Key accounting factors to consider when making lease modifications
In the aftermath of the pandemic, many organizations are re-evaluating the amount of available workspace in their leases, whether for space management or financial reasons. This requires real estate accountants to modify leases properly and stay compliant with GAAP and lease accounting processes.
What is a modification of a lease under GAAP?
Any changes to your financial obligation during the term of the lease will cause a modification to your lease accounting capitalization schedule from the date you realize the change until the end of the term. Modifying a capitalization schedule may require a different set of calculations than your original lease schedule. When you modify your lease schedule due to a change in the term of the lease, or a change to the liability, you can change the discount rate to be based on the new/remaining term.
Common examples of lease modification triggers include:
- Early renewals
- Extension of lease
- Cancel early
- Each time you receive an allowance payment from the landlord
- Blend & extend
- Rent tied to outside index (CPI) – Different rules for FASB & IASB
- Renegotiate your rent
- Expansion – Creates a new ROU Asset, therefore you will create a new capitalization schedule for the new space as opposed to re-measuring the existing schedule.
Lease accountants need to be aware of what will trigger a lease modification and how to properly account for it. Be sure to work with your legal team and management to ensure all lease changes are accurately and completely included in your financial information.
Accounting questions to ask yourself before entering a lease modification
The current trend of re-evaluating available workspace and leases means that lease accountants need to ensure they’re following compliance guidelines and best practices under ASC 842.
Here are four accounting factors to consider before modifying a lease.
1) Dates – What is the effective date of the modification?
The date in which the modification becomes effective is important when you are entering changes under the new standard. Your accounting policy will dictate when the negotiations are considered final, whether it’s in writing or verbally, and this will become your modification date. There is usually a gap between the official modification date and the effective date of the changes in terms. This impacts the recognition of the measurement of lease liability and ROU asset. For example, a lease extension is being negotiated to start in September 2021 but is signed in July 2021. The effective date of the modification will be July 2021 and all financial information should be adjusted as of that date.
Be careful around quarter or year end reporting and make sure all changes in those periods are included by gathering all pending lease modifications from legal or lease administration. It’s important to use the correct date of modification because it determines what interest rates you use, what expenses are recalculated for the remainder of the lease, and the new liability and corresponding ROU asset.
2) Costs – How will a change in lease expense affect my financial balances? How will current interest rates affect my lease accounting when I modify?
Any increase or decrease in your overall cash payments for the existing lease are going to directly impact the liability and asset on your books. Additionally, the modification date will dictate the interest rate to use on the new liability as noted above. The new lease liability will be remeasured as of the effective date of modification using the new interest rate and lease payments. Any difference in the liability from what’s been previously recorded will be adjusted against the ROU asset.
3) Increasing or reducing existing space – How will my accounting numbers change as I downsize or increase my available workspace?
Often, an existing lease will be modified for the addition of space, which changes the terms of the original lease and a brand-new lease is papered for the same property. For accounting purposes, we can treat this as a new lease with a corresponding interest rate as of the “new lease” date for all the new space. The new lease will begin immediately following the end of the old one.
If an existing lease is continuing with no changes and additional space is being leased from the same landlord, then the new space should be accounted for as a new lease with current interest rates, and the existing lease should remain unchanged. These will be treated as separate leases under their respective terms.
Any reductions in lease space would be considered partial terminations and the liability and ROU asset must be reduced as of the effective date of the modification. This may also 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.
4) Lease term – What if I am extending my lease term? Will I include options on the modification? How are my balances impacted by a reduction in term?
If you are extending a lease, the effective date of the modification will dictate the new interest rate which will be used to calculate the liability and adjust the ROU asset. This should not be accounted for as a new lease, but as a modification. Consider if any options were previously included as reasonably certain upon adoption before adding the new amounts, as they would have already been included in your balances.
A reduction in lease term will result in a modification of the liability and asset that is less than you have recorded. Any early terminations may result in a gain or loss for any difference in the reduction of the lease liability as compared to the reduction of the right-of-use asset.
If you are modifying a lease to end earlier and you had previously included options that were not exercised, you will have a decrease in the liability and potentially an adjustment to expense for the inclusion of the option payments in the original liability. Reasonably certain options that may have been included upon adoption potentially are not deemed certain upon modification of the lease due to new economic circumstances and will need to be considered for the modification.
Using software to simplify the lease modification accounting process
Utilizing purpose-built software can make it easier for you to follow the proper processes when entering lease modifications. MRI offers a variety of lease accounting software solutions for both SMB and enterprise organizations that can help you stay in compliance with IFRS 16, IASB, GASB, and FASB requirements. Keep your organization in good standing with software that simplifies journal entries for rent concessions, capitalization schedules for payments and asset management, and audit trails to easily access and review your data. See how MRI’s lease accounting solutions can benefit your business in the aftermath of COVID-19 and beyond.
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