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5.6 Accounting for a lease modification – lessor
Publication date: 30 Sep 2021
us Leases guide 5.6
A lessor’s accounting for a lease modification depends on the type of modification made to the lease. Depending on the changes made to the lease contract, a lease modification can result in either a separate new contract (i.e., accounted for separate from the original contract) or a new modified contract.
Figure LG 5-3 illustrates the steps to determine the accounting for a change made to a lease.
Figure LG 5-3
Lessor’s accounting for a lease modification
Lessor’s accounting for a lease modification
A lessor should account for all initial direct costs, lease incentives, and any other payments made to or by the entity in connection with a modification to a lease in the same manner as those items would be accounted for in connection with a new lease.
5.6.1 Separate new contract — lessor
A lessor should apply the same accounting as a lessee for a modification that results in a separate new contract. See LG 5.2.1.1 for more information on a lessee’s accounting for a separate new contract.
5.6.2 Single modified lease — lessor
If a lease modification is not accounted for as a separate contract, a lessor should reassess the modified contract for whether it is a lease or contains a lease. If the modified contract is a lease or contains an embedded lease, a lessor should account for as a single new lease from the effective date of the modification. Since the modified lease is recorded as a single new lease, the lease classification should be reassessed based on the modified terms. We believe a lessor should use the relative standalone selling prices at the modification date to allocate the remaining contract consideration among the applicable contract components at the modification date. See LG 2.3 for information about the definition of a lease. See LG 2.4.3 for information on the allocation of contract consideration to components. The accounting treatment depends on the lease type before and after the modification. See LG 3 for information on lease classification.
5.6.2.1 Direct financing lease prior to the modification
The accounting for the modification of a direct financing lease will depend on how the lease is classified after it is modified.
Figure LG 5-4 summarizes the accounting for the modification of a direct financing lease.
Figure LG 5-4
Accounting for the modification of a direct financing lease
Accounting for the modification of a direct financing lease
Modified lease classification |
Lessor accounting |
Example |
Direct financing lease |
The net investment in the modified lease does not change at the modification date. The lessor should adjust the discount rate for the modified lease so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease, net of any deferred selling profit, immediately before the effective date of the modification plus any capitalized initial direct costs incurred in conjunction with the modification |
Example LG 5-10 |
Sales-type lease |
The lessor should account for the modified lease in accordance with ASC 842-30. The commencement date of the modified lease is the effective date of the modification. In order to calculate the selling profit or loss on the lease, the fair value of the underlying asset is its fair value at the effective date of the modification and its carrying amount is the carrying amount of the net investment in the original lease immediately before the effective date of the modification. Initial direct costs incurred in conjunction with a modification should be expensed unless the fair value of the underlying asset at the modification date equals its carrying amount (i.e., there is no selling profit). In that case, the initial direct costs would be deferred and recognized over the lease term using a method that produces a constant periodic rate of return on the lease when combined with the interest income on the lease receivable and the residual asset. In applying the lease classification criteria, it is possible for lease arrangements with variable lease payments to be classified by a lessor as a sales-type lease. This may lead to the recognition of a selling loss (i.e., day-one loss) by the lessor even if the overall arrangement is expected to be profitable. In response to concerns raised in the post implementation review, the FASB published ASU 2021-05, which upon adoption requires a lessor to classify a lease with variable lease payments (that do not depend on an index or a rate) as an operating lease at the lease commencement date if classifying the lease as a sales-type lease (or direct financing lease) would result in recognition of a selling loss. See LG 10.10 for the effective date and transition requirements of ASU 2021-05. See Example LG 4-9 for an illustration of a lease with variable payments. |
Example LG 5-11 |
Operating lease |
The lessor should recognize the underlying asset at the carrying amount of the net investment in the original lease immediately before the effective date of the modification. Initial direct costs incurred in conjunction with the modification are initially capitalized and then recognized as an expense on the same basis as lease income. |
Example LG 5-12 |
Example LG 5-12, Example LG 5-13 and Example LG 5-14 illustrate the accounting for the modification of a direct financing lease.
