Historically, accounting for lease modifications is an area you may have found an infrequent need to address. The COVID-19 pandemic has upset that general rule, with lease concessions and terminations becoming all too common to afford relief to lessees under difficult economic conditions and disruptions. These adverse circumstances have served to place a spotlight on the necessity for entities to have processes and systems in place to account for lease modifications properly
Because many companies were forced to reduce on-site employees or to ask employees to work from home, the necessity for leased space significantly decreased in 2020 and into 2021. As restrictions are lifted in some areas, some companies are allowing their employees to return to the office and are requiring additional leased space once again, while others have decided to permanently reduce their real estate footprint and expenses. With these volatile changes affecting both the economy and how entities conduct their business and with the impending implementation of the new leases standard for private companies, many are asking, “How should we account for lease modifications under ASC 842?”
First, let’s consider the key questions for typical modifications under ASC 842, Leases.
Leases are contracts and have specific performance rights and obligations. If circumstances or agreements between the lessee and lessor require modifications, you should first determine if the lease contract already considered the changes at issue. If the initial contract provided for the relevant changes, modification accounting would not be applied under ASC 842 (or ASC 840). You also have to consider if the modified contract remains a lease. If a lease still exists, the modification could be accounted for in the following ways:
- A change to the accounting for the existing lease; or,
- A separate, new contract and the unchanged existing lease.
When the modification meets both of the following criteria, lessees and lessors account for the changes as a new, separate contract:
- The lessee obtains an additional right of use not included in the current lease.
- The additional right of use has a commensurable increase in the lease payments, taking the circumstances of the contract into account.
Modifications that are not treated as separate contracts will require you to reassess the lease classification and lease term as of the effective date of the modification and account for any initial direct costs, lease incentives, or any other modification-related payments using the same principles as if this were a new lease.
Using the rate implicit in the lease, if known, or more likely the incremental borrowing rate as of the effective date of the modification, the lessee is required to reallocate the remaining consideration, remeasure the lease liability, and adjust the right-of-use asset(s) if the modification results in any of the following conditions:
- The lessee obtains an additional right-of-use that is not included in the original lease nor accounted for as a separate contract.
- The lease term is changed.
- The lease is partially or fully terminated (which may result in a gain or loss for any difference in reduction of the lease liability as compared to the reduction of the right-of-use asset).
- The consideration only is changed in the lease.
If the lease classification is reassessed from a finance lease to an operating lease, a difference between the right-of-use asset carrying value after the aforementioned adjustments and the carrying value resulting from measurement under initial operating lease guidance would be treated in the same way as prepaid rent or a lease incentive.
If a modification is not considered as a separate contract, the accounting for a lessor depends on the classification of the original lease as compared to the reassessed classification of the modified lease as of the effective date of the modification.
Next, let’s address modification accounting considering the types of concessions afforded to lessees that are specifically related to the COVID-19 pandemic and the corresponding relief that the FASB offered as an accounting policy election to ease accounting burdens on those affected by the adverse impacts of the pandemic.
Effects of the COVID-19 Pandemic
With lessees suffering the financial impacts of the pandemic, many were unable to make payments according to their lease agreements. In response, some lessors offered lease concessions, most commonly in the form of payment forgiveness or deferrals, to lessees to maintain the business relationship and to reap any possible income. Under ASC 842 lease accounting, modifications that require accounting as if it were a new lease are assumed to affect the remaining lease term. This isn’t always the case when many are anticipating that the concessions won’t be long-term, but rather only temporary relief. So will you apply modification accounting for lease concessions that won’t reasonably affect the entire lease term?
The Financial Accounting Standards Board (FASB) issued the FASB staff question-and-answer document (Q&A) on Topic 842 and Topic 840: Accounting for Lease Concessions Related to the Effects of the COVID-19 Pandemic in April 2020 to address the concerns and implementation efforts and costs associated with accounting for leases that are “directly affected by the economic disruptions caused by the COVID-19 pandemic” and that “do not result in a substantial increase in the rights of the lessor or the obligations of the lessee.”
Citing the unprecedented global nature of the pandemic, the lack of specific guidance to address the resulting circumstances, and the challenges presented in time and costs to analyze and account for possibly a great magnitude of lease modifications within an entity, FASB made it possible for entities to make an accounting policy election to assume any concessions related specifically to the COVID-19 pandemic are explicitly stated as enforceable rights and obligations within a lease, whether they are explicitly stated or not.
As a result of making this policy election, you would not have to analyze each lease contract and could elect to apply or not to apply lease modification accounting under ASC 842 (or ASC 840). The policy election must be applied to similar leases with similar circumstances in a consistent manner.
Consider using a Leases Toolkit to assist you in your implementation and application of the new FASB Codification Topic 842, Leases, and to ensure that you have good process and documentation.