
impact on previously recognized initial direct costs and lease
incentives since the amounts associated with these items are already
reflected in the premodification ROU asset. Therefore, when a lease
is modified, only those new, additional initial direct costs,
prepaid rent, and lease incentives would result in an incremental
adjustment to the ROU asset.
8.6.3.3 Modification in Which Classification Changes From Finance Lease to Operating Lease
ASC 842-10
25-14 If a finance lease is
modified and the modified lease is classified as an
operating lease, any difference between the carrying
amount of the right-of-use asset after recording the
adjustment required by paragraph 842-10-25-12 or
842-10-25-13 and the carrying amount of the
right-of-use asset that would result from applying
the initial operating right-of-use asset measurement
guidance in paragraph 842-20-30-5 to the modified
lease shall be accounted for in the same manner as a
rent prepayment or a lease incentive.
While the interest expense and amortization expense
components of a lease’s total cost are measured and presented independently
of one another in a finance lease, expense in an operating lease is
recognized on a straight-line basis over the lease term. Because total lease
cost is recognized on a straight-line basis, the amortization component of
total lease cost is interdependent with the amount of interest expense
recorded in each period (see ASC 842-20-25-6 and Section 8.4.3.2 of this Roadmap for
more information about subsequent measurement of an operating lease and
determination of single lease cost). When an operating lease is initially
measured, any difference in the lease liability and ROU asset balance, such
as a prepaid lease or lease incentive, is accreted/amortized over the term
of the lease through this straight-line lease expense.
ASC 842-10-25-14 states that when a lease previously
classified as a finance lease becomes an operating lease as a result of a
lease modification, “any difference between the carrying amount of the [ROU]
asset after recording the adjustment required by paragraph 842-10-25-12 or
842-10-25-13 and the carrying amount of the [ROU] asset that would result
from applying the initial operating [ROU] asset measurement guidance in
paragraph 842-20-30-5” is treated similarly to a lease incentive or rent
prepayment. Differences between the lease liability and ROU asset as of the
effective date of the modification are likely to exist given expense
recognition patterns for a finance lease, since the ROU asset is generally
amortized on a straight-line basis whereas the lease liability is accreted
by using the effective interest rate method (see Section 8.4.3.1 for more information
about subsequent measurement of a finance lease). In effect, this guidance
dictates that the difference between the lease liability and ROU asset
immediately before the modification is accreted through the revised
straight-line lease expense in a manner similar to how the difference
between the ROU asset and lease liability as a result of lease incentives or
prepayments is treated in the subsequent measurement of a new operating
lease. This accretion serves to reduce the straight-line expense recognized
for the operating lease after the modification and reflects the fact that
the premodification classification led to a front-loaded expense pattern
(the front-loaded amount serves to reduce the operating lease expense and is
spread evenly over the remaining lease term to preserve a straight-line
pattern after the modification).
The example below illustrates the subsequent measurement of
a lease that is initially classified as a finance lease but subsequently
classified as an operating lease as a result of a lease modification.
Example 8-21
On January 1, 20X1, Company P (the
lessee) enters into an agreement with Company D (the
lessor) to lease office equipment for six years. In
addition, P has an option to renew the lease for one
additional year and determines that it is reasonably
certain to exercise this option. Lease payments are
made annually in arrears for fixed amounts of
$10,000, and P uses an incremental borrowing rate of
8 percent. The arrangement does not contain any
termination or purchase options, and there are no
residual value guarantees. Further, there are no
lease incentives, rent prepayments, or variable
lease payments. The economic life of the leased
asset is eight years, and the fair value of the
leased asset is $70,000 at commencement.
Given that the renewal option at
commencement is reasonably certain, P determines
that the lease term is seven years. In a manner
consistent with the approach outlined in ASC
842-10-55-2(a), P concludes that 75 percent or more
of the remaining economic life of the underlying
asset represents a major part of its remaining
economic life. Accordingly, P determines that the
criterion in ASC 842-10-25-2(c) is met and
classifies the lease as a finance lease, since the
lease represents 87.5 percent of the asset’s
remaining economic life (seven-year term divided by
eight-year economic life). Company P determines that
no other criteria in ASC 842-10-25-2 are met that
would result in a finance lease classification.
At lease commencement, P calculates
a lease liability and ROU asset of $52,064 on the
basis of the present value of the lease payments.
Company P records annual interest expense and
amortization in the following manner:
On January 1, 20X3, P and D agree to
reduce the term of the lease to five years (three
years remaining as of January 1, 20X3) and eliminate
the renewal option. No other terms of the original
lease agreement are amended by the modification, and
no additional payments are made. Because no
additional right of use is granted through the lease
modification, the modification is not accounted for
as a separate contract under ASC 842-10-25-8.
Company P’s incremental borrowing rate on the
effective date of the modification remains at 8
percent. The lease liability and ROU asset balance
immediately before the lease modification are
$39,927 and $37,188, respectively.
Company P remeasures the lease
liability on the basis of the remaining payments of
$10,000 per year for the revised lease term of three
years and determines that the modified lease
liability equals $25,771. Thus, P reduces its lease
liability by $14,156 and records an offsetting entry
to the ROU asset balance;16 accordingly, P’s ROU asset balance is reduced
to $23,032 as a result of the modification. The
related journal entry is as follows:
Company P performs a lease
classification test as of the modification date and
determines that the major part of the economic life
criterion is no longer met, since the revised lease
term of three years only represents 50 percent of
the remaining economic life (three-year term divided
by six-year remaining economic life). Because P
determines that no other criteria in ASC 842-10-25-2
that would result in finance lease classification
are met, P classifies the modified lease as an
operating lease.
Company P measures its revised lease
cost in a manner commensurate with the straight-line
recognition expense profile for operating leases.
This amount is calculated on the basis of the total
remaining lease payments of $30,000, adjusted for
the difference between the carrying amount of the
ROU asset balance after the adjustment for ASC
842-10-25-12 is recorded (i.e., the $14,156
reduction as a result of the remeasured lease
liability from the reduction in the lease term) and
what the carrying amount of the ROU asset would have
been after the guidance on initial measurement is
applied in accordance with ASC 842-20-30-5 (i.e.,
the initial measurement of a new ROU asset).17 As shown below, this amount reduces the
remaining cost in the lease by $2,739 for a total
straight-line lease expense of $9,087 per year.
As a result, P will account for the
lease liability and ROU asset balances after the
effective date of the modification as follows:18
8.6.3.4 Modification That Extends or Reduces the Lease Term of an Existing Lease (Other Than Through Exercise of an Option)
ASC 842-10
25-11 A lessee shall
reallocate the remaining consideration in the
contract and remeasure the lease liability using a
discount rate for the lease determined at the
effective date of the modification if a contract
modification does any of the following: . . .
b. Extends or reduces the term of an existing
lease (for example, changes the lease term from
five to eight years or vice versa), other than
through the exercise of a contractual option to
extend or terminate the lease (as described in
paragraph 842-20-35-5) . . .
25-12 In the case of [(b)] in
paragraph 842-10-25-11, the lessee shall recognize
the amount of the remeasurement of the lease
liability for the modified lease as an adjustment to
the corresponding right-of-use asset.
When a lease modification extends or reduces the lease term
(other than through the exercise of options included in the lease), a lessee
must remeasure and reallocate the consideration of the contract (see
Chapter 4).
In addition, the lessee would reassess lease classification on the basis of
the relevant assumptions that exist as of the effective date of the
modification (see Section
8.3.4).
As a result of the modification, the lessee would remeasure
its lease liability and recognize the amount resulting from the
remeasurement of the lease liability as an adjustment to the corresponding
ROU asset. That is, the lessee would recognize the difference between the
remeasured lease liability and the premodification lease liability as an
adjustment to the ROU asset.
Since the remeasurement amount is directly recognized as an
adjustment to the ROU asset, no income statement impact is associated with
this type of modification.