EXAMPLE LG 5-12
Modification of a direct financing lease that does not impact classification
Modification of a direct financing lease that does not impact classification
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease non-specialized digital imaging equipment. The following table summarizes information about the lease and the leased equipment at lease commencement.
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years, no renewal option |
Remaining economic life of the leased equipment |
10 years |
Purchase option |
None |
Annual lease payments |
$195,000 |
Payment date |
January 1 |
Fair value of the leased equipment at commencement |
$1,200,000 |
Lessor Corp’s carrying value of the leased equipment at commencement |
$1,200,000 |
Estimated residual value |
$400,000 |
Residual value guarantee |
$300,000 residual value guarantee is provided by a third party unrelated to Lessee Corp or Lessor Corp |
Rate implicit in the lease |
5.0% |
Other |
Title to the asset remains with Lessor Corp upon lease expiration |
At the end of year 1 of the lease, Lessor Corp agrees to modify the lease to extend the lease by one year. The key information at the modification date is shown in the following table.
Modification date |
December 31, 20X1 |
Remaining modified lease term |
5 years, no renewal option |
Remaining economic life |
9 years |
Purchase option |
None |
Annual lease payment |
$168,000 |
Payment date |
January 1 |
Fair value of the leased equipment at the modification date |
$1,000,000 |
Lessor Corp’s carrying amount of net investment in the lease on the modification date |
$1,055,201 (interest income of $50,201 was recorded in the first year of the lease) |
Estimated residual value |
$360,000 |
Residual value guarantee |
$275,000 residual value guarantee is provided by a third party unrelated to Lessee Corp or Lessor Corp |
Rate implicit in the modified lease |
6.75% |
The modified lease consideration is at a discount to the current market rate for the additional term for this particular lease contract. Collectibility of lease payments is probable. Any additional right of use, the original contract and the modified contract meet the definition of a lease.
How would Lessor Corp account for the lease modification?
Analysis
Determine if the lease modification is a separate new contract
As the modification does not grant an additional right of use (an increase in lease term is not considered an additional right of use), Lessor Corp would determine that the modification is not a separate new contract. Since the modified contract meets the definition of a lease, Lessor Corp should account for one new modified lease as of December 31, 20X1.
Reassess lease classification based on the terms of the modified lease
Based on the facts at lease commencement, Lessor Corp could reasonably conclude that the lease was not a sales-type lease because none of the criteria in ASC 842-10-25-2 were met (see LG 3.3 for lease classification criteria). Lessor Corp could further reasonably conclude that the lease was a direct ]financing lease because the sum of the present value of the lease payments and the present value of the residual asset guaranteed by the third-party guarantor was substantially all of the fair value of the leased equipment and collectibility of the lease payments was probable. Therefore, Lessor Corp would initially recognize a net investment in the lease of $1,200,000 and derecognized the carrying value of the equipment of $1,200,000.
At the lease modification date, Lessor Corp would base its lease classification reassessment on the equipment fair value as of the modification date and discount rate implicit in the modified lease (6.75%). Lessor Corp could reasonably conclude that the lease is not a sales-type lease because none of the criteria in ASC 842-10-25-2 are met (see LG 3.3 for lease classification criteria). Lessor Corp could further reasonably conclude that the lease is a direct financing lease because the sum of the present value of the lease payments and the present value of the residual asset guaranteed by the third-party guarantor is substantially all of the fair value of the leased equipment and collectibility of the lease payments is probable.
Account for the modified lease
To account for the modified lease, Lessor Corp would carry forward the net investment in the lease immediately before the effective date of the modification ($1,055,201); this would be the opening balance of the net investment in the modified lease. To retain the same net investment in the lease while the lease payments, lease term, and estimated residual value have changed, Lessor Corp must adjust the discount rate for the lease from the rate implicit in the modified lease of 6.75% to the rate that when applied to the total remaining lease payments and the estimated residual value produces a present value equal to the initial net investment of $1,055,201, which is 4.66%. Prospectively, Lessor Corp would recognize interest income on the lease based on 4.66%.
