ASC 842 Modifications and Remeasurement
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 (ASC 842 Glossary). Examples are adding an asset or extending the contractual term.
Unless it qualifies as a separate contract under ASC 842-10-25-8, the lessee remeasures the lease liability using a discount rate determined at the modification's effective date (ASC 842-10-25-11). When the modification adds a right of use, changes the term or changes only the consideration, that remeasurement is recorded against the right-of-use asset (ASC 842-10-25-12). A full or partial termination is treated differently (ASC 842-10-25-13).
In practice, a term extension raises the lease liability and the right-of-use asset by the same amount (ASC 842-10-25-12). The modification itself produces no gain or loss, and the month's lease cost is recorded as usual (ASC 842-20-25-6). Lease classification is reassessed at the modification's effective date (ASC 842-10-25-9).
The ASC 842 lease accounting standard, introduced by the Financial Accounting Standards Board (FASB), reshaped how organizations account for leases.
A critical aspect of this standard is how it addresses lease remeasurements and modifications. Lease modifications and remeasurements require careful attention under ASC 842. This guide focuses on these specific scenarios. For comprehensive coverage of all ASC 842 topics, visit our ASC 842 Complete Guide. This article aims to demystify these concepts, presenting them in an accessible manner while providing practical examples to enhance understanding.
Understanding Lease Modifications and Remeasurements
Lease modifications and remeasurements under ASC 842 occur when there are changes to the lease agreement that alter the scope or the consideration (payment amounts) of the lease. These changes can significantly impact the financial statements of both lessees (the ones who lease the assets) and lessors (the ones who own the assets).
What is a Lease Modification?
A lease modification happens when the lessee and lessor agree to change the terms and conditions of the lease agreement. Modifications can include changes to the lease term, changes to the leased asset (like adding or subtracting assets), or changes to the lease payments.
What is a Lease Remeasurement?
Remeasurement is the process of adjusting the lease liability and right-of-use (ROU) asset on the balance sheet to reflect changes in the lease's terms or assessments. This can occur due to a lease modification, a change in the lease term (like exercising an extension option), or a resolved contingency that makes variable payments fixed.
The index or rate moving under the existing terms is not a modification and does not trigger remeasurement (ASC 842-10-35-4(b), 35-5). Agreeing to add or change an index-based payment is a modification (KPMG Handbook: Leases, Question 6.7.06).
Lease Modification Accounting
When a lease modification occurs, the lessee must determine if the modification should be accounted for as a separate contract or if it requires remeasurement of the existing lease liability and ROU asset.
This determination depends on whether the modification grants the lessee an additional right of use not included in the original lease and if the lease payments increase commensurate with the standalone price for the additional right of use.
Separate Lease
If the modification grants an additional right of use at a price commensurate with its standalone price, the modification is accounted for as a separate lease.
This means the lessee would recognize a new lease liability and ROU asset for the modification without adjusting the original lease.
Existing Lease Remeasurement
If the modification does not qualify as a separate lease, the lessee must remeasure the lease liability using the discount rate as of the modification's effective date.
The ROU asset is adjusted by the same amount as the lease liability (ASC 842-10-25-12). A gain or loss arises only when the modification fully or partially ends the lease (ASC 842-10-25-13), or when a decrease would take the ROU asset below zero (ASC 842-20-35-4).
Separate Lease or Modification? The ASC 842-10-25-8 Test
A lease amendment is accounted for as a separate new lease only when both conditions in ASC 842-10-25-8 are met. The amendment must grant an additional right of use not included in the original lease, such as another floor. The lease payments must also increase commensurate with that right's standalone price, adjusted for the contract's circumstances. If either test fails, the amendment is a modification of the existing lease.
Extending the term does not pass the first test. KPMG's Handbook: Leases (paragraph 6.7.30, note 1) explains that lease term is an attribute of the existing right of use, so an extension is a modification remeasured under ASC 842-10-25-11(b). KPMG also concludes that an amendment adding a floor while changing the original floors' term or rent cannot be split into a separate contract (Question 6.7.09).
Exercising an option already written into the lease is not a modification. ASC 842-10-25-11(b) excludes the exercise of a contractual option to extend or terminate. If the lessee had judged the option not reasonably certain to be exercised, exercising it triggers a reassessment of the lease term (ASC 842-10-35-1(c)).
For a lease modification, the effective date is the date both lessee and lessor approve it (ASC 842 Glossary). KPMG restates that definition in Handbook: Leases, paragraph 6.7.20.
Modification and Remeasurement Journal Entries
When a lease modification is made under ASC 842, certain journal entries are required to reflect the changes in the financial statements accurately. These entries depend on whether the modification is treated as a separate lease or a remeasurement of the existing lease.
For a modification that results in a remeasurement, the lessee needs to adjust both the lease liability and the right-of-use (ROU) asset on their balance sheet. The lease liability is adjusted to reflect the present value of the future lease payments, using the discount rate at the modification date.
The ROU asset is adjusted by the same amount as the lease liability (ASC 842-10-25-12). For example, if the lease liability increases due to the modification, the ROU asset is increased by the same amount.