Scenarios in which a lessee extends or reduces the lease
term through the exercise of a renewal or termination option already
included in the lease are not considered lease modifications (see Section 8.5.1 for
additional discussion).
8.6.3.4.1 Illustrative Example — Modification Extends Lease Term but No Change in Lease Classification
ASC 842-10
Example 16 — Modification
That Increases the Lease Term
Case A — No Change in Lease
Classification
55-162 Lessee and Lessor
enter into a 10-year lease for 10,000 square feet
of office space in a building with a remaining
economic life of 50 years. Annual payments are
$100,000, paid in arrears. Lessee’s incremental
borrowing rate at the commencement date is 6
percent. The lease is classified as an operating
lease. At the beginning of Year 6, Lessee and
Lessor agree to modify the lease such that the
total lease term increases from 10 years to 15
years. The annual lease payments increase to
$110,000 per year for the remaining 10 years after
the modification. Lessee’s incremental borrowing
rate is 7 percent at the date the modification is
agreed to by the parties.
55-163 At the beginning of
Year 6, Lessee’s lease liability and its
right-of-use asset both equal $421,236 (that is,
because the lease payments are made annually in
arrears and because the lease payments are even
throughout the lease term, the lease liability and
right-of-use asset will be equal).
55-164 The modification does
not grant an additional right of use to the
lessee; rather, it changes (modifies) an attribute
of the right to use the 10,000 square feet of
office space Lessee already controls. That is,
after the modification, Lessee still controls only
a single right of use transferred to Lessee at the
original lease commencement date.
55-165 Because the
modification does not grant Lessee an additional
right of use, the modification cannot be a
separate contract. Therefore, at the effective
date of the modification, Lessee reassesses
classification of the lease (which does not change
in this Example — see Case B [paragraphs
842-10-55-166 through 55-167] for a change in
lease classification) and remeasures the lease
liability on the basis of the 10-year remaining
lease term, 10 remaining payments of $110,000, and
its incremental borrowing rate at the effective
date of the modification of 7 percent.
Consequently, the modified lease liability equals
$772,594. The increase to the lease liability of
$351,358 is recorded as an adjustment to the
right-of-use asset (that is, there is no income or
loss effect from the modification).
Below is an additional analysis of certain aspects of
the FASB’s example above.
Remeasurement of the Lease Liability
The new lease liability
is calculated as the present value of the revised lease payments for the
extended 10-year term. The calculation results in a lease liability of
$772,594; therefore, a $351,358 adjustment is recorded as an increase to
the premodification liability balance of $421,236 at the beginning of
year 6. In addition, in a manner consistent with the guidance in ASC
842-10-25-12, the lessee would similarly recognize an increase to the
ROU asset. The resulting entry is as follows:
Determining the Revised Lease Cost
In a manner consistent
with ASC 842-20-25-8, the lessee calculates the remaining lease cost of
the operating lease as of the modification date as the total lease
payments (both paid and not yet paid), adjusted by the periodic lease
cost recognized in prior periods. The resulting revised lease cost is
recognized on a straight-line basis over the remaining lease term. The
table below illustrates these calculations.
8.6.3.4.2 Illustrative Example — Modification Extends Lease Term and Lease Classification Changes
ASC 842-10
Example 16 — Modification That
Increases the Lease Term
Case B — Change in Lease
Classification
55-166 Assume the same facts
as in Case A (paragraphs 842-10-55-162 through
55-165), except that the underlying asset is a piece
of equipment with a 12-year remaining economic life
at the effective date of the modification.
Consequently, when the lessee reassesses
classification of the lease in accordance with
paragraph 842-10-25-1 as of the effective date of
the modification based on the modified rights and
obligations of the parties, the lessee classifies
the modified lease as a finance lease (that is,
because the remaining lease term of 10 years is for
a major part of the 12-year remaining economic life
of the equipment).
55-167 Consistent with Case
A, at the effective date of the modification, the
lessee remeasures its lease liability based on the
10-year remaining lease term, 10 remaining payments
of $110,000, and its incremental borrowing rate of 7
percent. Consequently, the modified lease liability
equals $772,594. The increase to the lease liability
of $351,358 is recorded as an adjustment to the
right-of-use asset (that is, there is no income or
loss effect from the modification). However,
different from Case A, beginning on the effective
date of the modification, Lessee accounts for the
10-year modified lease as a finance lease.
Below is an additional analysis of certain aspects of the
FASB’s example above.
8.6.3.4.2.1 Remeasurement of the Lease Liability
The new lease liability
is calculated as the present value of the revised lease payments for the
extended 10-year term. The calculation results in a lease liability of
$772,594, resulting in the need for a $351,358 adjustment to the
premodification liability balance of $421,236 at the beginning of year
6. In addition, in a manner consistent with the guidance in ASC
842-10-25-12, the lessee would similarly recognize an adjustment to the
premodification ROU asset balance of $421,236 at the beginning of year
6. The resulting entry is as follows:
8.6.3.4.2.2 Revised Expense Recognition Pattern
As a result of the modification, the lease
classification changed from an operating lease to a finance lease.
Therefore, as opposed to the recognition of lease expense (presented as
a single line item) on a straight-line basis, the subsequent measurement
as a finance lease results in the separate recognition of interest
expense and amortization expense. These two amounts would be presented
in a manner consistent with interest from debt and amortization or
depreciation of other nonfinancial assets.
In this example, the
lessee would recognize the following interest and amortization expense
each period:
8.6.3.5 Modification Granting the Lessee an Additional Right of Use Not Included in the Original Contract or Accounted for as a Separate Contract
ASC 842-10
25-11 A lessee shall
reallocate the remaining consideration in the
contract and remeasure the lease liability using a
discount rate for the lease determined at the
effective date of the modification if a contract
modification does any of the following:
-
Grants the lessee an additional right of use not included in the original contract (and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8) . . . .
25-12 In the case of [(a)] in
paragraph 842-10-25-11, the lessee shall recognize
the amount of the remeasurement of the lease
liability for the modified lease as an adjustment to
the corresponding right-of-use asset.
When a lease modification grants the lessee an additional
right of use that is not included in the original contract and that does not
meet both of the criteria to be accounted for as a separate contract, a
lessee must remeasure and reallocate the consideration in the contract (see
Chapter 4).
In addition, the lessee would reassess lease classification on the basis of
the relevant assumptions that exist as of the effective date of the
modification (see Section
8.3.4).
As a result of the modification, the lessee would remeasure
its lease liability and recognize the amount resulting from the
remeasurement of the lease liability as an adjustment to the corresponding
ROU asset. That is, the lessee would recognize the difference between the
remeasured lease liability and the premodification lease liability as an
adjustment to the ROU asset.
Since the remeasurement amount is directly recognized as an
adjustment to the ROU asset, no income statement impact is associated with
this type of modification.
The example below from ASC 842-10-55-168 through 55-176
illustrates a modification in which an additional right of use is
granted.
ASC 842-10
Example 17 — Modification That
Grants an Additional Right of Use
55-168 Lessee enters into a
10-year lease for 10,000 square feet of office
space. The lease payments are $100,000 per year,
paid in arrears. Lessee’s incremental borrowing rate
at lease commencement is 6 percent. At the beginning
of Year 6, Lessee and Lessor agree to modify the
contract to include an additional 10,000 square feet
of office space on a different floor of the building
for the final 4 years of the original 10-year lease
term for a total annual fixed payment of $150,000
for the 20,000 square feet.
55-169 The increase in the
lease payments (of $50,000 per year) is at a
substantial discount to the market rate at the date
the modification is agreed to for leases
substantially similar to that for the new 10,000
square feet of office space that cannot be
attributed solely to the circumstances of the
contract. Consequently, Lessee does not account for
the modification as a separate contract.
