Lease Modifications Under IFRS 16
Table of Contents
Lease Modifications
Lease modifications occur when there is a change in the terms of a lease that was not part of the original terms and conditions of the lease. In most cases, these necessitate the lessor and lessee to make changes to the way they account for the lease.
The following are examples of a lease modification:
- An increase in lease payments are negotiated
- The lease term is extended or reduced
- There is a change in residual value guarantees
In the rest of this article, we will explore how lessees and lessors accounts for lease modifications.
Lessees
IFRS 16 paragraph 36 requires a lessee to remeasure the lease liability to reflect any reassessments or lease modifications. This involves the lessee recalculating the present value of the lease liability on the date the modification occurs. The remeasurement is recorded as an adjustment to the right-of-use asset. The right-of-use asset can however not be reduced to a balance less than zero - any excess remeasurement adjustments should instead be recognised in profit or loss.
Should the modification decrease the scope of the lease, the lessee should account for the partial or full termination of the lease by reducing both the lease liability and the right-of-use asset by the percentage that was terminated.
However, in certain cases, the modification could result in a new lease altogether, that is recognised separately from the original lease. In such cases, no remeasurement of the original lease may be necessary. For this to apply, the remeasurement must meet the following criteria (see paragraph 44):
- There is an increase in the scope of the lease, adding the right to use one or more underlying assets and
- The consideration payable by the lessee increases commensurate (in line) with the change in scope (based on stand-alone selling prices).
Lessee example
The carrying amount of the lease liability immediately before the remeasurement is 500 000, while the right-of-use asset is 150 000. After a change to the lease term, the entity recalculates the lease liability to be R200 000 (an adjustment of -300 000). The journal entry for the remeasurement, on the day of remeasurement is as follows:
Dr Lease Liability 300 000
Cr Right-of-use asset 150 000
Cr Profit on remeasurement of lease liability 150 000
Discount Rate Guidelines
When doing the remeasurement, the lessee should use a
- revised discount rate if:
- There was a change in the lease term
- There was a change in the assessment of an option to purchase the underlying asset
- Variable lease payments changed (only if the payments are linked to a floating interest rate)
- unrevised discount rate if:
- Change in amount expected to pay under residual value guarantee
- Variable lease payments changed due to index or rate changing (excluding interest rates)
Lessors
Finance Leases
Similar to lessees, a modification to a finance lease can also result in the recognition of a separate lease. The conditions are the same as mentioned above (increase in scope of the lease, with a proportionate increase in consideration).
For other modifications, not resulting in a separate lease, the lessor shall consider whether the modification would have resulted in the lease being an operating lease, if it had been in effect at the inception date.
A lease that would have been an operating lease - the lessor shall:
- Account for the lease modification as a new lease from the effective date of the modification; and
- Measure the carrying amount of the underlying asset as the net investment in the lease immediately before the effective date of the lease modification.
Effectively, the lease will continue as an operating lease going forward, but the lessor has to recognise the underlying asset again. The underlying asset was derecognised when the finance lease was recognised.
A lease that would not have been an operating lease - the lessor shall remeasure the net investment in the lease (financial asset) based on the guidance of IFRS 9. In the vast majority of cases, this will simply mean remeasuring the net investment in the lease through profit or loss.
Operating Leases
The treatment for operating leases is straightforward, as there is minimal impact on the statement of financial position.
The lessor shall account for the modification as a new lease. Any prepaid or accrued lease payments, that occurred as a result of a mismatch between actual and straight-lined lease payments, shall be considered as lease payments for the new lease.
If at the modification date, there are prepaid lease payments (a liability for the lessor), this amount will increase the total lease payments that are recognised as rental income on a straight-line basis. A simple illustration is: There is a liability that has to be written-off over the new/remaining lease term. This will require a debit entry, for which the corresponding credit entry will be increased rental income.
The opposite holds true for accrued lease payments (an asset for the lessor). These amounts will reduce the lease payments that are recognised as income on a straight-line basis.
Conclusion
It is important for lessees and lessors to understand how to correctly account for lease modifications in the financial statements. While lease modifications can feel overwhelming at first, they are easy to navigate once you understand the requirements for the different lease types.
For more information or specific queries, please contact us at insight@leash.co.za.