Accounting for a Lease Modification Under ASC 842

ASC 842 changed lease accounting by requiring companies to recognize most leases on their balance sheets. This rule mandates that leases longer than 12 months are recorded as a lease liability, representing the present value of future lease payments, and a corresponding right-of-use (ROU) asset. A lease modification is a change to the terms of an existing lease contract that was not part of the original agreement, resulting in a change to the scope of or consideration for the lease. Understanding how to account for these changes is necessary for entities navigating their lease portfolios.

Identifying a Lease Modification

A lease modification can manifest in several ways, such as altering the physical space being leased or changing the payment structure. For instance, a company leasing three floors of an office building that agrees with the landlord to add a fourth floor has entered into a lease modification. An agreement to extend the contractual term of a lease, outside of any options included in the original contract, also constitutes a modification.

Changes that only affect the consideration in the contract, like an agreement to reduce monthly payments for a period in exchange for higher payments later, are also modifications. These events trigger a reassessment because they alter the rights and obligations established at the lease’s inception. The effective date of a modification is the date the change is approved by both parties, which triggers any required accounting adjustments.

The exercise of a right that was already part of the original contract is not a modification. For example, if a lease agreement included an option to renew, exercising it is not a modification if the lessee was already deemed reasonably certain to exercise it. The potential payments for that renewal period would have already been included in the initial calculation of the lease liability and ROU asset.

Changes to lease payments based on a variable index or rate, such as the Consumer Price Index (CPI), are not considered modifications. Periodic adjustments to payments based on changes in the CPI do not constitute a lease modification. These adjustments are treated as variable lease payments and are expensed as incurred rather than requiring a full remeasurement of the lease liability and ROU asset.

Determining the Accounting Treatment

Once an event is identified as a lease modification, the next step is to determine the accounting treatment. ASC 842 provides a framework for this, which hinges on whether the modification should be treated as a new, separate lease or as an adjustment to the existing one. This assessment is guided by a two-pronged test, and both conditions must be met for the modification to be accounted for as a separate contract.

The first condition is that the modification must grant the lessee an additional right of use not included in the original lease, meaning the lessee gains the right to use a new, distinct asset. Leasing an additional floor in an office building would represent an additional right of use. An extension of the lease term for an asset already being used does not qualify as an additional right of use under this test.

The second condition requires that lease payments increase by an amount commensurate with the standalone price for the additional right of use. The standalone price is the price the lessor would charge a similar customer for the new, separate right of use, adjusted for any unique circumstances. If the increase in lease payments reflects the current market rate for the additional asset, this condition is met.

If both conditions are satisfied, the modification is accounted for as a new, separate lease. If either or both conditions are not met, the modification is not treated as a separate contract. For example, if a lessee adds another floor to its office lease but receives a significant discount, the payment increase may not be commensurate with the standalone price, and the modification would require remeasurement of the original lease.

Accounting for Modifications as a Separate Lease

When a lease modification meets both criteria, it is accounted for as a separate contract. This treatment bifurcates the arrangement into two leases: the original, unmodified lease and the new one created by the modification. The accounting for the original lease is left unchanged.

The entity applies initial recognition and measurement guidance to the new component of the lease. This involves calculating a new lease liability based on the present value of the payments for the additional right of use and recognizing a corresponding new ROU asset. The discount rate used is the rate implicit in the new lease or the lessee’s incremental borrowing rate at the modification’s effective date.

The process mirrors the accounting for a brand-new lease. The original ROU asset and lease liability continue to be amortized and accreted as they were prior to the modification. This approach reflects the economic substance of creating a new leasing arrangement alongside the pre-existing one.

Accounting for Modifications Not Treated as a Separate Lease

When a lease modification does not meet the criteria to be treated as a separate contract, the lessee must remeasure and adjust the accounting for the single, modified lease. This remeasurement is done as of the effective date of the modification.

The first step is to determine the appropriate discount rate. The lessee must use a revised discount rate, which is the lessee’s incremental borrowing rate as of the modification’s effective date. This new rate is then used to remeasure the lease liability by calculating the present value of the remaining lease payments under the modified terms.

The adjustment to the ROU asset is the next step. The change in the lease liability—the difference between its remeasured value and its balance immediately before the modification—is recorded as a corresponding adjustment to the ROU asset. For example, if a modification extends the lease term, the remeasured lease liability will increase, and this increase is added to the ROU asset.

Modifications Decreasing Lease Scope

The accounting for a modification that decreases the scope of the lease, such as a partial termination, is different. The lessee must first derecognize a portion of both the ROU asset and the lease liability. The amount derecognized should be proportionate to the decrease in the scope of the lease. Any difference between the derecognized portion of the ROU asset and the lease liability is recognized as a gain or loss.

Following this partial derecognition, the lessee then remeasures the remaining lease liability using the modified lease payments and a revised discount rate. The difference arising from this remeasurement is then recorded as an adjustment to the remaining carrying amount of the ROU asset. This two-step process ensures the gain or loss on the termination is recognized immediately.

Required Disclosures for Lease Modifications

When a lease modification occurs, ASC 842 requires specific disclosures in the financial statements. These disclosures are both qualitative and quantitative and explain the nature and financial impact of the changes to lease agreements. This information is included in the notes to the financial statements, within the broader lease accounting footnote.

Qualitatively, a company must disclose information about its lease modifications, explaining the nature of the changes. This includes describing the reasons for the modifications and their general effect on the company’s leasing arrangements. This provides context for why the company’s lease-related assets and liabilities have changed beyond normal amortization and interest accretion.

Quantitatively, entities are required to disclose the amounts related to the remeasurement of lease liabilities and the corresponding adjustments to ROU assets. If a modification results in a gain or loss, such as from a partial termination of a lease, that amount must be disclosed. These disclosures help reconcile the beginning and ending balances of the ROU assets and lease liabilities.