55-170 Instead, Lessee
accounts for the modified contract, which contains 2
separate lease components — first, the original
10,000 square feet of office space and, second, the
right to use the additional 10,000 square feet of
office space for 4 years that commences 1 year after
the effective date of the modification. There are no
nonlease components of the modified contract. The
total lease payments, after the modification, are
$700,000 (1 payment of $100,000 + 4 payments of
$150,000).
55-171 Lessee allocates the
lease payments in the modified contract to the 2
separate lease components on a relative standalone
price basis, which, in this Example, results in the
allocation of $388,889 to the original space lease
and $311,111 to the additional space lease. The
allocation is based on the remaining lease terms of
each separate lease component (that is, 5 years for
the original 10,000-square-foot lease and 4 years
for the additional 10,000-square-foot lease). The
remaining lease cost for each separate lease
component is equal to the total payments, as
allocated, which will be recognized on a
straight-line basis over their respective lease
terms. Lessee remeasures the lease liability for the
original space lease as of the effective date of the
modification — the lease classification of which
does not change as a result of the modification — on
the basis of all of the following:
-
A remaining lease term of 5 years
-
Annual allocated lease payments of $77,778 in Years 6 through 10 (see paragraph 842-10-55-173)
-
Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.
55-172 The remeasured lease
liability for the original space lease equals
$318,904. Lessee recognizes the difference between
the carrying amount of the modified lease liability
and the carrying amount of the lease liability
immediately before the modification of $102,332
($421,236 – $318,904) as an adjustment to the
right-of-use asset.
55-173 During Year 6, Lessee
recognizes lease cost of $77,778. At the end of Year
6, Lessee makes its lease payment of $100,000, of
which $77,778 is allocated to the lease of the
original office space and $22,222 is allocated to
the lease of the additional office space as a
prepayment of rent. Lessee allocates the lease
payment in this manner to reflect even payments for
the even use of the separate lease components over
their respective lease terms.
55-174 At the commencement
date of the separate lease component for the
additional office space, which is 1 year after the
effective date of the modification, Lessee measures
and recognizes the lease liability at $241,896 on
the basis of all of the following:
-
A lease term of 4 years
-
Four allocated annual payments of $72,222 ([allocated lease payments of $311,111 − $22,222 rent prepayment] ÷ 4 years)
-
Lessee’s incremental borrowing rate at the commencement date of the separate lease component for the additional office space of 7.5 percent.
55-175 At the commencement
date, the right-of-use asset for the additional
office space lease component is recognized and
measured at $264,118 (the sum of the lease liability
of $241,896 and the prepaid rent asset of
$22,222).
55-176 During Years 7–10,
Lessee recognizes lease cost of $77,778 each year
for each separate lease component and allocates each
$150,000 annual lease payment of $77,778 to the
original office space lease and $72,222 to the
additional office space lease.
Below is an additional analysis related to the FASB’s
example above, including the key calculations, amortization schedule, and
journal entries. Assume that the space per square foot is economically
similar in nature such that each square foot should receive an equal
allocation of the revised contract consideration.
8.6.3.5.1 Evaluating Contract Components
As noted in ASC 842-10-55-170, Lessee accounts for the
modified contract as two separate lease components:
-
Component 1 — “[T]he original 10,000 square feet of office space.”
-
Component 2 — “[T]he right to use the additional 10,000 square feet of office space for 4 years that commences 1 year after the effective date of the modification.”
The modified contract does not include any nonlease
components. The total lease payments, after the modification, are $700,000
(1 payment of $100,000 + 4 payments of $150,000).
8.6.3.5.2 Allocating Consideration in the Contract
8.6.3.5.2.1 Determining Relative Stand-Alone Price
In accordance with ASC
842, Lessee would allocate the consideration to the separate lease
components in the contract on a relative stand-alone price basis. The
table below illustrates how to determine the allocation percentages that
will be used to allocate the consideration in the contract in the
example above for each of the two components in the contract (see
details in ASC 842-10-55-171).
8.6.3.5.2.2 Determining the Remaining Lease Cost for Each Component
ASC 842-10-55-171 notes
that, in this scenario, the “remaining lease cost for each separate
lease component is equal to the total payments, as allocated, which will
be recognized on a straight-line basis over their respective lease
terms.” The graphic below shows the related calculations.
8.6.3.5.3 Accounting for Component 1
For this component, lease classification did not change as a
result of the lease modification. As noted in ASC 842-10-55-171, “Lessee
remeasures the lease liability for the original space lease as of the
effective date of the modification.” This remeasurement is based on the
following facts:
-
“A remaining lease term of 5 years.”
-
“Annual allocated lease payments of $77,778 in Years 6 through 10” (calculated as the total consideration allocated of $388,889 divided by the five-year term), which are recognized on a straight-line basis over the remaining five years.
-
“Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.”
As indicated in ASC 842-10-55-172, “[t]he remeasured lease
liability for the original space lease equals $318,904,” which is calculated
as the present value of the lease payments allocated to Component 1,
discounted by using the 7 percent discount rate as of the effective date of
the modification. Further, “Lessee recognizes the difference between the
carrying amount of the modified lease liability and the carrying amount of
the lease liability immediately before the modification of $102,332
($421,236 – $318,904) as an adjustment to the right-of-use asset.”
The resulting calculations
for Component 1 are as follows:
8.6.3.5.3.1 Lease Liability and ROU Asset Remeasurement
The resulting journal
entry to reflect the change in the lease liability and ROU asset is as
follows:
The liability is reduced in this example because the
additional right of use is priced at a discount and this discount is
effectively split between the two postmodification lease components.
8.6.3.5.3.2 Lease Cost Recognition and Year 6 Payment Allocation
For the remainder of the
lease term (i.e., years 6–10), Lessee recognizes a lease cost of $77,778
for Component 1. As discussed in ASC 842-10-55-173, in year 6, Lessee is
required to make a lease payment of $100,000, which represents $77,778
of lease cost related to Component 1 for year 6 and $22,222 related to a
prepayment of Component 2. That is, Lessee records the following journal
entry:
8.6.3.5.4 Accounting for Component 2
Lessee determined that this lease component is classified as
an operating lease. As noted in ASC 842-10-55-174, “[a]t the commencement
date of the separate lease component for the additional office space, which
is 1 year after the effective date of the modification, Lessee measures and
recognizes the lease liability at $241,896.” This measurement and
recognition are based on the following facts listed in ASC 842-10-55-174:
-
“A lease term of 4 years.”
-
“Four allocated annual payments of $72,222 ([allocated lease payments of $311,111 − $22,222 rent prepayment] ÷ 4 years).” Note that in year 6, before the commencement of the lease for Component 2, the lessee made a payment of $100,000, of which $77,778 was allocated to Component 1 and $22,222 was allocated to Component 2.
-
“Lessee’s incremental borrowing rate at the commencement date of the separate lease component for the additional office space of 7.5 percent.”
As indicated in ASC 842-10-55-175, the ROU asset equals
$264,118, which is calculated as the lease liability of $241,896 plus the
prepaid rent asset of $22,222.
The resulting calculations
for Component 2 are as follows:
8.6.3.5.4.1 Lease Liability and ROU Asset Recognition
The resulting journal
entry is recorded at the beginning of period 7 to reflect the
recognition of the lease liability and ROU asset related to Component
2:
8.6.3.5.4.2 Lease Cost Recognition
For the remainder of the lease term (i.e., years 7–10),
Lessee recognizes a lease cost of $77,778 for Component 2.
8.6.3.5.4.2.1 Lease Payment Allocation (Years 7–10)
As discussed in ASC 842-10-55-176, Lessee allocates
$77,778 of the $150,000 annual lease payment to Component 1 and
$72,222 to Component 2.
8.6.3.6 Modification That Changes Only the Consideration in the Contract
ASC 842-10
25-11 A lessee shall
reallocate the remaining consideration in the
contract and remeasure the lease liability using a
discount rate for the lease determined at the
effective date of the modification if a contract
modification does any of the following: . . .
d. Changes the consideration in the contract
only.
