FRS 116 Leases – How to Deal with Lease Modifications?
In the world of business, leases are all around us. Equipment, real estates as well as the automobile, are assets that people would usually lease. Throughout the lease term, there may be some modifications to the lease. There are two categories of modification, which are change in scope and change in consideration. Under the general category of a change in scope, there are some other subcategories such as extending or shortening of the lease term, as well as adding and removing the assets (Introduction to Contra Asset Accounts).
If any modifications take place, the lessee should take some actions to deal with the change according to the requirements specified in FRS 116: Leases. In this article, we will have a look at the lease modifications, and it should be able to provide you with some insights. If you need further assistance on this matter, feel free to contact an accounting firm in Johor Singapore and let the professionals help you.
A modification in the lease may cause an increase in the scope of a lease as it may increase the right of using one or more underlying assets. It may also bring to an increase in consideration of the lease, where the amount gained is the same as the stand-alone price for the extension in scope accompanied by any appropriate adjustment. If a lease modification has fulfilled both situations mentioned above, the lessee should treat it as a separate lease (Also see FRS 116 Leases – Disclosing Information Related to Finance Leases and Operating Leases).
On the contrary, the lessee should not consider the modification as a separate lease if the conditions above do not apply to those modification made. In this case, on the day the lease modification takes effect, the lessee should allocate the consideration related to the modification in the revised contract. It should also identify the lease term of that modified lease.
A modification in the lease would bring to the need of remeasurement of the lease liability. When remeasuring the lease liability, the lessee should discount the amended lease payments by using a modified discount rate. If the interest rate implicit in the lease can be determined readily, the lessee should take it as the revised discount rate for the remaining lease term. If one is unable to identify that rate, he should take the lessee’s incremental borrowing rate as at the date the modification takes effect as the revised discount rate.
If a lease modification cannot be considered as a separate lease (Also see FRS 116 Leases – Lease Modifications for a Finance Lease), the lessee should remeasure the lease liability by reducing the right-of-use asset’s carrying amount for lease modifications which leads to a smaller scope of the lease. This is for it to show the entire or part of the termination of the lease. The lessee should also recognise any loss or gain related to the termination in profit or loss. Besides, for all other lease modifications, the lessee needs to deal with the remeasurement by adjusting the right-of-use asset.
Now, let us look at one of the modifications that would usually happen, which is the extension of the lease term.
There is a lease that started on 1st January 2014. On 1st January 2015, the lessee and lessor have agreed on an extension of a lease that will expire on 1st January 2019. The extension will last for two years, and hence this brings the expiry date to 31st December 2021.
In this case, the modification that happened does not add the right of using the underlying asset. Thus, the modification should not be treated as a separate lease. The lessee should account for the modification on the day it takes effect, that is 1st January 2015. Thus, it needs to remeasure its existing lease liability on 1st January 2015 according to the modifies lease payments before making a corresponding adjustment to the right-of-use asset.
Another modification that may occur is a reduction in the leased space.
A lessor has leased a building with three floors to a lessee on 1st January 2016. All the three floors have the same size, and the yearly lease payment was RM75,000. On 1st January 2018, the lessor and lessee have agreed on the termination of the lease of ground floor from 1st January 2019. In 2018, the lease payment stayed at RM75,000 per annum and will be reduced to RM50,000 for the year 2019 onwards.
This modification has caused the scope of the lease to reduce as there is a termination on the right to use one of the floors. As the ground floor and the other two floors constitute different lease components, the lessee should account for them separately. This means that the modification has not brought any impact to the other two floors, which the lessor will still lease to the lessee as the lease terms related to them remain unchanged.