Lease modifications: separate contract or remeasure

In this lesson you will

Apply the two conditions for a separate contract in 842-10-25-8
Remeasure the liability and ROU asset for term extensions and consideration changes
Account for full and partial terminations with a gain or loss
Reassess classification at the modification date

What counts as a modification

A lease modification is a change to the terms and conditions of a contract that changes the scope of or the consideration for a lease. Exercising an option already in the contract is not a modification; it is a reassessment of the lease term under 842-10-35-1. Negotiating a new extension, adding space, or cutting rent are modifications.

Step 1: is it a separate contract?

Under 842-10-25-8 a modification is a separate contract when both:

it grants an additional right of use not included in the original lease, such as an additional asset, and
the lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the contract.

If both are met, the original lease is unchanged and the new right of use is accounted for as a new lease. A tenant who takes an extra floor at market rent has two leases.

Step 2: if not separate, reassess and remeasure

When the modification is not a separate contract, the entity reassesses classification as of the modification's effective date using the modified terms and current facts, such as fair value and remaining economic life (842-10-25-9).

A lessee reallocates the remaining consideration and remeasures the lease liability using a discount rate determined at the effective date of the modification when the modification (842-10-25-11):

grants an additional right of use that is not a separate contract,
extends or reduces the term (other than by exercising an existing option),
fully or partially terminates the lease, or
changes the consideration only.

For an additional right of use, a term change, or a change in consideration only, the lessee adjusts the ROU asset by the change in the liability. No gain or loss arises.

For a full or partial termination, the lessee reduces the ROU asset in proportion to the reduction in the right of use and recognizes any difference between that reduction and the liability reduction as a gain or loss. A full termination derecognizes both balances, with the difference in profit or loss.

Initial direct costs, incentives and other payments made in connection with a modification are treated as they would be for a new lease (842-10-25-10).

Practical traps

Using the old rate. The revised discount rate applies at the modification date. A client that keeps the commencement rate understates or overstates the new liability.
Rent concessions. A rent reduction is a change in consideration only and requires remeasurement under 842-10-25-11. Do not book it as a reduction of expense.
Classification flips. An extension can push the term to the major part of economic life and turn an operating lease into a finance lease.
Lessor side. Lessors follow their own modification guidance (Lesson 8).

Documentation

For each modification, keep the amendment, the separate contract analysis, the new rate source, the old and new liability computations, the entry, and the reclassification analysis. The modification remeasurement worksheet lays this out, and the private company elections guide walks through more fact patterns.

Worked example

Extending a lease at Kestrel Dental Group, PC

Kestrel Dental Group, PC has the five-year office lease from Lesson 4 at $60,000 per year, discount rate 6 percent. At the end of Year 2, with three payments remaining, the landlord agrees to extend the lease by three years at $62,000 per year. The original lease had no renewal option. Kestrel's incremental borrowing rate at the modification date is 7 percent.

Separate contract? No additional asset is added, so condition 1 fails. This is an extension of term and requires remeasurement.

Liability before modification: $60,000 x 2.6730 = $160,381.

Remeasured liability at 7 percent: three payments of $60,000 ($60,000 x 2.6243 = $157,459) plus three payments of $62,000 starting in Year 6, discounted ($62,000 x 2.6243 / 1.07^3 = $132,818). Total: $290,277.

Entry: debit ROU asset $129,896, credit lease liability $129,896.

Classification: the remaining term is now six years for an office suite; no criterion is met, so the lease stays operating. Single lease cost is recalculated over the remaining six years from the modification date.

Self-check

Answer each question before you open the answer.

A tenant leases an additional floor at the market rate for that floor. How is it accounted for?
Show answer
As a separate contract. It adds a right of use and the payments increase commensurate with the standalone price, so both 842-10-25-8 conditions are met.
Which discount rate applies when a lessee remeasures for a modification that extends the term?
Show answer
A discount rate determined at the effective date of the modification (842-10-25-11), not the commencement rate.
Does a partial termination produce a gain or loss for the lessee?
Show answer
It can. The ROU asset is reduced in proportion to the reduction in the right of use, and the difference between that reduction and the liability reduction is recognized in profit or loss.

Sources

FASB, ASU 2016-02, Leases (Topic 842), Section A

Back to the syllabus

Standards are paraphrased from the primary sources listed above; read the source before relying on a requirement. This lesson is training material, not professional advice. Report an error