25-12 In the case of [(d)] in
paragraph 842-10-25-11, the lessee shall recognize
the amount of the remeasurement of the lease
liability for the modified lease as an adjustment to
the corresponding right-of-use asset.
When a lease modification changes only the consideration in
the contract, a lessee must remeasure and reallocate the consideration in
the contract (see Chapter
4). In addition, the lessee would reassess lease
classification on the basis of the relevant assumptions that exist as of the
effective date of the modification (see Section 8.3.4).
As a result of the modification, the lessee would remeasure
its lease liability and recognize the amount resulting from the
remeasurement of the lease liability as an adjustment to the corresponding
ROU asset. That is, the lessee would recognize the difference between the
remeasured lease liability and the premodification lease liability as an
adjustment to the ROU asset.
Since the remeasurement amount is directly recognized as an
adjustment to the ROU asset, no income statement impact is associated with
this type of modification.
The example below from ASC 842-10-55-186 through 55-189
illustrates a modification in which only the lease payments are changed.
ASC 842-10
Example 19 — Modification That
Changes the Lease Payments Only
55-186 Lessee enters into a
10-year lease for 10,000 square feet of office
space. The lease payments are $95,000 in Year 1,
paid in arrears, and increase by $1,000 every year
thereafter. The original discount rate for the lease
is 6 percent. The lease is an operating lease. At
the beginning of Year 6, Lessee and Lessor agree to
modify the original lease for the remaining 5 years
to reduce the lease payments by $7,000 each year
(that is, the lease payments will be $93,000 in Year
6 and will continue to increase by $1,000 every year
thereafter). The modification only changes the lease
payments and, therefore, cannot be accounted for as
a separate contract. The classification of the lease
does not change as a result of the modification.
55-187 Lessee remeasures the
lease liability for the modified lease on the basis
of all of the following:
-
Remaining lease term of 5 years
-
Payments of $93,000 in Year 6, increasing by $1,000 each year for the remainder of the lease term
-
Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.
55-188 The remeasured lease
liability equals $388,965. Lessee recognizes the
difference between the carrying amount of the
modified lease liability and the lease liability
immediately before the effective date of the
modification of $40,206 ($429,171 premodification
lease liability – $388,965 modified lease liability)
as a corresponding reduction to the right-of-use
asset. Therefore, the adjusted right-of-use asset
equals $376,465 as of the effective date of the
modification. Lessee calculates its remaining lease
cost as $462,500 (the sum of the total lease
payments, as adjusted for the effects of the lease
modification, of $960,000 reduced by the total lease
cost recognized in prior periods of $497,500), which
it will recognize on a straight-line basis over the
remaining lease term.
55-189 During Year 6, Lessee
recognizes lease cost of $92,500 ($462,500 remaining
lease cost ÷ 5 years). As of the end of Year 6,
Lessee’s lease liability equals $323,193 (present
value of the remaining lease payments, discounted at
7 percent), and its right-of-use asset equals
$311,193 (the balance of the lease liability – the
remaining accrued rent balance of $12,000). Lessee
recognizes additional lease cost of $92,500 each
year of the remaining lease term and measures its
lease liability and right-of-use asset in the same
manner as at the end of Year 6 each remaining year
of the lease term. The following are the balances of
the lease liability and the right-of-use asset at
the end of Years 7 through 10 of the lease.
The table below summarizes
the calculations related to the lease liability and ROU asset in the example
above.
Before the modification, the annual lease cost is the sum of
all lease payments ($995,000) allocated on a straight-line basis over the
10-year lease term.
8.6.3.6.1 Remeasurement of the Lease Liability and ROU Asset
The new lease liability on
the effective date of the modification is calculated as the present value of
the revised lease payments for the remaining lease term. The calculation
results in a lease liability of $388,965; therefore, a $40,206 adjustment is
needed at the beginning of year 6. In addition, in a manner consistent with
the guidance in ASC 842-10-25-12, the lessee would recognize an offsetting
entry in the amount of the remeasurement of the lease liability for the
modified lease as an adjustment to the corresponding ROU asset. The lessee
records the following journal entry:
8.6.3.6.2 Determining the Revised Lease Cost
In a manner consistent with ASC 842-20-25-8, the lessee
would calculate the remaining lease cost of the operating lease as of the
modification date as the total lease payments (both paid and not yet paid),
adjusted by the periodic lease cost recognized in prior periods. The
resulting revised lease cost would be recognized on a straight-line basis
over the remaining lease term.
In this example, the
calculation of the remaining lease cost would be as follows:
8.6.3.7 Modification Decreases the Scope of the Lease (a Full or Partial Termination)
ASC 842-10
25-11 A lessee shall
reallocate the remaining consideration in the
contract and remeasure the lease liability using a
discount rate for the lease determined at the
effective date of the modification if a contract
modification does any of the following: . . .
c. Fully or partially terminates an existing
lease (for example, reduces the assets subject to
the lease) . . . .
25-13 In the case of (c) in
paragraph 842-10-25-11, the lessee shall decrease
the carrying amount of the right-of-use asset on a
basis proportionate to the full or partial
termination of the existing lease. Any difference
between the reduction in the lease liability and the
proportionate reduction in the right-of-use asset
shall be recognized as a gain or a loss at the
effective date of the modification.
When a lease modification reduces the scope of a lease
through a full or partial termination of the lease (i.e., reduces the
underlying asset that is available for use by the lessee — for example, by
reducing the square footage leased in a building or by removing a lease
component from an arrangement containing multiple lease components), a
lessee must remeasure and reallocate the consideration in the contract (see
Chapter 4).
In addition, the lessee would reassess lease classification on the basis of
the relevant assumptions that exist as of the effective date of the
modification (see Section
8.3.4). The resulting accounting for a lease modification
that reduces the scope of a lease depends on whether it is a full or partial
termination:
-
Accounting for a full termination — In the case of a full termination, the lessee would derecognize the lease liability and ROU asset. The difference would be recognized in the income statement as a gain or loss.
-
Accounting for a partial termination — In the case of a partial termination, the lessee would first remeasure its lease liability and reflect the change as an adjustment to the premodification lease liability. The lessee would then reduce the ROU asset on a proportionate basis. Any difference between the proportionate reduction in the ROU asset and corresponding lease liability is recognized in the income statement as a gain or a loss on the effective date of the modification.
Connecting the Dots
Full or Partial Termination
of One or More (but Not All) Lease Components19
Entities often enter into lease contracts that
include multiple underlying assets accounted for as separate lease
components in accordance with ASC 842-10-15-28. As discussed in
Section
8.6.3.5, when a lease modification grants a lessee an
additional right of use that is not included in the original
contract (provided that the lease payments do not increase in a
manner commensurate with the stand-alone price), the lessee must
apply modification accounting to all the
lease components in the contract. Similarly, a change in the terms
or conditions of a contract with several lease components that
results in a full or partial termination of one or more (but not
all) of the lease components constitutes a modification of the
entire contract. Therefore, the lessee would reallocate the
consideration in the contract on the basis of modification-date
stand-alone prices and would reassess lease classification and
remeasure the lease liability for all the
remaining lease components.
According to the implementation guidance in ASC 842, there
are two alternative approaches for reducing the ROU asset when a
modification results in the reduction of the scope of the lease.
-
Approach 1: Remeasure the ROU asset on the basis of the liability change — Under this approach, the lessee would first remeasure its lease liability on the basis of the revised lease payments. The lessee would then determine the percentage reduction in the lease liability by comparing the remeasured liability with the premodification liability. The resulting percentage would be applied to the premodification ROU asset, and any difference between the lease liability adjustment and the resulting ROU asset adjustment amount would be recognized in the income statement as a gain or loss.
