Understanding ASC 842: Lease reassessments and modifications
The ASC 842 lease accounting standard adoption brought significant changes to lease accounting, adding additional reporting requirements and complexities. Beginning the second year of many entities’ adoption of the standard, here’s a comprehensive understanding of lease reassessments and modifications, the circumstances that trigger a lease reassessment and how to account for some of the more common scenarios.
Lease reassessments vs. lease modifications
A few complexities of the lease standard derive from whether there have been triggering events for lease reassessments or modifications and how to account for these changes. A lease modification involves a change in the scope of a lease or the consideration for a lease that was not part of its original terms and conditions.
On the other hand, a lease reassessment involves changes to facts, assumptions or other circumstances that do not involve renegotiating the lease terms and conditions of the underlying lease.
A lease modification can be easily identified; it requires a substantive change that was not included in the original terms and conditions of the lease, while a lease reassessment can occur when assumptions and other events outside the lease have changed, which can be difficult at times to identify.
Triggers for lease reassessment
The question to then ask is what defines a change to the facts, assumptions or other circumstances that requires a reassessment? Under ASC 842, a lessee should reassess the lease term or an option to purchase the underlying asset if any of the following have occurred:
1. An event written into the contract obliges the lessee to exercise (or not exercise) an option. For example, the contract might stipulate that the lessee must communicate their intention to vacate within 60 days of the lease term.
2. The lessee physically elects to exercise an option that it had previously determined it was not reasonably certain to exercise, or conversely, physically elects not to exercise an option it was previously reasonably certain to exercise. In this case, the key distinction being physically elects to exercise an option, a change in the reasonably certain to exercise decision on its own would not qualify.
3. A “triggering event” occurs. This is defined as a significant event or change in circumstance that is within the control of the lessee and directly affects the assessment of whether the lessee is reasonably certain to exercise an option. Furthermore, a change in market-based factors should not, in isolation, trigger reassessment as these are outside of the control of management.
Lease reassessment triggering event examples
To better understand the concept of triggering events, let’s consider a few examples:
|
Scenario |
Has a triggering event occurred? |
|
Example 1: Management decides to close multiple locations and communicates the decision internally and publicly. However, the properties are not identified and communication to the lessors will not occur until the date legally required to terminate the leases. |
In this case, a reassessment is not triggered in isolation of a decision and communication as the specific properties were not identified. This decision can be reversed without economic cost or consequence to the lessee. A triggering event would have been deemed to have occurred if the properties were identified publicly. |
|
Example 2: The lessee operates a public mall and is reasonably certain not to exercise the renewal option. The city announces a major renovation of the city center in which the mall is located. The renovation is expected to increase the fair value of the building and consumer traffic. A year after renovations, the lessee is far exceeding expectations and could not relocate to another location and replicate results. They are now reasonably certain to exercise the renewal option. |
While previously viewing the location as reasonably certain not to exercise the renewal option, a year later is now reasonably certain to exercise the option, the lessee would not reassess this lease term unless physically exercised. The success of the store is not an event or change in circumstances under management’s control; only a change in market-based factors has occurred. |
|
Example 3: Same facts as above, however, the lessee closes another facility that, other than the current facility, was the only other location capable of handling the distribution of online orders. |
In contrast to the case above, the decision made by the lessee was within their control and affects the lessee’s economic reasons to exercise the renewal option. Reassessment would be done in this case. |
Lease reassessments: Change in amounts probable under a residual value guarantee
In some cases, lease agreements include a residual value guarantee that requires the underlying asset to be returned at a fair value at or above the guarantee. Under ASC 842, a lessee should include in the initial measurement of lease payments at lease commencement the amount that is probable to be owed under a residual value guarantee. It is worth noting that reimbursement for damage, excessive wear and tear, or usage is considered similar to variable lease payments and does not constitute a residual value guarantee. A lessee should reassess amounts probable of being owed when facts and circumstances change, suggesting that lease payments may change.
Lease reassessments: Resolution of contingency
Contingencies are frequently included in lease arrangements and their accounting for is dependent on the likelihood of the future event occurring. Similar to residual value guarantees, which are an example of a contingency event, remeasurement of lease payments for contingencies are required when some or all of the variable payments that will be made for the remainder of the lease term are resolved to meet the definition of a lease payment. For example, an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of a lease term. These payments would then be required to be reassessed into the remaining lease payments.
If a lease would include a contingent termination provision, a lessee should consider this when evaluating the reasonably certain lease term. The process would be to first derive the probability of the contingency occurring or arising, and further determine the likelihood the lessee will choose to terminate.
Resolution of contingency: Variable lease payments
There are two types of variable lease payments under Topic 842. The first type includes variable lease payments that depend on an index or rate such as Consumer Price Index (CPI), a market interest rate or fair market rent, which are included in lease payments on commencement date.
The second type includes other variable lease payments, which are excluded from lease payments at commencement date and are accounted for as variable lease costs. While variable lease payments dependent on an index or rate would be included in the initial measurement at the date of commencement, any further change to the lease payments based on these specific rates would not be included unless remeasurement is required for another reason (e.g., a change in lease term due to exercise of a renewal or purchase option). When rates based on CPI or other market rates are used, the lease payments would not be subsequently adjusted, even when a floor payment is present.
