Theory and Practice
A lease modification is a change in the terms of the contract – for example, adding or terminating the right to use certain assets, shortening or extending the lease term, or changing the consideration. The accounting treatment depends on the nature of the change:
Separate contract or not: Both IFRS 16 and ASC 842 first determine if the modification is effectively a new, separate lease. A modification is treated as a separate lease if it adds the right to use one or more underlying assets at a commensurate increase in rent (IASB, 2016; Financial Accounting Standards Board, 2016b). For instance, a lease of one floor of a building is modified to grant the lessee an additional floor at market rent – this would be a separate lease (accounted for prospectively, leaving the original lease unchanged). If the modification does not meet the criteria for a separate contract, then it is accounted for as a remeasurement of the existing lease.
Lessee accounting for modifications (not separate): Under IFRS 16, the lessee must remeasure the lease liability on the effective date of the modification using a revised discount rate (generally the current incremental borrowing rate) (IASB, 2016). The ROU asset is adjusted by the same amount. No immediate gain or loss is recorded unless the modification involves a partial or full termination of the lease. If the scope of the lease is reduced – e.g., the lessee releases a portion of the leased space or shortens the lease term – the lessee reduces the carrying amount of the ROU asset and lease liability accordingly and recognizes a proportionate gain or loss (IASB, 2016). For example, if a modification shortens a lease’s term, the lessee will remeasure the liability to the shorter term (using a new discount rate) and reduce the ROU asset; any difference between the reduction in the liability and the write-down of the ROU asset is taken to profit or loss at the time of modification. If the modification extends the lease term or changes future cash flows otherwise (without reducing scope), typically no Income Statement impact arises – the lessee just remeasures the liability and adjusts the ROU asset prospectively.
Under ASC 842, the process is conceptually similar: the lessee remeasures the lease liability at the modification date and adjusts the ROU asset accordingly (Financial Accounting Standards Board, 2016b). However, US GAAP has an additional step – the lessee must re-assess the lease classification as of the modification date (i.e., operating vs finance) (Financial Accounting Standards Board, 2016b). If a modification of an operating lease would result in a finance lease classification (for example, by lengthening the term such that it meets capital lease criteria), the lessee must account for the lease from that point on as a finance lease. Similarly, a finance lease could become an operating lease if modified. In contrast, IFRS has a single lessee model, so no classification change occurs – a lease is always effectively “finance” from the lessee perspective. Aside from classification, US GAAP’s measurement approach to modifications is otherwise in line with IFRS (the liability is remeasured with a new discount rate, and the ROU asset is adjusted, with gain/loss recognized only if the modification is effectively a partial termination) (Financial Accounting Standards Board, 2016b).
Practical insight: Lessees should implement controls to identify and assess lease modifications promptly. Under both frameworks, modifications require recalculation of the liability (new discount rate, updated cash flows) and typically an adjustment of the asset. IFRS’s approach may be simpler since there’s no need to consider dual classification; US GAAP’s classification check could mean a change in expense pattern (e.g., an operating lease modified could turn into a finance lease with front-loaded expense thereafter). Companies with large lease portfolios often use software to manage these calculations. Note also that certain modifications can be favorable or unfavorable – for instance, if a lease is modified to lower the rent, the lessee will record the reduction by decreasing the liability and the ROU asset, recognizing a gain to the extent the liability decrease exceeds the asset decrease. Conversely, an unfavorable modification (increasing scope or rent) generally increases both the liability and asset, with no immediate Income Statement hit.