EXAMPLE LG 5-13
Modification of a direct financing lease that changes lease classification to a sales-type lease
Modification of a direct financing lease that changes lease classification to a sales-type lease
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease non-specialized digital imaging equipment. The following table summarizes information about the lease and the leased equipment at lease commencement.
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years, no renewal option |
Remaining economic life of the leased equipment |
10 years |
Purchase option |
None |
Annual lease payments |
$195,000 |
Payment date |
January 1 |
Fair value of the leased equipment at commencement |
$1,200,000 |
Lessor Corp’s carrying value of the leased equipment at commencement |
$1,200,000 |
Estimated residual value |
$400,000 |
Residual value guarantee |
$300,000 residual value guarantee is provided by a third party unrelated to Lessee Corp or Lessor Corp |
Rate implicit in the lease |
5.0% |
Other |
Title to the asset remains with Lessor Corp upon lease expiration |
At the end of year 2 of the lease, Lessor Corp agrees to modify the lease to extend the lease term by three years. The key information at the modification date is as shown in the following table.
Modification date |
January 1, 20X3 |
Remaining modified lease term |
6 years, no renewal option |
Remaining economic life |
7 years |
Purchase option |
None |
Annual lease payment |
$190,000 |
Payment date |
January 1 |
Fair value of the leased equipment at the modification date |
$1,000,000 |
Lessor Corp’s carrying amount of net investment in the lease on the modification date |
$903,169 (interest income of $93,169 was recorded in the first 2 years of the lease) |
Estimated residual value |
$100,000 |
Residual value guarantee |
$75,000 residual value guarantee is provided by a third party unrelated to Lessee Corp or Lessor Corp |
Rate implicit in the modified lease |
8.49% |
The modified lease consideration is at a discount to the current market rate for the additional term for this particular lease contract. The collectibility of lease payments is probable. Any additional right of use, the original contract, and the modified contract meet the definition of a lease.
How would Lessor Corp account for the lease modification?
Analysis
Determine if the lease modification is a separate new contract
As the modification does not grant an additional right of use (an increase in lease term is not considered an additional right of use), Lessor Corp would determine that the modification is not a separate new contract. Since the modified contract meets the definition of a lease, Lessor Corp would account for one new modified lease as of January 1, 20X3.
Reassess lease classification based on the terms of the modified lease
Based on the facts at lease commencement, Lessor Corp could reasonably conclude that the lease was not a sales-type lease because none of the criteria in ASC 842-10-25-2 were met (see LG 3.3. for lease classification criteria). Lessor Corp could further reasonably conclude that the lease was a direct financing lease because the sum of the present value of the lease payments and the present value of the residual asset guaranteed by the third-party guarantor was substantially all of the fair value of the leased equipment and collectibility of the lease payments is probable. Therefore, Lessor Corp would initially recognize a net investment in the lease of $1,200,000 and derecognized the carrying value of the equipment of $1,200,000.
At the lease modification date, Lessor Corp could reasonably conclude that the lease is a sales-type lease because the remaining lease term of six years represents a major part of the remaining economic life of seven years (see LG 3.3. for lease classification criteria).
Account for the modified lease
To account for the modified lease, Lessor Corp would recognize a net investment in the sales-type lease of $1,000,000 (the fair value of the equipment on that date) and derecognize the net investment in the original direct financing lease of $903,169. The difference between these two amounts ($96,831) is the selling profit. See LG 4.3.1.1 for further details on accounting for selling profit.
After the modification, Lessor Corp would account for the lease in accordance with ASC 842-30, as it would any other sales-type lease.
EXAMPLE LG 5-14
Modification of a direct financing lease that changes lease classification to an operating lease
Modification of a direct financing lease that changes lease classification to an operating lease
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease non-specialized digital imaging equipment. The following table summarizes information about the lease and the leased equipment at lease commencement.
