Re-assessment or lease modification?
By Adil Khan
Manager Audit and Assurance Services,Mazars Abu Dhabi, UAE
It is sometimes very crucial to determine, whether the scenario in place would be treated as re-assessment or lease modification.
In this article I would like to through light on the difference between the re-assessment and the lease modification and their accounting treatments under IFRS 16 with the help of number of illustrations. Subsequent to initial application of the IFRS 16, it is likely to encounter the issues of the lease re-assessment and lease modification.
According to the IFRS 16, A re-assessment of the lease liability takes place if the cash flows change based on the original terms and conditions of the lease. Changes that were not part of the original terms and conditions of the lease would be considered as lease modifications.
A lease modification is a change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and conditions of the lease. Any change that is triggered by a clause that is already part of the original lease contract, including changes due to a market rent review clause or the exercise of an extension option, is a re-assessment and not a modification.
Executive summary on lease modification:
There could be multiple reasons why the lessor and the lessee renegotiate and modify their existing lease contracts. One purpose could be to increase or shorten the lease period of an existing contract (with or without changing the other substantial contractual terms); another reason could be to change the underlying asset (e-g, a lessee already leases 2 floors of a building, and both parties agree to add a 3rd one). The lessor might agree to reduce lease payments as a rent concession/discount to support a restructuring to assist lessee upon the request.
Very important to note that the new agreements could also be in-substance modifications of an existing lease. For instance, in between a lease, the same parties enter into a new lease agreement for the same underlying asset starting when the original lease ends. The original lease remains effective, without any changes. In substance, this is comparable to a modification of the existing lease which extends the lease term without adding the right to use more underlying assets, and it should be accounted for as a lease modification.
The point of discussion under this article would be mainly on lease modifications. The accounting for lease modification depends on how the contract is modified. Lease modification could be treated in different ways depending on the modification(s):
- Modification of the lease – Increases in the scope of a lease will be treated as separate lease contract.
- Modification of the lease – Increases in the scope of a lease will not be treated as separate lease contract.
- Modification of the lease – Decreases in the scope of a lease.
- Modification of the lease – No change in the scope of a lease.
Kindly note that, the effective date of the modification is the date on which the parties agree to the modification of the lease.
1-In case of modification if there is Increases in the scope of a lease when it is treated as separate contract?
If a modification increases the scope of the lease by adding the right to use more underlying assets, and the increase in the lease consideration is equivalent, the modification is accounted for as a separate lease. To be equivalent, the increase in the lease consideration does not need to be equal to the standalone price of the increase in scope.
Example, if a lessee already leases floors in a building and the modification adds the right to use an additional floor, the additional consideration could be different from the stand-alone price, because the lessor could avoid costs of looking for a new lessee (such as marketing costs).
Illustration:/ Separate lease contract:
Company A (the “Lessee”) enters into a 10-year lease for 2,000 square meters of office space. At the start of Year 6, Lessee and Lessor made amendments the original lease for the remaining 5 years to include an additional 3,000 square meters of office space in the same building. The increase in total consideration for the lease is proportional with the current market rate for the new 3,000 square meters of office space, adjusted for the discount that Lessee receives because Lessor does not incur costs that it would otherwise have incurred if leasing the same space to a new tenant (e-g, marketing costs).
As per the IFRS 16, the Lessee should account for the modification as a separate lease, separate from the original 10-year lease. Because the modification grants Lessee an additional right to use an underlying asset, and the increase in consideration for the lease is commensurate with the stand-alone price of the additional right-of-use adjusted to reflect the circumstances of the contract. Further to clarify, the additional underlying asset is the new 3,000 square meters of office space. No need to make any adjustments to the accounting for the original lease of 2,000 square meters of office space as a result of this modification, this modification (3,000 square meters) will be treated as new separate contract for the 5 years.
2-In case of modification if there is Increases in the scope of a lease when it is not treated as separate contract?
If a modification increases the scope of the lease without adding the right to use more underlying assets, or the increase in lease consideration is not proportional, the modification is accounted for by remeasuring the existing lease. The lessee will remeasure the lease liability at the date of the modification, using a revised discount rate, and it makes a corresponding adjustment to the right-of-use asset.
Illustration:/ not a separate lease contract:
Company A (the “Lessee”) enters into a 10-year lease for 5,000 square meters of office space. The annual lease payments are $100,000 payable at the end of each year. The interest rate at the commencement is 6% per annum. At the start of Year 7, Lessee and Lessor agree to amend the original lease by extending the lease term by further 4 years. The annual lease payments are unchanged (i.e $100,000 payable at the end of each year from Year 7 to Year 14). Lessee’s incremental borrowing rate at the start of Year 7 is 7% per annum.
As per the IFRS 16, at the start of Year 7, Lessee will remeasure the lease liability based on (i) remaining 8 years, (ii) annual payments of $100,000 and (iii) new rate of 7%. Lessee will recognize the difference between the modified lease liability and the carrying amount of the lease liability immediately before the modification and will pass an adjustment to the right-of-use asset in the statement of financial position by the same difference. No impact will be on P&L due to no change in underlying asset.
3-In case of modification if there is decrease in the scope of a lease
The scope of the lease decreases if the lease is modified to terminate the right of use of one or more underlying assets or to shorten the contractual lease term.
For example, a lessee that already leases 3 floors of a building could decrease the scope of the lease by agreeing with the lessor to reduce the lease by 1 floor for the remaining lease term. In this case, the lessee remeasures the lease liability at the date of the modification, using a revised discount rate. The lessee will decrease the carrying amount of the right-of-use asset to reflect the partial/full termination of the lease and will recognize gain/(loss) in the profit or loss.
Illustration:/ modification decreases the scope of a lease:
Company A (the “Lessee”) entered in-to a lease for 5,000 square meters of office space for 10 years. The lease payments are fixed $50,000 per year. After 5 years, the parties amend the contract to reduce the office space by 2,500 square meters. Onward 6 years, the annual lease payments will be C30,000. At the beginning of year 6 the rate is 5%.
Assuming the carrying amount of the lease liability and right of use asset is $210,618 and $184,002 respectively.
How this modification will be accounted for?
The lessee will calculate the revised lease liability for the remaining 5 years after adjustment of the above lease terms. Revised lease liability will be $129,884.
In a first step, the ROU asset and the lease liability will be reduced by 50%, because the original office space is reduced by 50%. The difference between these two amounts will be recognized as a gain in profit or loss amounting $13,308 (Which is 50% of 210,618 = 105,309 and 50% of 184,002 = 92,001 (105,309 – 92001 = 13,308)).
In a second step, the ROU asset has to be adjusted to reflect the updated discount rate and the change in the consideration. Accordingly, the difference between the remaining lease liability ($105,309) and the modified lease liability ($129,884) is recognized as an adjustment to the right-of-use asset amounting $24,575.
4-In case of modification if there is no change in the scope
If there is a change in the consideration for the lease, without increasing or decreasing the scope of the lease, results in a remeasurement of the lease liability and a corresponding adjustment to the ROU asset. The lessee remeasures the lease liability, using the revised rate for the remaining the lease term, and pass a corresponding adjustment to the ROU asset merely (no impact in the P&L).