Breaking Down Modifications
Let’s start by highlighting what a lease modification is, as defined by US GAAP ASC 842:
A lease modification is a change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease (for example, a change to the terms and conditions of the contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term).
- Definition of Lease Modification: A lease modification (i.e. accounting for a lease amendment) involves altering the terms and conditions of a lease contract, leading to changes in the scope or consideration of the lease, such as lease payments or the lease term.
- Standard Lease Modification: Standard lease modifications are common and typically involve formal changes to lease agreements, including adjustments to rent, lease duration, property alterations, or usage arrangements. These modifications require re-evaluating the right-of-use (ROU) asset and lease liability.
- Software Solutions: Utilizing specialized software like NetLease simplifies the process of handling lease modifications, streamlining tasks such as updating lease schedules, creating journal entries, and recalculating discount rates. This software is especially valuable for managing complex lease modifications and reducing the risk of errors.
Determining the Scope of Lease Modifications
The first step in evaluating a lease modification is to determine whether the change falls under the scope of ASC 842. A lease modification is within the scope if it results in changes to the rights and obligations of the parties involved in the lease. This typically means that the modification leads to changes in the total consideration (lease payments), the lease term, or both.
The most common lease modification users will run across is referred to as a ‘standard lease modification’. A standard lease modification refers to a formal change in the terms and conditions of a lease agreement, typically involving adjustments to rent, lease duration, property alterations, or usage arrangements. Such modifications require the re-evaluation of the right of use (ROU) asset and lease liability and must be agreed upon by both the landlord and the tenant.
Example: A lease agreement contains an option to renew or extend the lease for 2 years. The lessee was not reasonably certain to exercise the renewal at the initial commencement of the lease. As such, the lessee did not include the renewal period in their lease schedule as required under ASC 842. A year into the lease, the lessee elects to exercise the renewal clause and renew or extend the lease for the stated period.
Accounting for Lease Modifications
So, what might a standard lease modification look like?
We will walk through a few inputs required using our example above of a lease renewal or extension:
- Identify Modification Effective Date: The effective date is the date when both parties agree to the lease modification. Typically, the month in which the agreement is obtained is most likely the date that the lease modification should be recorded.
- Identify New Lease End Date: Users will need to evaluate and review their contract to obtain the new lease end date.
- Update Discount Rate: The discount rate used to calculate the present value of future lease payments is required to be updated or revised for the new lease term. Readers may learn more about discount rate options and access our risk-free discount rate tool here.
- Payment Considerations: It is not uncommon for lease extensions to contain escalating lease payments. Once again, users should reference lease contracts and review for any change in monthly or annual lease payment terms.
Example Modification Journal Entry:
Example Post-Modification Amortization Schedule:
NetLease Can Help
Users will have two options to evaluate lease modifications:
The hard way – spreadsheets
Performing a modification within an Excel document can be cumbersome due to its delicate nature. Within Excel, a lease amortization schedule is built from a combination of multiple formulas that flow cohesively. Once a modification is identified, the owner of the Excel document containing the lease must re-value the lease from a point in time and edit these formulas to reflect the change. There is a high risk of human error in this process.
The simple solution.
The easier answer is to use custom-made software like NetLease.
In only a few clicks, NetLease users will have an updated lease amortization schedule and updated post-modification journal entries.
As seen below, users will identify modification type, input effective date, enter the new lease end date, and finally recalculate their discount rate. If the user has escalating lease payments, they will also be prompted to input payments as seen below:
Modifications under ASC 842 are much more involved than under previous standards. To handle these modifications, we highly recommend using a software solution like NetLease. The recalculation process becomes automated, organized, and consistent, letting you skip the treacherous spreadsheet.
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