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years, no renewal option |
Remaining economic life of the leased equipment |
10 years |
Purchase option |
None |
Annual lease payments |
$195,000 |
Payment date |
January 1 |
Fair value of the leased equipment at commencement |
$1,200,000 |
Lessor Corp’s carrying value of the leased equipment at commencement |
$1,200,000 |
Estimated residual value |
$400,000 |
Residual value guarantee |
$300,000 residual value guarantee is provided by a third party unrelated to Lessee Corp or Lessor Corp |
Rate implicit in the lease |
5.0% |
Other |
Title to the asset remains with Lessor Corp upon lease expiration |
At the end of year 1 of the lease, Lessor Corp agrees to modify the lease to shorten the lease term by two years. The key information at the modification date is shown in the following table.
Modification date |
January 1, 20X2 |
Remaining modified lease term |
2 years, no renewal option |
Remaining economic life |
9 years |
Purchase option |
None |
Annual lease payment |
$190,000 |
Payment date |
January 1 |
Fair value of the leased equipment at the modification date |
$1,000,000 |
Lessor Corp’s carrying amount of net investment in the lease on the modification date |
$1,055,201 (interest income of $50,201 was recorded in the first year of the lease) |
Estimated residual value |
$700,000 |
Residual value guarantee |
No residual value guarantee is provided |
Rate implicit in the modified lease |
5.43% |
The modified lease consideration is at a discount to the current market rate for the additional term for this particular lease contract. Collectibility of lease payment is probable. Any additional right of use, the original contract, and the modified contract meet the definition of a lease.
How would Lessor Corp account for the lease modification?
Analysis
Determine if the lease modification is a separate new contract
As the change in lease term is not an additional right of use, Lessor Corp would determine that the modification is not a separate new contract. Since the modified contract meets the definition of a lease, Lessor Corp would account for one new modified lease as of January 1, 20X2.
Reassess lease classification based on the terms of the modified lease
Based on the facts at lease commencement, Lessor Corp could reasonably conclude that the lease was not a sales-type lease because none of the criteria in ASC 842-10-25-2 were met (see LG 3.3 for lease classification criteria). Lessor Corp could further reasonably conclude that the lease was a direct] financing lease because the sum of the present value of the lease payments and the present value of the residual asset guaranteed by the third-party guarantor was substantially all of the fair value of the leased equipment and collectibility of the lease payments was probable. Therefore, Lessor Corp would initially recognize a net investment in the lease of $1,200,000 and derecognized the carrying value of the equipment of $1,200,000.
At the lease modification date, Lessor Corp could reasonably conclude that the modified lease as an operating lease because it does not meet any of the criteria to be classified as a sales-type lease or direct financing lease (see LG 3.3 for lease classification criteria).
Account for the modified lease
Lessor Corp would account for the modified lease by derecognizing the net investment in the lease of $1,055,201 and recognizing the equipment at the same amount. If collectibility of the lease payments is probable, Lessor Corp would recognize the remaining lease payments on a straight-line basis over the two-year modified lease team and record depreciation on the equipment.
5.6.2.2 Operating lease prior to the modification — lessor
The accounting for the modification of an operating lease will depend on how the lease is classified after it is modified.
Figure LG 5-5 summarizes the accounting for the modification of an operating lease.