-
Approach 2: Remeasure the ROU asset on the basis of the ROU asset reduction — Under this approach, the lessee would first remeasure its lease liability on the basis of the revised lease payments. The lessee would then determine the percentage reduction in the physical space or productive capacity that resulted from the lease modification. In the determination of the postmodification carrying amount, the resulting percentage would be applied to the premodification liability and premodification ROU asset, resulting in both of the following:
-
Any difference between the change in the premodification liability and postmodification liability and the change in the premodification ROU asset and postmodification ROU asset would be recognized in the income statement as a gain or loss.
-
Any difference between the remaining lease liability and the remeasured lease liability, calculated by using the proportionate change resulting from the reduction of the physical right of use and the present value of the postmodification lease payments, would be recognized as an adjustment to the ROU asset, reflecting the change in the consideration paid for the lease and the revised discount rate.
-
Connecting the Dots
Modifications That Decrease
the ROU Asset
The implementation guidance in ASC 842 provides two
viable approaches for remeasuring a ROU asset as a result of a lease
modification that decreases the scope of the lease. We believe that
the approach for remeasuring the ROU asset as a result of a
modification that decreases the scope of a lessee’s right of use is
an accounting policy election and, therefore, should be applied
consistently to all similar types of modifications. In addition, we
believe that a lessee should disclose its elected accounting policy
if the impact of this policy is material to its financial
statements.
8.6.3.7.1 Penalty for a Partial Termination
The parties in an existing lease may agree to terminate
the lessee’s right to use (1) some of the assets under the lease (e.g.,
discrete pieces of equipment) or (2) a portion of an asset (e.g., one of
several leased floors in an office building). In some cases, the lessee
might agree to increase the lease payments for the remaining portion of
the lease. Previously, under ASC 840, lessees were required to evaluate
whether such an increase in lease payments was, in substance, a
termination penalty (which would be recognized as an expense
immediately) or only a modification of future lease payments (which
would be accounted for prospectively over the remaining lease term).20 However, ASC 842 does not contain similar guidance and instead
requires both parties to apply the new modification framework.
In such circumstances, the lessee should treat the
increased lease payments as part of the revised consideration in the
modified contract and should allocate the payments to the remaining
lease and nonlease components. Specifically, ASC 842-10-35-4 and ASC
842-10-25-11 state that upon a modification that is not accounted for as
a separate contract, including a partial termination, a lessee must
“remeasure the lease payments” and “reallocate the remaining
consideration in the contract and remeasure the lease liability.”
Importantly, ASC 842-10-25-11 neither requires nor permits entities to
allocate a portion of the remaining consideration to the terminated
component(s) of the contract. Instead, the remaining consideration is
entirely allocated to the remaining components in the contract.
We believe that the Board intended this outcome, since
it would often be highly complex and costly to determine what portion of
the revised lease payments is related to the terminated components of a
contract rather than to the remaining components. Similarly, this
complexity was part of the Board’s basis for its prospective approach to
modifications in ASC 606, as described in paragraph BC78 of ASU 2014-09:
The Boards also decided that a contract
modification should be accounted for prospectively when the goods or
services to be provided after the modification are distinct from the
goods or services already provided (see paragraph 606-10-25-13(a)).
The Boards decided that this should be the case regardless of
whether the pricing of the additional promised goods or services
reflected their standalone selling prices. This
is because accounting for those types of modifications on a
cumulative catch-up basis could be complex and may not
necessarily faithfully depict the economics of the modification
because the modification is negotiated after the original
contract and is based on new facts and circumstances.
Therefore, this approach avoids opening up the accounting for
previously satisfied performance obligations and, thus, avoids any
adjustments to revenue for satisfied performance obligations.
[Emphasis added]
The Board intentionally aligned many of the principles
in the ASC 842 modification framework with those in ASC 606. Paragraph
BC169 of ASU 2016-02 explains this alignment:
The
guidance on lease modifications in Topic 842 was developed
principally with the following in mind:
- The accounting for lease modifications in previous GAAP was generally considered to be very complex (often explained only by flowchart). In the Board’s view, the lease modifications guidance in Topic 842 is less complex and more intuitive to apply than the previous guidance.
- Contracts that contain leases frequently contain nonlease components (that is, other goods or services). This was particularly important to the Board’s considerations about lease modification accounting for lessors because Topic 606 contains a robust framework for accounting for modifications of contracts with customers to provide nonlease goods and services (for example, supplies for use with leased equipment or services such as maintenance or operation of the underlying asset).
Therefore, we believe that allocating the revised
consideration in the contract prospectively only to the remaining
components, even if such allocation does not reflect the economic
substance of the revised payments, is consistent with the Board’s intent
in (1) aligning the modification framework in ASC 842 with that in ASC
606 and (2) reducing the complexity of accounting for lease
modifications.
Further, ASC 842 does not contain explicit guidance on
how a lessee should account for a termination penalty paid to a lessor
upon a partial termination of a lease; however, ASC 842-10-30-5(d) does
include guidance on how to include termination payments and penalties21 within the scope of lease payments more generally:
At the commencement date, the lease payments shall
consist of the following payments relating to the use of the
underlying asset during the lease term: . . .
d. Payments for penalties for terminating the lease if the
lease term (as determined in accordance with paragraph
842-10-30-1) reflects the lessee exercising an option to
terminate the lease.
Therefore, such a penalty should be included in the
consideration allocated to the components in the contract upon a partial
termination. As discussed above, the revised consideration in the
contract should be allocated only to the remaining components, rather
than in part to the terminated component(s). As a result, the full
amount of the termination penalty is recognized prospectively.
We believe that the basis for this outcome is
appropriately consistent with the one discussed above. Frequently, a
lessee and lessor may negotiate a termination payment in conjunction
with a renegotiation of the ongoing lease payments or in contemplation
of the existing ongoing lease payments, and the lessor may be
economically satisfied with a lower termination payment than it would
otherwise accept (or may require a higher termination payment than it
would otherwise accept) because of the ongoing lease payments.
Therefore, it would be highly complex and costly to differentiate
between, for example, a termination penalty related to a terminated
lease component and a prepayment for the remaining lease components. In
other cases, the parties may simply choose to finance the termination
penalty over the remaining lease term by adjusting the remaining lease
payments. As discussed above, the modification treatment appears clear
when future lease payments are adjusted and we do not believe that the
timing of the payment should dictate the accounting outcome.
In contrast to a partial termination, a termination
penalty paid as part of a full termination of a lease (i.e., when there
are no remaining components in the contract) should be included in the
determination of the gain or loss upon termination in accordance with
ASC 842-20-40-1 and ASC 842-20-40-3. However, as discussed in
Section 8.6.3.7.2, the guidance on full
terminations only applies when the lessee’s right of use ceases
contemporaneously with the execution of the modification (e.g., assets
are immediately returned to the lessor or space is immediately vacated),
which we believe will occur infrequently for leases of certain types of
assets (e.g., real estate) because of the time and administrative burden
that typically accompany relocating.
Example 8-22
On September 15, 2019, Lessee
enters into a 15-year lease for six floors of an
office building for a total of $6 million per
year, with no termination or renewal options. On
September 15, 2024, Lessee and Lessor agree to
immediately terminate the lease of two of those
six floors while retaining the lease of the other
four floors for the remaining 10-year lease term.
Lessee also agrees to pay Lessor a $4 million
termination penalty, which is determined by
comparing the remaining lease payments related to
the two floors being terminated with current
market rates. That is, the $4 million represents
the “in-the-money” portion of the terminated lease
components.
In accordance with ASC
842-10-35-4 and ASC 842-10-25-11, Lessee should
remeasure the lease liability for the remaining
lease components (i.e., the four remaining floors)
by remeasuring the lease payments and allocating
those lease payments to the remaining components
in the contract. Although $4 million is
contractually specifically related to the
terminated space, the $4 million termination
penalty should be included in those revised lease
payments — and thus deferred as part of the ROU
asset for the remaining floors — rather than being
recorded as part of any gain or loss upon
termination. Lessee should then apply the guidance
in ASC 842-10-25-13 (by using one of the
approaches discussed above) to determine the gain
or loss to be recognized as a result of the
partial termination.
