A lease modification is a change in scope and/or consideration of a lease which was not part of the initial terms and conditions of the lease agreement. Lease modifications are treated as separate new leases (by both lessee and lessor) if there is a change in scope and the increase in consideration is commensurate with the increase in scope.
Identifying a lease modification
Let's say you company has three leases:
- Lease A: A lease for office space whose lease payments are due to change with change in the consumer price index,
- Lease B: A 3-year lease for an item of machinery, and
- Lease C: A 5-year lease for 20 delivery trucks.
During 20X9, CPI changed from 110 to 115, the lease for machinery was modified to allow an extension option, and you added an additional 5 deliver trucks on a lease whose term would match with the existing leased trucks.
Change in lease payments in Lease A due to a change in index is not a modification because the change in lease payments was agreed at the inception. It is reflected by remeasuring the lease liability and adjusting the associated right of use asset.
The introduction of an extension option in Lease B is a lease modification because the extension option was not envisioned at the commencement date of the lease.
The increase in number of delivery trucks in Lease C is also a lease modification because it increases the scope of the lease.
As IFRS 16 adopts different models for lessee and lessor, accounting for lease modification is also different for each party.
Accounting for lease modifications by a lessee
A lessee treats a lease modification as a separate lease if both the following conditions are met:
- The modification increases the scope of the lease by adding one or more underlying asset to the lease; and
- The consideration increases by an amount commensurate with the stand-alone price of the new underlying assets added.
When these conditions are met, a new lease liability and a new right of use asset are created to the extent of increased scope.
If the aforementioned conditions are not met, the lease modification is not treated as a separate lease but by remeasuring the lease liability. This involves reallocating consideration to lease and non-lease components and discounting the lease payments at the revised discount rate. Revised discount rate is the interest rate implicit in the lease for the remainder for the lease term if it can be readily determined or the lessee's incremental borrowing rate at the effective date of termination. Review lease interest rates here.
If the modification has resulted in a decrease in scope of the lease, the carrying amount of the right of use asset is reduced and any gain or loss is recognized in profit or loss. However, if there is an increase in scope, there is an increase in the right of use asset.
In the examples discussed above, Lease C would qualify for separate recognition but Lease B would not.
Let's assume further that in Lease B, the remaining lease term is 1 year, the quarterly lease rentals are $100,000 which would increase to $120,000 during the extension, the original IBR was 8% which has since increased to 2%, and the lessee is almost certain to avail the extension.
We can verify that the lease liability before the modification would be $376,197.
|Payment||Lease Payment||Discount Factor||PV|
After the modification, the lease liability would need to be remeasured at the revised discount rate.
|Payment||Lease Payment||Discount Factor @ 12%||PV|
This remeasurement of lease liability is recognized by the following journal entry:
|Right of use asset||1,056,793|
Accounting for lease modifications by a lessor
Accounting for lease modification by a lessor depends on whether the lease is initially classified as a finance lease or an operating lease.
Modification to a finance lease
When a finance lease is modified such that the modification increases the scope of the lease, and there is an increase in consideration commensurate with the increase in scope, the modification is treated as a new lease.
When a lease modification does not qualify for recognition as a separate lease, and the lease would have qualified for operating lease classification had the modification been in effect at the inception date, the lease modification is treated as a new lease and the net investment in lease just before modification becomes the carrying amount of the underlying asset. However, if such a lease wouldn't qualify for an operating lease classification at inception, the modification is treated just like a modification in financial asset accounted for under IFRS 9.
Modification to an operating lease
A modification to an operating lease is always accounted for by the lessor as a new lease. Any prepaid or accrued lease rentals are reflected in the new lease.