In 2022, most commercial entities and nonprofit organizations initially adopted the provisions of the new lease standard, ASC 842, Leases. While the new lease standard updated the accounting and disclosure requirements for both lessee (tenant) and lessor (landlord) accounting, the changes were more impactful to lessees.  

The most significant change to a lessee’s accounting was a new requirement to record operating lease commitments on the entity’s balance sheet (statement of financial position) which were previously considered to be off-balance sheet commitments. Additionally, capital leases were recast as finance leases, but the initial measurement accounting remains largely consistent with superseded accounting guidance under ASC 840.  The remainder of this blog will describe how a lessee should account for changes to its leases after initial measurement at the lease commencement date, more commonly referred to as remeasurement accounting.

Remeasurement

Simply put, the concept of remeasurement means to update the carrying values of the lease liability and related right-of-use (ROU) asset on the lessee’s books for the current terms of the lease contract.  Only certain events or facts and circumstances will trigger a remeasurement of an existing lease liability and ROU asset. Additionally, the same remeasurement accounting guidance applies to both operating and finance leases.

Is the Event a Formal Lease Amendment or Another Type of Event?

The first thing to understand is what happened. Was there a formal amendment that changed the legal terms and conditions of the lease? Or did something happen that changed the relevant facts and circumstances surrounding the lease? The answer will drive the lessee’s accounting for that lease.

1. Lease agreement was formally modified

If there are changes to the formal legal terms and conditions of the lease agreement, resulting in an amended lease agreement, then there will be an impact on the lessee’s accounting. How the lessee accounts for the amendments depends on what changed in the lease terms. Please note that this section does not apply to situations where an existing lease condition is executed by the lessee during the lease term, such as a lessee exercising an existing option to renew the lease beyond its original term.

Separate Contract Accounting
If the amendments do both of the following, then the new ROU asset and lease liability is accounted for separately from the existing (old) ROU asset and liability.  

• Increase in ROU asset AND
• Increase in lease payments is commensurate with market rates

The existing ROU asset and lease liability for the original lease agreement do not get updated for the amendments. Instead, the amendments are accounted for as a separate contract, using a discount rate that applies at the amendment date, commensurate with the remaining lease term. In effect, a lessee will have two right-of-use assets and two lease liabilities on their books for both the original lease and the amendments to the lease.

For example, an entity’s lease agreement is formally amended to add an additional 2,500 sq feet of office space and the lease payments for that new space are at market rates for similar office space in that geographic area.

Remeasure Existing Lease Liability and ROU Asset
If the lease amendment is any of the following, individually, then the book carrying value of the existing ROU asset and lease liability is remeasured using the amended lease terms.

• Change in lease term;
• Change in lease payments; or
• Increase in ROU asset without corresponding increase in lease payments at market rates

For example, three months prior to the maturity date, the lease agreement is formally amended to extend the term for another 3 years from the original maturity date.

If any of the above amendments result in a reduction of the leased asset or lease term, then the lessee will apply lease termination accounting. Termination accounting applies to both partial lease terminations and full lease terminations. Partial lease termination accounting can be accounted for taking either a ROU asset approach or lease liability approach. Both methods of partial termination accounting and full lease termination accounting will result in a gain or loss impact to operating income for the reduction in lease scope.

2. Lease agreement was not formally modified

There are a few different reasons that the lease may be remeasured, even if the legal terms and conditions of the original lease agreement are still in effect. Note that a lessee follows the same remeasurement accounting principles as described in the prior section under the subheader, “Remeasure Existing Lease Liability and ROU Asset”.

Change in Lease Term for Extension or Termination Option or Decision to Exercise Purchase Option
In these instances, an entity would only remeasure the lease liability and ROU asset upon a specific triggering event.  Triggering events represent a significant event or change in circumstances that is within control of the lessee that directly affects whether the lessee is reasonably certain to exercise or not exercise the option to extend or terminate the lease or purchase the underlying leased asset. It’s important to emphasize that these events are not influenced by factors outside of the lessee’s control.  Common examples of a controllable triggering event by the lessee are investing significant leasehold improvements into the leased property or a sublease of the leased asset that continues into the lease extension term.

Other Remeasurement Events
Remeasurement accounting also applies in instances where variable payments become fixed payments or when there is change in amounts probable of being owed under residual value guarantees. In both cases, a lessee would only remeasure when relevant facts and circumstances change. For example, remeasurement accounting would apply when an event occurs that results in variable lease payments that were linked to the performance or use of the underlying leased asset becoming fixed payments for the remainder of the lease term.

Remeasurement accounting – the debits and credits

The first step for remeasurement is always to remeasure the lease liability first. Factor in changes to the fixed lease payments, lease maturity date, and if the discount rate should be updated to reflect a change in lease term. The offsetting adjustment is recorded to the ROU asset. However, there could be a gain or loss impact as well if the remeasurement is due to a lease termination.

Finance Lease vs Operating Lease

Certain remeasurement event types and lease modifications require reassessment of the lease’s classification as either operating or finance lease. However, the accounting effect of remeasurements is the same for both operating and finance leases. Always remeasure the lease liability first, then adjust the ROU asset and for any gain or loss impact as a result of the event.

We’re Here for You

We recognize that applying the accounting guidance from the lease standards can be tricky and not something you experience on a regular basis. Please reach out to consult with us if your entity experiences any changes in its leasing arrangements. ORBA’s skilled team of professionals are here to help.

For more information, contact Kelly Buchheit at [email protected] or 312.670.7444, or ask your ORBA advisor. Sign up here to receive our new audit blogs.