One example, however, where a lessee would update their lease payments based on variable changes would be a case of minimum annual guarantee clauses where the payments are dependent on the performance or results, which include a price floor established after the increase of rental payments.
Minimum annual guarantee (MAG) clause example
ABC Co. leases 10% of an office building for 10 years. At commencement of the lease, the Year 1 payment is equivalent to $100,000. The lease dictates that each subsequent year is equivalent to a minimum annual guarantee of 5% of annual sales with a limit that the annual payment cannot be lower than the previous year.
Would ABC Co. remeasure for each new higher MAG lease payment?
|
|
Sales |
5% of annual sales |
Lease payment |
Remeasure? |
|
Year 1 |
$ 2,050,000 |
$ 102,500 |
$100,000 |
N/A |
|
Year 2 |
$ 2,150,000 |
$ 107,500 |
$102,500 |
Yes |
|
Year 3 |
$ 2,250,000 |
$ 112,500 |
$107,500 |
Yes |
|
Year 4 |
$ 2,075,000 |
$ 103,750 |
$112,500 |
Yes |
|
Year 5 |
$ 2,100,000 |
$ 105,000 |
$112,500 |
No |
|
Year 6 |
$ 2,300,000 |
$ 115,000 |
$112,500 |
No |
|
Year 7 |
$ 2,350,000 |
$ 117,500 |
$115,000 |
Yes |
|
Year 8 |
$ 2,400,000 |
$ 120,000 |
$117,500 |
Yes |
|
Year 9 |
$ 2,500,000 |
$ 125,000 |
$120,000 |
Yes |
|
Year 10 |
$ 2,450,000 |
$ 122,500 |
$125,000 |
Yes |
In a scenario where the minimum annual guarantee does not allow for the lease payments to decrease after each year’s revaluation of payments, these payments are considered to become fixed for the remainder of the lease term and, therefore, would be remeasured into the right-of-use asset (ROU). The difference between this case and the variable payments that depend on an index or rate is that CPI, market interest rate and fair market rent are all specifically scoped out of requiring a lease be remeasured each period requiring change.
Lease modifications: Accounted for as a separate contract
Lease modifications can be accounted for in two ways, either accounted for as a separate or not accounted for as a separate contract. To be deemed a separate contract, two criteria are required to be present: the modification grants the lessee an additional ROU not included in the original lease and the lease payments increase commensurate with the standalone selling price for the additional right of use.
An example of this scenario would be the leasing of an additional expansion space of an office building not included in the initial lease, where payments increase relative to the market price per square foot leased. When both criteria have been met, the lessee would account for this new lease agreement similar to the initial measurement guidance for leases.
Lease modifications: Accounted for as a separate contract
A common scenario that arises that is accounted for as a separate contract is the subleasing of the underlying asset leased. In a sublease agreement, the original lessee, or intermediate lessee, should continue to account for the initial lease, or head lease as is, unless contractually replaced as the primary obligor. In this case, the intermediate lessee would recognize sublease income over the lease term. If lease costs are in excess of the sublease income to be received under the sublease agreement, this is indicative that the carrying value of the ROU asset may not be recoverable and should be assessed under ASC 360, Long-lived Asset Impairment guidance.
Once a triggering event has been deemed to have occurred under ASC 360, the original lessee should perform the recoverability test over the asset group. Impairment-triggering events can be solely market based and not within the control of the lessee and do not trigger a reassessment of the lease term or exercise of the purchase option, even if renewal options had initially been considered reasonably certain to exercise. If the asset fails the recoverability test under ASC 360, the lessee would perform the fair value test for the asset group, analyzing what a market participant would maximize the benefit of the asset group at its highest and best use.
Lease modifications: Not accounted for as a separate contract
If the two criteria to be accounted for as a separate contract are not met, then the lease modification would be accounted for in combination with the original lease. In a lease modification not accounted for as a separate contract, the lease liability should be remeasured at an updated discount rate and assessed on the effective date of the reassessment event or modification. The following are examples of modifications that would not be accounted for separately:
1. Granting the lessee an additional right-of-use not included in the original contract, but not at the standalone selling price of the additional ROU
2. An extension or reduction of the term of an existing lease, other than through the exercise of a contractual option to extend or terminate
3. Changes to the consideration contract only
4. Full or partial termination of an existing lease
In cases 1 through 3 three above, the remeasurement of the lease liability effects the ROU asset in proportion to the corresponding change in the liability. In case 4, the effect should reduce the carrying amount of the asset in proportionate value to reflect the termination; the difference would be recognized as a gain or loss.
How Wipfli can help
Understanding lease reassessments and modifications under ASC 842 is crucial for lessees to help ensure compliance with the standard and can be complex. By recognizing the triggers for these events and the difference between lease reassessment and lease modification, lessees can better manage their lease portfolios and mitigate potential risks. Wipfli’s team can address your questions about this standard and its potential impact on your organization. Our dedicated audit and accounting team can provide you with the guidance you need to help stay in compliance and build confidence with your customers or clients.
Contact us to learn more about how our team can help create value for your business.
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