8.6.3.7.2 Reduction in Lease Term Versus Lease Termination
The guidance in ASC 842-10-25-11(c) applies to full or
partial terminations and results in potential gains or losses when the
lease is remeasured. On the other hand, ASC 842-10-25-11(b) applies to
lease term extensions or reductions and requires
the lessee to recognize the amount of the remeasurement of the lease
liability for the modified lease as an adjustment to the corresponding
ROU asset, which generally does not result in a gain or a loss.
If a modification results in a reduced lease term for part of the leased asset (e.g., a reduced term
for a percentage of the leased space), the guidance in ASC
842-10-25-11(c) does not apply. Although the guidance in ASC
842-10-25-11(b) does not explicitly address this issue, we believe that
this guidance applies to reductions in the lease term of either the
entire leased asset or part of the leased asset. That is, regardless of
whether the term is reduced for the entire lease or for only a part or a
percentage of the lease (e.g., 20 percent of the leased space), the
lessee would apply the guidance in ASC 842-10-25-11(b). In addition, the
guidance in ASC 842-10-25-11(c) does not apply to a modification that
results in the termination of all or part of a lessee’s right of use
after a specified period (rather than immediate termination).
In such cases, the lessee still has the right to use the
leased asset for that period; therefore, the modification consists of a
reduction in the lease term rather than a full or partial termination
and the lessee would apply the guidance in ASC 842-10-25-11(b). The only
time that the guidance on full or partial terminations applies is when
all or part of the lessee’s right of use ceases contemporaneously with
the execution of the modification (e.g., assets are immediately returned
to the lessor or space is immediately vacated).
The example below from ASC 842-10-55-177 through 55-185
illustrates two approaches to measuring an ROU asset in a scenario in
which a modification decreases the scope of a lease.
ASC 842-10
Example 18 — Modification
That Decreases the Scope of a Lease
55-177 Lessee enters into a
10-year lease for 10,000 square feet of office
space. The annual lease payment is initially
$100,000, paid in arrears, and increases 5 percent
each year during the lease term. Lessee’s
incremental borrowing rate at lease commencement
is 6 percent. Lessee does not provide a residual
value guarantee. The lease does not transfer
ownership of the office space to Lessee or grant
Lessee an option to purchase the space. The lease
is an operating lease for all of the following
reasons:
-
The lease term is 10 years, while the office building has a remaining economic life of 40 years.
-
The fair value of the office space is estimated to be significantly in excess of the present value of the lease payments.
-
The office space is expected to have an alternative use to Lessor at the end of the lease term.
55-178 At the beginning of
Year 6, Lessee and Lessor agree to modify the
original lease for the remaining 5 years to reduce
the lease to only 5,000 square feet of the
original space and to reduce the annual lease
payment to $68,000. That amount will increase 5
percent each year thereafter of the remaining
lease term.
55-179 The classification of
the lease does not change as a result of the
modification. It is clear based on the terms of
the modified lease that it is not a finance lease
because the modification reduces both the lease
term and the lease payments. Lessee remeasures the
lease liability for the modified lease at the
effective date of the modification on the basis of
all of the following:
-
A remaining lease term of 5 years
-
Lease payments of $68,000 in the year of modification (Year 6), increasing by 5 percent each year thereafter
-
Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.
55-180 The remeasured lease
liability equals $306,098.
> Case A — Remeasuring the
Right-of-Use Asset Based on Change in Lease
Liability
55-181 The difference between
the premodification liability and the modified
lease liability is $284,669 ($590,767 – $306,098).
That difference is 48.2 percent ($284,669 ÷
$590,767) of the premodification lease liability.
The decrease in the lease liability reflects the
early termination of the right to use 5,000 square
feet of space (50 percent of the original leased
space), the change in the lease payments, and the
change in the discount rate.
55-182 Lessee decreases the
carrying amount of the right-of-use asset to
reflect the partial termination of the lease based
on the adjustment to the carrying amount of the
lease liability, with any difference recognized in
profit or loss. The premodification right-of-use
asset is $514,436. Therefore, at the effective
date of the modification, Lessee reduces the
carrying amount of the right-of-use asset by
$247,888 (48.2% × $514,436). Lessee recognizes the
difference between the adjustment to the lease
liability and the adjustment to the right-of-use
asset ($284,669 – $247,888 = $36,781) as a
gain.
> Case B — Remeasuring the
Right-of-Use Asset Based on the Remaining Right of
Use
55-183 Lessee determines the
proportionate decrease in the carrying amount of
the right-of-use asset based on the remaining
right-of-use asset (that is, 5,000 square feet
corresponding to 50 percent of the original
right-of-use asset).
55-184 Fifty percent of the
premodification right-of-use asset is $257,218
(50% × $514,436). Fifty percent of the
premodification lease liability is $295,384 (50% ×
$590,767). Consequently, Lessee decreases the
carrying amount of the right-of-use asset by
$257,218 and the carrying amount of the lease
liability by $295,384. At the effective date of
the modification, Lessee recognizes the difference
between the decrease in the lease liability and
the decrease in the right-of-use asset of $38,166
($295,384 − $257,218) as a gain.
55-185 Lessee recognizes the
difference between the remaining lease liability
of $295,384 and the modified lease liability of
$306,098 (which equals $10,714) as an adjustment
to the right-of-use asset reflecting the change in
the consideration paid for the lease and the
revised discount rate.
Below is a summary of the two different approaches to
remeasuring the ROU asset in this example.
Approach 1 — Remeasuring the ROU Asset on the
Basis of the Percentage Change in Lease Liability
Under this approach, the lessee calculates the
percentage decrease in the lease liability as a result of the
modification. This percentage is applied to the premodification ROU
asset to determine the postmodification ROU asset balance. The
difference between the change in the postmodification ROU asset and the
postmodification lease liability represents a gain or loss that is
recognized in the income statement as of the date of the modification.
See ASC 842-10-55-181 and 55-182 above for details related to the
calculation of the gain and the adjustments to the ROU asset under
Approach 1.
Journal Entries
As a result of the
calculations detailed in ASC 842-10-55-181 and 55-182, the lessee
records the following journal entry to account for the remeasurement of
the lease liability, ROU asset, and gain related to the
modification.
Determining the Revised Lease Cost
In a manner consistent with ASC 842-20-25-8, the lessee
calculates the remaining lease cost of the operating lease as of the
modification date as the total lease payments (both paid and not yet
paid) and any adjustments resulting from a lease modification (including
amounts attributable to a gain or loss from the modification), less the
periodic lease cost recognized in prior periods. In other words, the
remaining lease cost is calculated as the sum of (1) the
postmodification balance for the ROU asset and (2) the expected future
accretion of the liability (i.e., the difference between the total
future lease payments and the postmodification lease liability balance).
The resulting revised lease cost is then recognized on a straight-line
basis over the remaining lease term.
The table below
illustrates the calculations related to the remaining lease cost.
Approach 2 — Remeasuring the ROU Asset on the
Basis of the Percentage Change in the Right of Use
Under this approach, the lessee calculates the
percentage decrease in the physical space subject to the right of use as
a result of the modification. This percentage is applied to the
premodification ROU asset to determine the postmodification ROU asset
balance. The difference between the change in the premodification
balance and postmodification balance and the lease liability adjustment
represents a gain or loss that is recognized in the income statement as
of the date of the modification.
See ASC 842-10-55-183 through 55-185 above for details
related to the calculation of the gain and the adjustments to the ROU
asset under Approach 2.
Journal Entries
As a result of the
calculations detailed in ASC 842-10-55-183 through 55-185, the lessee
records the following journal entries to account for the partial
derecognition of the lease liability, ROU asset, and gain related to the
modification. In addition, the lessee records, as an adjustment to the
ROU asset, the difference between the premodification lease liability of
$295,384 (50 percent of $590,767) and the modified lease liability of
$306,098.