Figure LG 5-5
Accounting for the modification of an operating lease
Accounting for the modification of an operating lease
Modified lease classification |
Lessor accounting |
Example |
Direct financing lease |
The net investment in the lease on the modification date equals the lessor’s carrying value of the asset adjusted for any accrued rent asset or liability on that date. Any selling profit and initial direct costs incurred in conjunction with the modification are deferred and included in the measurement of the initial net investment in the modified lease. Any unamortized initial direct costs associated with the original lease may continue to be included in the measurement of the initial net investment in the modified lease. |
|
Sales-type lease |
The net investment in the lease on the modification date will equal fair value of the asset. Selling profit/loss would be adjusted for any prepaid or accrued rent on that date and any initial direct costs incurred in conjunction with the modification. In applying the lease classification criteria, it is possible for lease arrangements with variable lease payments to be classified by a lessor as a sales-type lease. This may lead to the recognition of a selling loss (i.e., day-one loss) by the lessor even if the overall arrangement is expected to be profitable. In response to concerns raised in the post implementation review, the FASB published ASU 2021-05, which upon adoption requires a lessor to classify a lease with variable lease payments (that do not depend on an index or a rate) as an operating lease at the lease commencement date if classifying the lease as a sales-type lease (or direct financing lease) would result in recognition of a selling loss. See LG 10.10 for the effective date and transition requirements of ASU 2021-05. See Example LG 4-9 for an illustration of a lease with variable payments. |
Example LG 5-16 |
Operating lease |
No gain or loss is recognized as a result of the modification. A new straight-line lease income is calculated based on the remaining payments adjusted for any prepaid or accrued rent at the date the modification is recorded. Any initial direct costs incurred in conjunction with the modification are initially capitalized and then recognized as an expense on the same basis as lease income. |
Example LG 5-15 |
Example LG 5-15 and Example LG 5-16 illustrate the accounting for the modification of an operating lease and a sales-type lease, respectively.
EXAMPLE LG 5-15
Modification of an operating lease that does not impact lease classification
Modification of an operating lease that does not impact lease classification
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease property to be used as a retail store. The following table summarizes information about the lease and the leased property at lease commencement.
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years, no renewal option |
Purchase option |
None |
Annual lease payments |
$500,000 in the first 2 years and $510,000 in each year thereafter |
Payment date |
January 1 |
Remaining economic life of the leased property |
40 years |
Fair value of the leased property at commencement |
$7,000,000 |
Other |
Title to the asset remains with Lessor Corp upon lease expiration |
On January 1, 20X4, Lessee Corp and Lessor Corp amend the original lease contract to increase the term of the lease for an additional three years. The key information at the modification date is shown in the following table.
Modification date |
January 1, 20X4 |
Remaining modified lease term |
5 years, no renewal option |
Purchase option |
None |
Annual lease payments |
$507,000 for the next two years and $509,000 for the three years added to the term |
Payment date |
January 1 |
Accrued rent asset |
$8,000 |
Remaining economic life of the leased property |
37 years |
Fair value of the leased property at the modification date |
$6,750,000 |
Estimated residual value |
$50,000 |
Rate implicit in the modified lease |
3.28% |
The increase in lease consideration is at a discount to the current market rate for the additional term for this particular lease contract. Collectibility of lease payments is probable. Any additional right of use, the original contract, and the modified contract meet the definition of a lease.
How would Lessor Corp account for the lease modification?
Analysis
Determine if the lease modification is a separate new contract
Since there is no additional right of use (an increase in lease term is not considered an additional right of use), Lessor Corp would determine that the modification is not a separate new contract. As the modified contract meets the definition of a lease, Lessor Corp would account for one new modified lease as of January 1, 20X4.
Reassess lease classification based on the terms of the modified lease
Based on the facts at lease commencement, Lessor Corp could reasonably conclude the lease was an operating lease because it did not meet any of the criteria to be classified as a sales-type lease or as a direct financing lease (see LG 3.3 for lease classification criteria). At the lease modification date, Lessor Corp could reasonably conclude that the modified lease is an operating lease because it does not meet any of the criteria to be classified as a sales-type lease or as a direct financing lease.
Account for the modified lease
Lessor Corp would recognize the lease payments to be received under the modified lease, net of its accrued rent asset balance immediately before the modification, on a straight-line basis over the remaining five-year lease term as shown below.
1/1/X4 |
$507,000 |
|
1/1/X5 |
507,000 |
|
1/1/X6 |
509,000 |
|
1/1/X7 |
509,000 |
|
1/1/X8 |
509,000 |
|
Total payments |
$2,541,000 |
|
Less: accrued rent asset |
($8,000) |
|
Net payments |
$2,533,000 |
Lessor Corp would recognize annual straight-line income of $506,600 ($2,533,000 ÷ 5 years).
