Lease modifications arise from changes to the underlying contract agreed between the lessee and the lessor subsequent to commencement of the lease.
Under IFRS 16, the accounting for the modification depends on whether the modified terms increase or decrease the scope of the lease, and whether increases in scope require consideration to be paid that is commensurate with a ‘stand-alone price’ for the new scope of the lease.
Modifications – Separate Leases
A lease modification is accounted for as a separate lease if:
- The modification increases the scope of the lease by adding the right to use one or more underlying assets; and
- The consideration for the lease increases by an amount commensurate with the standalone price for the increase in scope.
Modifications – Not Separate Leases
The accounting treatment required for lease modifications that are not accounted for as separate leases is summarised below:
A. Decrease in scope
- Decrease right-of-use asset and lease liability by their relative scope compared to the original lease taking the difference to P&L
- Remeasure lease liability using revised discount rate* with off-set to RoU asset
B. All other lease modifications
- Remeasure lease liability using revised discount rate*
- Remeasure right-of-use asset by same amount
- No P&L impact
* The prevailing incremental borrowing rate at date of modification is used unless the implicit rate in the lease is readily determinable.
Entity A has a 10-year lease on 5.000 square metres of office space with annual payments of $100.000 payable at the end of each year.
The rate used to discount the payments is Entity A’s incremental borrowing rate of 6% as the implicit rate is not readily determinable.
At the beginning of Year 7, Entity A and the lessor amend the lease by extending it for an additional 4 years. The annual payments remain unchanged.
At the beginning of Year 7, Entity A’s incremental borrowing rate is 7%.
The modification is not accounted for as a new lease as it does not convey the right to use any additional assets. The lease is for the same underlying property.
Therefore, the lease is remeasured using a revised discount rate (i.e. the incremental borrowing rate at the time of the modification; not the original discount rate).
The lease liability immediately prior to the modification is $346.511.
Present value of Years 7 – 14 (8 years), $100.000 a year, 7% discount = $597.130
Adjustment required = newly remeasured liability – previous carrying value of liability = $597.130 – $346.511 = $250.619
Entry required as a result of the modification:
Dr Right-of-use asset $250.619
Cr Lease liability $250.619
Entity B has a 10-year lease on 5.000 square metres of office space with annual payments of $50.000 payable at the end of each year.
The rate used to discount the payments due is Entity B’s incremental borrowing rate of 6% as the implicit rate is not readily determinable.
At the beginning of Year 6, Entity B and the lessor agree to reduce the lease to 2.500 square metres and reduce the remaining payments to $30.000 a year.
At the beginning of Year 7, Entity A’s incremental borrowing rate is 5%.
The modification is a decrease in scope from the original contract so the lease liability and right-of-use asset must be remeasured.
The lease liability immediately prior to the modification is $210.618 and the right-of-use asset is $184.002.
The scope of the decrease in the right-of-use asset is 50%, as the leased space has decreased from 5.000 square metres to 2.500.
Present value of years 6 – 10 (5 years), $30.000 a year, 5% discount = $129.884
Step 1: Entry required to adjust the carrying balances to reduce scope
Dr Lease liability $105.309 ($210.618 original * 50%)
Cr Right-of-use asset $92.001 ($184.002 original * 50%)
Cr P/L $13.308 (b)
Step 2: Entry required to adjust lease liability to the required revised balance of $129.884
Dr Right-of-use asset $24.575 (corresponds to liability adjustment)
Cr Lease liability $24,575 ($210.618 – $105.309 + $24.575 (b) = $129.884)