Determining the Revised Lease Cost
In a manner consistent with ASC 842-20-25-8, the lessee
will calculate the remaining lease cost of the operating lease as of the
modification date as the total lease payments (both paid and not yet
paid) and any adjustments resulting from a lease modification (including
amounts attributable to a gain or loss from the modification), less the
periodic lease cost recognized in prior periods. In other words, the
remaining lease cost is calculated as the sum of (1) the
postmodification balance for the ROU asset and (2) the expected future
accretion of the liability (i.e., the difference between the total
future lease payments and the postmodification lease liability balance).
The resulting revised lease cost is then recognized on a straight-line
basis over the remaining lease term.
The calculation of the
remaining lease cost would be as follows:
Connecting the Dots
Modifications That
Decrease the ROU Asset and Increase the Lease
Liability
In certain interest rate environments, a lease
modification that decreases the scope of the lease may result in
an increase in the lease liability associated with a lower IBR
assumption. A partial termination, as opposed to a lease
modification, is characterized by the recognition of a profit
and loss (P&L) impact. The guidance on partial terminations
in ASC 842-10-25-13 refers to the requirement for the lessee to
“decrease the carrying amount of the ROU asset” as well as “the
reduction in the lease liability.” The implementation guidance
in ASC 842-10-55-177 through 55-185 outlines two alternative
approaches for adjusting the ROU asset when a modification
results in the reduction of the scope of the lease (Example 18).
However, this guidance does not explicitly contemplate a partial
termination in which the lease liability would
increase.
We believe that, in such circumstances, it would
be acceptable to apply an approach aligned with that in Example
18, Case B. That is, the determination of the decrease in the
modified ROU asset would be based on the decrease in the
remaining right of use of the leased space after the partial
termination. In applying this approach upon the partial
termination, the percentage decrease of the leased asset (e.g.,
square footage) would be applied to the premodification ROU
asset and premodification lease liability to decrease the
carrying amount of the ROU asset and the lease liability. For
example, if the square footage were to decrease by 8 percent,
there would be an 8 percent decrease in the ROU asset and lease
liability. The subsequent P&L impact would be recorded for
the difference in the reduced premodification lease liability
and ROU asset.
Subsequently (in a second step in Case B), the
lease liability is calculated by using the revised lease
payments and an updated discount rate. Therefore, an additional
adjustment to the ROU asset and lease liability is recorded as
the difference between the (1) reduced premodification lease
liability (calculated above) and (2) the modified lease
liability reflecting the change in the consideration paid for
the lease and the revised discount rate. According to View 1,
the P&L is only affected through the first step, detailed
above, for any difference in the reduced ROU and lease
liability. There is no incremental impact on the P&L in the
second step.
We believe that other views may also be
acceptable depending on an entity’s specific facts and
circumstances. Entities should consider consulting with their
accounting advisers when contemplating an approach other than
the one outlined above.
8.6.4 Other Scenarios Related to Lease Modifications
8.6.4.1 Lease Modifications in Connection With the Refunding of Tax-Exempt Debt
ASC 842-10
55-16 In some situations, tax-exempt debt is issued to finance construction of a facility, such as a plant or
hospital, that is transferred to a user of the facility by lease. A lease may serve as collateral for the guarantee
of payments equivalent to those required to service the tax-exempt debt. Payments required by the terms of
the lease are essentially the same, as to both amount and timing, as those required by the tax-exempt debt. A
lease modification resulting from a refunding by the lessor of tax-exempt debt (including an advance refunding)
should be accounted for in the same manner (that is, in accordance with paragraphs 842-10-25-8 through
25-18) as any other lease modification. For example, if the perceived economic advantages of the refunding
are passed through to the lessee in the form of reduced lease payments, the lessee should account for the
modification in accordance with paragraph 842-10-25-12, while the lessor should account for the modification
in accordance with the applicable guidance in paragraphs 842-10-25-15 through 25-17.
Governmental authorities often use tax-exempt debt to finance the construction of a facility (e.g., a
plant or a hospital) that they will lease to another entity. As noted above, the payment terms of the lease
generally mirror, with respect to both amount and timing, “those required by the tax-exempt debt.” Such
a lease “may serve as collateral for the guarantee of payments equivalent to those required to service
the tax-exempt debt.”
If the governmental authority enters into a refunding arrangement that replaces the existing tax-exempt
debt with new debt (as would be the case if the authority wanted to take advantage of lower interest
rates), the resulting change in the debt service payments may result in a reduction of the corresponding
lease payments. This reduction of lease payments would be accounted for as a modification. See
Section 8.6.3.6 for additional discussion of modifications that result only in a change to consideration in
the contract.
8.6.4.2 Applying the Modification Guidance to a Master Lease Agreement
As described in Section
13.4, a master lease agreement may specify that the lessee
will obtain control of multiple underlying assets (e.g., equipment) at
various times during the term of the agreement. In accordance with ASC
842-10-55-17, the lessee’s accounting in such cases depends on whether it is
obligated or committed to use, and therefore obtain control of, “a minimum
number of units or dollar value of equipment.” If so, the lessee should take
into account this minimum quantity when separating lease components and
allocating the consideration in the contract to the separate lease
components. Because the minimum quantity is factored into the initial
separation of and allocation to the lease components, the lessee’s
attainment of control of the underlying assets throughout the term of the
master lease agreement does not result in a lease modification. However,
because the lessee may obtain control of the underlying assets at different
times during the master lease agreement, the separate lease components may
have different lease commencement dates, as explained in ASC 842-10-55-22.
Note that if a lessee obtains control of underlying assets in addition to
the minimum quantity or value specified in the master lease agreement, there
would be a lease modification.
In addition, ASC 842-10-55-18 stipulates that if the lessee is not obligated or committed to use a minimum quantity of equipment, the attainment of control over each underlying asset must be accounted for as a lease modification in accordance with ASC 842-10-25-8 through 25-18. Depending on the terms of the arrangement, the resulting modification may result in accounting for each new asset as a separate lease or in a remeasurement of the existing lease. Because the equipment is not subject to a minimum commitment, the entity would not include the equipment in the initial separation of and allocation to the lease components in the contract. See Section 13.4 for additional information on accounting for master lease agreements.
8.6.4.3 Lease Modifications That Involve More Than One Change
ASC 842-10
25-11 A lessee shall reallocate the remaining consideration in the contract and remeasure the lease liability using a discount rate for the lease determined at the effective date of the modification if a contract modification does any of the following:
- Grants the lessee an additional right of use not included in the original contract (and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8)
- Extends or reduces the term of an existing lease (for example, changes the lease term from five to eight years or vice versa), other than through the exercise of a contractual option to extend or terminate the lease (as described in paragraph 842-20-35-5)
- Fully or partially terminates an existing lease (for example, reduces the assets subject to the lease)
- Changes the consideration in the contract only.
25-12 In the case of (a), (b), or (d) in paragraph 842-10-25-11, the lessee shall recognize the amount of the remeasurement of the lease liability for the modified lease as an adjustment to the corresponding right-of-use asset.
25-13 In the case of (c) in paragraph 842-10-25-11, the lessee shall decrease the carrying amount of the right-of-use asset on a basis proportionate to the full or partial termination of the existing lease. Any difference between the reduction in the lease liability and the proportionate reduction in the right-of-use asset shall be recognized as a gain or a loss at the effective date of the modification.
When a lease modification is not accounted for as a separate contract, a lessee must reallocate the remaining consideration in the contract and remeasure its lease liability. If the modification extends or reduces the lease term of an existing lease (see Section 8.6.3.4), provides the lessee with an additional right of use not accounted for as a separate contract (see Section 8.6.3.5), or changes the consideration in the contract (see Section 8.6.3.6), the lessee should recognize the amount resulting from the remeasurement of the lease liability as an adjustment to the corresponding ROU asset. If the modification reduces the scope of a lease through a full or partial termination of the lease, the lessee should instead record a proportionate reduction in the ROU asset as well as a gain or loss for any difference between the decrease in the lease liability and the decrease in the ROU asset (see Section 8.6.3.7).
