Lease Modification Accounting for Lessees and Lessors

A lease modification represents a change to the terms and conditions of an existing lease agreement. Under the accounting standard ASC 842, all leases are reflected on the balance sheet, so any modification can directly impact a company’s reported assets and liabilities. A misinterpretation of the modification guidance can lead to material misstatements in a company’s financial statements. The accounting treatment hinges on a careful analysis of the change, which determines the steps for both the lessee and the lessor.

Identifying a Lease Modification

A lease modification is formally defined as a change in the scope of a lease or the consideration for a lease that was not part of the original terms. The guidance in ASC 842 requires entities to scrutinize changes to determine if they meet this definition.

Common events that constitute a lease modification include altering the fundamental aspects of the agreement. Adding or removing the right to use one or more of the underlying assets, such as leasing an additional floor in an office building or returning a vehicle from a fleet lease, are clear changes in scope. Similarly, extending or shortening the contractual lease term beyond what was initially agreed upon qualifies as a modification. Any change to the lease payments, such as a negotiated reduction in monthly rent, also falls under this umbrella.

It is equally important to recognize what does not constitute a modification. The exercise of an option to extend, terminate, or purchase the asset does not trigger modification accounting if that option was part of the original contract and was factored into the initial measurement of the lease. If a company determined at the beginning of a lease that it was reasonably certain to exercise a five-year renewal option, doing so is merely the fulfillment of an existing term, not a change to it.

Modification vs Separate Contract

Once a lease modification has been identified, the next step is to determine its classification. Under ASC 842, a modification must be assessed to see if it should be treated as a new, separate lease contract or as an adjustment to the existing one. This classification is dictated by a two-part test where both conditions must be met.

The first condition is that the modification grants the lessee an additional right of use not included in the original lease. This means adding a new, distinct asset. For example, a company leasing three vehicles that modifies its agreement to lease a fourth vehicle would meet this condition. An extension of the lease term for an asset already being used is not an additional right of use.

The second condition requires that the payment for the additional right of use is commensurate with its standalone price. The standalone price is what the lessor would charge for that right of use in a separate transaction, adjusted for the contract’s circumstances. If the company leasing the fourth vehicle agrees to pay a market rate for that specific vehicle, this second condition would be met.

If both conditions are present, the modification is accounted for as a new, separate contract, and the original lease agreement remains unchanged. The new right-of-use asset and its liability are recorded independently. If either condition is not met, the modification is not a separate contract and must be accounted for by adjusting the existing lease.

Lessee Accounting for a Modification

When a lease modification is not accounted for as a separate contract, the lessee must remeasure and adjust the existing lease accounts on the modification’s effective date. This involves updating both the lease liability and the corresponding right-of-use (ROU) asset. The change in the lease liability is recorded as a direct adjustment to the ROU asset on the balance sheet.

To do this, the lessee calculates the present value of the remaining lease payments using a revised discount rate. The appropriate rate is the rate implicit in the lease if determinable, or the lessee’s incremental borrowing rate at the effective date of the modification. This updated rate captures the current economic conditions and the lessee’s credit standing.

If the modification decreases the scope of the lease, such as reducing the square footage of rented office space, the accounting is more complex. In this scenario, the lessee must first derecognize a portion of the ROU asset and lease liability corresponding to the part of the asset they no longer have the right to use. Any difference between the reduction in the liability and the reduction in the asset is recognized as a gain or loss in the income statement for that period.

Lessor Accounting for a Modification

For a lessor, the accounting for a lease modification that is not a separate contract depends on the classification of the original lease. The procedures differ for operating leases compared to sales-type and direct financing leases, because the underlying economics and initial accounting treatment for these lease types are different.

If the original lease was an operating lease, the accounting for a modification is straightforward. The lessor does not remeasure the lease accounts at the modification date but accounts for the change prospectively. The lessor recognizes the remaining lease payments, as altered by the modification, as lease income on a straight-line basis over the revised lease term. Any initial direct costs are amortized over the new term.

The process is more involved for sales-type and direct financing leases. When a modification occurs, the lessor must first reassess the lease classification under the modified terms as of the modification date. The inputs for this classification test, such as the fair value of the asset and the discount rate, must be updated to reflect conditions at the modification date.

If the lease continues to qualify as a sales-type or direct financing lease, the lessor adjusts its net investment in the lease. This involves recalculating the lease receivable based on the modified payments and term, with any resulting adjustment recognized in income. If the modification causes the lease to no longer meet the classification criteria, it must be reclassified, typically to an operating lease. This would require the lessor to derecognize the net investment in the lease from its balance sheet and recognize the underlying asset, recording it at its original carrying amount, less any impairment.