Accounting for Lease Modifications – Lessee and Lessor Perspective

A lease modification is a change in the scope or consideration of a lease that was not part of the original terms and conditions. Modifications can include changes to lease term, rent, assets leased, or purchase options. Both lessees and lessors must assess whether modifications result in a new lease, a remeasurement, or a partial termination.

This article outlines how to account for lease modifications under U.S. GAAP (ASC 842) and IFRS (IFRS 16) for both lessees and lessors, with practical examples and journal entries.

1. What Qualifies as a Lease Modification?

A lease modification involves:

✦ Adding or removing leased assets

✦ Extending or shortening lease term

✦ Increasing or decreasing lease payments

✦ Changing contractual lease conditions (e.g., purchase options)

Modifications must be accounted for when the revised terms are legally enforceable.

2. Lessee Accounting for Lease Modifications

Step 1: Determine Whether the Modification is a Separate Lease

A modification is treated as a separate lease if:

✦ It grants the lessee an additional right-of-use not included in the original lease, and

✦ The lease payments increase commensurately with the standalone price

Example: Lessee adds new floorspace to an existing lease at market rates; Accounting: treat as a separate lease with new ROU asset and lease liability

Step 2: If Not Separate, Reassess and Recalculate

If not a separate lease, the lessee must:

✦ Reassess lease classification (finance vs. operating)

✦ Recalculate lease liability using updated discount rate

✦ Adjust the ROU asset accordingly

Example:

✦ Original lease liability = $100,000

✦ After modification (rent increase or term extension) → liability increases by $20,000

Journal entry:Dr. ROU Asset – $20,000 / Cr. Lease Liability – $20,000.

If lease term is reduced or payments decrease, decrease ROU asset and recognize loss if asset balance is insufficient.

Dr. Lease Liability – $15,000 / Cr. ROU Asset – $14,000 / Cr. Gain on Lease Modification – $1,000.

3. Lessor Accounting for Lease Modifications

Step 1: Determine Whether the Modification is a Separate Lease

Same test as for lessees:

✦ Adds new right-of-use + commensurate increase in consideration → separate lease

Dr. Lease Receivable – $40,000 / Cr. Leased Asset – $40,000.

Step 2: If Not Separate – Remeasure or Reclassify

For Operating Leases:

✦ No derecognition of underlying asset

✦ Adjust future lease income and deferred balances

✦ Straight-line lease income must be recalculated over revised term

For Finance Leases:

✦ Reassess lease receivable

✦ Adjust carrying amount and recognize gain or loss if applicable

✦ Recalculate interest income using new lease terms

Dr. Lease Receivable – $5,000 / Cr. Gain on Lease Modification – $5,000.

4. Common Scenarios and Treatment

✦ Extension of lease term → remeasure liability/receivable

✦ Termination of part of lease → reduce liability/receivable and ROU/asset

✦ Change in lease payments (e.g., rent reduction) → remeasure using new discount rate

Lessees must always use updated discount rate on remeasurement. Lessors may or may not update rate, depending on nature of change.

5. Disclosure Requirements

Both lessees and lessors must disclose:

✦ Nature and reason for significant lease modifications

✦ Impact on lease liabilities, ROU assets, income or expense

✦ Qualitative effects on cash flows and operations

✦ Any reassessments of lease classification or scope

Disclosure example: “During the year, the Company renegotiated several lease contracts to extend terms by two years. This resulted in a $600,000 increase in lease liabilities and right-of-use assets.”