If the lease liability falls by more than the ROU asset's carrying amount, the asset goes to zero and the rest is recognized in profit or loss (ASC 842-20-35-4). KPMG applies this to modifications in its Handbook: Leases, Question 6.7.30.
Conversely, for modifications treated as separate leases, a new lease liability and ROU asset are recognized for the additional right of use granted by the modification, without altering the original lease's accounting. These journal entries ensure that the financial statements present the lease's current terms and conditions accurately, maintaining the integrity of financial reporting under ASC 842.
Examples of Lease Modifications and Remeasurements
Example 1: Lease Extension
A company amends its office lease to extend the term at current market rent. The extension is still not a separate lease, because lease term is an attribute of the existing right of use (KPMG Handbook: Leases, paragraph 6.7.30, note 1; ASC 842-10-25-11(b)). The company must remeasure the lease liability using the revised lease term and adjust the ROU asset accordingly.
Example 2: Addition of Another Floor
Suppose a business leasing two floors in a building decides to lease an additional floor under the same lease agreement, with the lease payments increasing by an amount commensurate with the standalone price of leasing the additional floor. This would be treated as a separate lease for the additional floor, requiring recognition of a new lease liability and ROU asset.
Example 3: Change in Lease Payments
If the lessee and lessor agree to change only the lease payments, that is a modification under ASC 842-10-25-11(d). The lessee must remeasure the lease liability using the updated lease payments and adjust the ROU asset accordingly. This adjustment reflects the new expectation of future lease payments.
The index or rate moving under the existing terms is not a modification and does not trigger remeasurement (ASC 842-10-35-4(b), 35-5). Agreeing to add or change an index-based payment is a modification (KPMG Handbook: Leases, Question 6.7.06).
How ASC 842 Modification Accounting Differs from ASC 840
ASC 842 replaced ASC 840, and its modification guidance does not carry over. KPMG's Handbook: Leases calls it "substantially different from, and more extensive than," the Topic 840 guidance (paragraph 6.7.80).
Private companies adopted ASC 842 for fiscal years beginning after December 15, 2021, and interim periods in fiscal years beginning after December 15, 2022 (ASC 842-10-65-1(b)). A lease that began under ASC 840 and is amended on or after the effective date follows ASC 842 from the modification's effective date. The transition rules are ASC 842-10-65-1(q) for former operating leases and 65-1(t) for former capital leases.
Under ASC 840-10-35-4, a change in provisions that would have produced a different classification at inception was treated as a new agreement. That is the old rule as KPMG summarizes it in Handbook: Leases, Question 7.8.70. ASC 842 instead reassesses classification at the modification's effective date (ASC 842-10-25-9) and remeasures the lease liability (ASC 842-10-25-11).
Termination penalties also changed. KPMG notes (Question 6.7.15) that under ASC 840 and ASC 420, a lessee may have recognized a penalty at the modification date.
Under ASC 842, KPMG concludes that a penalty in a partial termination is not expensed up front. The penalty is a lease payment, so it increases the remeasured lease liability, and the offsetting entry is to the remaining right-of-use asset. It is then recognized as part of lease cost over the remaining term of the space kept.
A gain or loss under ASC 842-10-25-13 can still arise in a partial termination. It equals the difference between the proportionate decrease in the lease liability and the proportionate decrease in the right-of-use asset, and it excludes the penalty.
Keeping Lease Records Current as Terms Change
Lease modifications and remeasurements under ASC 842 are critical aspects that require careful consideration by both lessees and lessors. They ensure that the financial statements accurately reflect the terms and conditions of lease agreements as they evolve over time.
By understanding how to account for these changes, organizations can maintain compliance with ASC 842 and provide transparent reporting to stakeholders. Whether it's extending a lease, adding new assets, or adjusting lease payments, the way these modifications are accounted for has a significant impact on an organization's balance sheet and income statements.
Through practical examples, we've seen how these adjustments are made, providing clarity to a complex process and ensuring organizations can navigate their lease accounting with confidence.
At iLeasePro, our leasing experts have worked with both ASC 840 and ASC 842 for years, and we understand the changes, the logic behind them, and why they're important.
We can help explain them to you to make sure you get them right, and we can provide the right software products to help you record and implement the ASC 842 changes correctly.
To do this, you can call iLeasePro at 888-351-4606, or you can go to iLeasePro and access our excellent information about our software products and how they can help you with ASC 842. We'll give you all the information you need to simplify the recording process and show you how to use it to improve your bottom line.
Frequently asked questions
- What is a lease adjustment under ASC 842?
- Lease adjustment is not a defined ASC 842 term; in practice the phrase is used loosely, usually for the remeasurement after a modification. The right-of-use asset normally moves by the same amount as the lease liability (ASC 842-10-25-12). If a decrease exceeds the asset's carrying amount, the remainder goes to profit or loss (ASC 842-20-35-4). A full or partial termination can produce a gain or loss (ASC 842-10-25-13), measured from the proportionate decreases in the liability and the asset.