Background
IFRS 16 Leases was issued in January 2016 and it is effective for accounting periods beginning on or after 1 January 2019.
Companies have interacted with the standard for close to six years now and this is no longer a new standard. While the users have understood most of the concepts and practical issues in lease accounting, lease modification remains challenging for most.
This publication will delve into what constitutes a lease modification and how companies should account for the modification in line with IFRS 16. We will focus on the lessee accounting.
What is a lease modification?
IFRS 16 defines a lease modification as 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.
A lease modification includes:
- increasing or decreasing the right to use (ROU) one or more underlying assets;
- extending or shortening the contractual lease term; or
- increasing or decreasing the contractual lease payments.
The standard distinguishes between a lease modification that is accounted for as a separate lease and that which is not accounted for as a separate lease at the effective date of the lease modification.
In a summary:
- For a modification that is accounted for as a separate lease, the lessee does not adjust the initial lease. The lessee will account for the new lease separately; and
- For a modification that is not accounted for as a separate lease, the lessee remeasures the initial lease; no new lease is created.
A lease modification to a short-term lease will be considered a new lease in cases where the lessee applies the recognition exemption for short-term leases.
Guidelines for accounting for lease modifications
A lessee accounts for a lease modification as a separate lease if both of these conditions are met:
- 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 equivalent to the standalone price for the increase in scope and any appropriate adjustments to that stand-alone price to reflect the circumstances of the particular contract.
For a modification that is not a separate lease, the lessee remeasures the lease liability at the effective date of the modification using a revised discount rate. The lessee shall account for the remeasurement of the lease liability by:
- for modifications that decrease the scope of the lease: decreasing the carrying amount of the right-of-use asset to reflect the partial or full termination of the lease, and recognising a gain or loss that reflects the proportionate decrease in scope; and
- for all other modifications: making a corresponding adjustment to the right-of-use asset.
The diagram below provides a summary of the accounting for lease modifications by a lessee.
The effective date of a lease modification
This is the date when both parties agree to the lease modification. In practice, this is usually the date when the modified contract is signed by both parties. The lease liability and right-of-use asset are remeasured at this date for modifications that are not accounted for as separate leases.
However, companies have to assess the unique scenarios where a modification is agreed on a certain date but the change in the right of use or consideration happens at a different date.
Is lease modifications different from lease reassessments?
Yes. Lease modifications are different from lease reassessments.
Lease reassessments are changes in the lease payments based on contractual clauses included in the original contract whereas lease modifications are changes 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.
Common examples of scenarios that result in reassessments for lessees include change in:
- the lease term due to assessment of renewal or termination options;
- assessment of whether a purchase option will be exercised;
- the expected amount payable under a residual value guarantee;
- the future lease payments from a change in the index or rates used to determine those payments;
- the lease payments resulting from a change in floating interest rates.
After the commencement date, a lessee remeasures the lease liability to reflect changes to the lease payments. A lessee recognises the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset.
If the carrying amount of the right-of-use asset has already been reduced to zero and there is a further reduction in the measurement of the lease liability, then the lessee recognises any remaining amount of the remeasurement in profit or loss.
The lessee remeasures the lease liability by discounting the revised lease payments using a revised discount rate or an unchanged discount rate depending on the scenario as illustrated below;
By Alexander Thuku,
Senior Consultant and Accounting Panel Expert, AARO
