In 2022, Accounting Standards Codification (ASC) 842 was the talk of the town. ASC 842 was a lease accounting standard issued by the Financial Accounting Standards Board (FASB), that required all leases longer than 12 months to be reflected on a company's balance sheet. The goal was to enhance financial transparency by giving a clear picture of an entity's lease obligations. During the year of adoption, companies navigated how to properly adopt the new standard as well as evaluated the impact on the their balance sheets and income statements. The impacts of ASC 842 will continue to be seen in the following years. One of the main aspects of ASC 842 that will continue to present itself is how to handle lease modifications.

Lease Modifications – A Few Things to Know!

Leases that have been recorded under ASC 842 eventually may have amended terms subsequent to the lease commencement date. Per ASC 842, a lease modification is 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. These changes could include lease extensions, early termination of the lease, change in timing of lease payments, or a change in leased space. There is separate guidance provided for lessees and lessors.

Lease Modifications for a Lessee

When a modification is identified, an entity shall determine if the modification to the contract shall be treated as a separate contract (that is, separate from the original contract). A lease modification should be treated as a separate contract when both of the following conditions are present:

  1. 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).
  2. 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.

If both of these conditions are met, then the modified lease should be treated as a separate lease, which is treated similar to how leases were accounted for at the adoption of ASC 842.

If both criteria are not met then the modification is not accounted for as a sperate contract, and the entity shall reassess the classification of the original lease as of the effective date of the modification. When an entity is required to reassess lease classification, the entity shall reassess classification of the lease on the basis of the facts and circumstances on the modified terms and conditions, as of the date the reassessment is required.

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:

  1. 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).
  2. 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.
  3. Fully or partially terminates an existing lease (for example, reduces the assets subject to the lease).
  4. Changes the consideration in the contract only.

In the case of 1, 2, or 4, 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.

In the case of 3, 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.

Reach out for assistance!

The implementation of ASC 842 continues to be a complex new area of accounting. Please reach out to your Delap team whenever there are changes in your lease agreements. We can help ensure you are properly accounting for all new leases and lease modifications in the future.

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