FASB ASC Topic 842 Leases – Contract Modifications

After all the diligent work to assemble your “day-one” accounting for leases under the new lease accounting standard (Topic 842), including identifying a complete population of leases, carefully applying transitional practical expedients and selecting the appropriate discount rates, there are more challenges with the subsequent “day-two-and-thereafter” accounting. 

In its most simplistic form and holding the lease portfolio constant, the subsequent accounting is as easy as running the amortization schedules for lease assets and liabilities and posting the journal entries. A challenge is how to account for lease modifications, new leases and lease terminations. Of these, lease modifications are particularly arduous under the new rules.

According to the Topic 842 glossary, lease modifications are a change in the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease. Depending on the nature of the modification, a change to a lease contract is accounted for either as a separate lease contract (i.e., a separate unit of account) or a modification to the original lease (i.e., the existing unit of account). Common examples of lease modifications are extensions or reductions in the lease term not originally included in the contract, changes in lease payments and changes in the scope of the leased asset, such as obtaining additional square footage in a warehouse lease.

Before analyzing the nature of the modification, Topic 842 requires a lessee to reassess whether a contract is or contains a lease only if the terms and conditions of the contract are changed. Presuming that a modified contract still qualifies as a lease under Topic 842, the next step is determining the nature of the modification.

A modification is accounted for as a separate lease contract if: 

• 1.a. the modification grants the lessee a right to use an additional asset(s) not contemplated in the original agreement; and
• 1.b. the lease payments associated with the additional right-of-use asset(s) are commensurate with standalone pricing.  

Following this type of modification, the lessee will have two units of account, the original lease and the new lease.

A modification is not accounted for as a separate lease contract if the modification:

• 2.a. . grants additional right-of-use asset(s) not included in the original contract and the lease payments associated with the additional right-of-use assets(s) are commensurate with standalone pricing, but the modification is also changing other elements of the contract (e.g., a change to the consideration of the original right-of-use asset);
• 2.b. extends or reduces the term of the existing lease, other than through the exercise of an existing renewal or termination option;
• 2.c. changes the consideration in the contract only; or
• 2.d. fully or partially terminates an existing lease.

These types of modifications require the lessee to reassess the lease classification (i.e., operating or finance classification), remeasure the lease liability using the discount rate on the lease modification effective date and adjust the right-of-use asset. In modification examples 2.a., 2.b. and 2.c., the change in the lease liability through the remeasurement process results in a direct adjustment to the right-of-use asset (i.e., a balance sheet adjustment only). In modification example 2.d., the change is recognized in the income statement as a gain or loss.

Modification example 2.a. is unique. It seemingly contains all the necessary elements to be accounted for as a separate contract as outlined in 1.a. and 1.b., but because it also contains another modifying action (a change to the consideration of the original right of use), Topic 842 prohibits it from being accounted for as a separate contract.

Organizations need to find a suitable way to calculate Topic 842 right-of-use assets and lease liabilities at the transition date and the subsequent lease accounting. Generally, an Excel-based solution would be appropriate for a noncomplex portfolio of only a few leases. If the profile is more complex and/or voluminous, management is likely better served by a lease software solution like simpLEASE from Schneider Downs. In addition to offering clients this solution, we also provide advisory services for the technical aspects of lease accounting.