EXAMPLE LG 5-16
Modification of an operating lease that changes lease classification to a sales-type lease
Modification of an operating lease that changes lease classification to a sales-type lease
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease non-specialized digital imaging equipment. The following table summarizes information about the lease and the leased equipment at lease commencement.
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years, no renewal option |
Purchase option |
None |
Annual lease payments |
$150,000 in the first year with a 4% increase each year thereafter |
Payment date |
January 1 |
Remaining economic life of the leased equipment |
10 years |
Carrying value and fair value of the equipment at lease commencement |
$1,300,000 |
At the beginning of year 4 of the lease, Lessee Corp and Lessor Corp agree to extend the lease term for four additional years. The key components at the modification date are shown in the following table.
Modification date |
January 1, 20X4 |
Remaining modified lease term |
6 years, no renewal option |
Purchase option |
None |
Annual lease payments |
$173,000 |
Payment date |
Annually on January 1 |
Accrued rent asset |
$19,229 |
Remaining economic life of the leased equipment |
7 years |
Lessor Corp’s carrying value of the leased equipment |
$910,000 |
Fair value of the equipment at the modification date |
$1,000,000 |
Estimated residual value |
$50,000 |
Rate implicit in the modified lease |
3.28% |
The modified lease consideration is at a discount to the current market rate for the additional term for this particular lease contract. Any additional right of use, the original contract, and the modified contract meet the definition of a lease.
How would Lessor Corp account for the lease modification?
Analysis
Determine if the lease modification is a separate new contract
Since the change in lease term is not an additional right of use, Lessor Corp would not account for the modification as a new lease, separate from the original five-year lease. As the modified contract meets the definition of a lease, Lessor Corp would account for one new modified lease as of January 1, 20X4.
Reassess lease classification based on the terms of the modified lease
Based on facts at lease commencement, Lessor Corp could reasonably conclude that the lease was an operating lease because none of the criteria in ASC 842-10-25-2 were met (see LG 3.3 for lease classification criteria). Lessor Corp would calculate a straight-line rental revenue amount of $162,490 annually. At lease modification, Lessor Corp could reasonably conclude that the modified lease is a sales-type lease since the modified lease is for a major part of the remaining economic life of the equipment.
Account for the modified lease
Lessor Corp would record a selling profit based on the following:
Lease receivable |
$959,000 |
Less: carrying value of the leased asset at the modification date |
(910,000) |
Plus: present value of the unguaranteed residual value |
41,000 |
Less: accrued rent asset balance before the modification |
(19,229) |
Selling profit |
$70,771 |
The net investment in the modified lease is $1,000,000 (lease receivable plus unguaranteed residual value).
After the modification, Lessor Corp would account for the lease in accordance with ASC 842-30, as it would any other sales-type lease, using the discount rate for the lease at the modification date.
5.6.2.3 Sales-type lease prior to the modification
The accounting for the modification of a sales-type lease will depend on how it is classified after it is modified.
Figure LG 5-6 summarizes the accounting for the modification of a sales-type lease.
Figure LG 5-6
Accounting for the modification of a sales-type lease
Accounting for the modification of a sales-type lease
Modified lease classification |
Lessor accounting |
Example |
Direct financing lease |
The net investment in the modified lease does not change at the modification date. The lessor should adjust the discount rate for the modified lease so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease, net of any deferred selling profit immediately before the effective date of the modification plus any capitalized initial direct costs incurred in conjunction with the modification. |
The accounting is the same as shown in Example LG 5-10 |
Sales-type lease |
Same as a direct financing lease |
The accounting is the same as shown in Example LG 5-10 |
Operating lease |
The lessor should recognize the underlying asset at the carrying amount of the net investment in the original lease immediately before the effective date of the modification. Any initial direct costs incurred in conjunction with the modification are expensed on the same basis as the lease income. |
The accounting is the same as shown in Example LG 5-12 |
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