While the guidance in ASC 842 is clear on the accounting for a lease
modification that results in a single change, some lease modifications may
include multiple changes that need to be accounted for in different ways on
the basis of the nature of the change. ASC 842 does not clearly address how
to account for these types of lease modifications.
A lessee’s approach to modifications involving more than one
change will typically depend on the nature of the changes and whether they
would individually lead to different accounting treatments upon
remeasurement of the lease liability (i.e., all adjustments recognized on
the balance sheet versus potential for gain or loss in the income
statement). We generally believe that the lessee should account for each
change included in the modification in accordance with the guidance
applicable to that change rather than view one change as predominant. That
is, the lessee should generally not simply adjust the ROU asset for the
total remeasurement in the lease liability by using the modification
guidance applicable to the most significant change.
To properly account for each change, it may be helpful for a
lessee to bifurcate the original lease into the portions that are subject to
the different remeasurement rules in ASC 842-10-25-12 and 25-13. For
example, we believe that in dealing with a modification involving an
immediate termination of part of a lessee’s right of use coupled with a
lease term extension for the remaining right of use, it would be reasonable
for the lessee to first bifurcate the existing lease liability and ROU asset
on the basis of the portion of the lease affected by each change. The
bifurcation between the two portions should be on the basis of the relative
stand-alone prices.
Once the lease liability and ROU asset have been allocated
between the two portions, the lessee would apply the modification guidance
in ASC 842-10-25-11 through 25-13 to the balances allocated to each portion.
The lessee would thus derecognize the balances allocated to the terminated
portion of the lease (with a corresponding gain or loss) and would remeasure
the lease liability allocated to the retained portion of the lease (with a
corresponding adjustment to the ROU asset) by using the remaining lease term
and incremental borrowing rate determined as of the effective date of the
modification. The lessee would also reassess the classification of the lease
as of the effective date of the modification.
Example 8-23
Lessee has an existing lease for
5,000 square feet of office space with a remaining
lease term of three years. Lessee and Lessor agree
to modify the lease to (1) immediately terminate the
lease of 1,000 square feet of the office space and
(2) extend the lease term for the remaining 4,000
square feet to five years. On the basis of the
relative stand-alone prices, Lessee bifurcates the
ROU asset and lease liability into the portion
subject to the immediate termination (1,000 square
feet) and the portion subject to the lease term
extension (4,000 square feet). Lessee then (1)
applies the guidance in ASC 842-10-25-13 to the
portion of the ROU asset and lease liability
associated with the immediate termination (i.e.,
derecognizes those balances and records a gain or
loss for the difference) and (2) applies the
guidance in ASC 842-10-25-12 to the portion of the
ROU asset and lease liability associated with the
lease term extension (i.e., remeasures the lease
liability and makes a corresponding adjustment to
the ROU asset).
8.6.4.4 Lease Modifications in Connection With Reference Rate Reform
ASC 848-20
15-2 The guidance in this
Subtopic, if elected, shall apply to contracts that
meet the scope of paragraph 848-10-15-3 if either or
both of the following occur:
-
The terms that are modified directly replace, or have the potential to replace, a reference rate within the scope of paragraph 848-10-15-3 with another interest rate index. If other terms are contemporaneously modified in a manner that changes, or has the potential to change, the amount or timing of contractual cash flows, the guidance in this Subtopic shall apply only if those modifications are related to the replacement of a reference rate. For example, the addition of contractual fallback terms or the amendment of existing contractual fallback terms related to the replacement of a reference rate that are contingent on one or more events occurring has the potential to change the amount or timing of contractual cash flows and the entity potentially would be eligible to apply the guidance in this Subtopic.
-
The interest rate used for margining, discounting, or contract price alignment is modified as a result of reference rate reform.
15-3 Other than a
modification of the interest rate used for
margining, discounting, or contract price alignment
in accordance with paragraph 848-20-15-2(b), for
contracts that meet the scope of paragraph
848-10-15-3, the guidance in this Subtopic shall not
apply if a contract modification is made to a term
that changes, or has the potential to change, the
amount or timing of contractual cash flows and is
unrelated to the replacement of a reference rate.
That is, this Subtopic shall not apply if contract
modifications are made contemporaneously to terms
that are unrelated to the replacement of a reference
rate.
35-11 If an entity elects
the optional expedient in this paragraph for a
modification of a contract within the scope of Topic
840 or 842 that meets the scope of paragraphs
848-20-15-2 through 15-3, the entity shall not do
any of the following:
-
Reassess lease classification and the discount rate (for example, the incremental borrowing rate for a lessee)
-
Remeasure lease payments
-
Perform other reassessments or remeasurements that would otherwise be required under Topic 840 or 842 when a modification of a lease contract is not accounted for as a separate contract.
In March 2020, the FASB issued ASU 2020-04,
which established a new FASB Codification topic, ASC 848, on reference rate
reform. Specifically, the new guidance addresses constituents’ concerns
about some of the potential accounting consequences of the global markets’
anticipated transition away from LIBOR and other interbank offered rates to
alternative reference rates. The FASB also issued ASU
2021-01 in January 2021 to clarify the scope of ASC
848.
Entities whose lease contracts refer to LIBOR or another
interbank offered rate may seek to modify their arrangements to designate a
replacement reference rate. In the absence of the optional relief provided
by ASC 848, entities would be required to apply ASC 842’s normal lease
modification framework to account for such changes. (See Section 8.6 for a
discussion of the lessee’s lease modification accounting and Section 9.3.4 for a
discussion of the lessor’s lease modification accounting.)
When applying the lease modification relief in ASC 848 to eligible leases, an
entity would not (1) reassess the lease classification or the discount rate
or (2) remeasure lease payments or perform the other reassessments or
remeasurements that would otherwise be triggered by a modification under ASC
842 when that modification is not accounted for as a separate contract. The
modification of terms on which variable lease payments depend will not cause
the lessee to remeasure the lease liability. The effects of such changes
will instead be recognized in profit or loss in the period in which the
obligation for those payments is incurred.
Under ASU 2020-04, an entity that elects to apply an
expedient under a particular Codification topic, subtopic, or industry
subtopic must apply that expedient to all contract modifications that are
within the scope of the ASU and are accounted for under that topic,
subtopic, or industry subtopic.
Footnotes
15
In this section, we are assuming that the change is
substantive and has economic substance. We would not require or
accept a reassessment based on changes that lack economic substance
(e.g., insignificant changes designed to trigger a reassessment to
achieve a desired accounting outcome). Consultation with auditors
and accounting advisers is recommended in circumstances in which a
modification appears to lack substance.
16
Lessee records the difference
between the premodification lease liability and
postmodification lease liability as an adjustment
to the ROU asset in accordance with ASC
842-10-25-12, since the modification is a
reduction of lease term in accordance with ASC
842-10-25-11(b).
17
In our example, the
measurement of the ROU asset under ASC 842-20-30-5
would equal the initial measurement of the
modified lease liability of $25,771 described
above, since there are no prepaid lease payments,
lease incentives, or initial direct costs.
18
A company may apply one of two
approaches to subsequently account for an
operating lease, each of which results in the same
outcome. The table below illustrates the
subsequent measurement of an operating lease by
using the “plug” approach described in Example
8-13 in Section 8.4.3.2
(Approach B), which presents amortization activity
net for the adjustment to the ROU asset. See
Approach A in the aforementioned example for an
illustration of how a company would amortize this
adjustment when the adjustment is tracked
separately from the ROU asset balance.
19
Although written from the perspective of a
lessee, the concepts described in this Connecting the Dots
also apply to lessors.
20
See ASC 840-20-55-4 through 55-6.
21
Although this discussion focuses on termination
penalties paid to the lessor, we believe that the conclusion
reached would also apply to any consideration received by the
lessee from the lessor upon a partial termination of a
lease.