Lease modifications extending the lease term

Lease modifications extending the lease term

Seemingly innocuous changes to an agreement

could be a lease modification.

They could affect your right-of-use asset and lease liability

at unexpected times with major consequences for balance sheet ratios.

Are you prepared for them?

IFRS 16 contains detailed guidance on how to account for lease modifications. A lease modification is defined as a change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and conditions of the lease. A lease modification includes adding or terminating the right to use one or more underlying assets, or extending or shortening the contractual lease term. Lease modifications extending the lease term

IFRS 16’s lease modification guidance can be summarised into the following diagram:

Lease modifications extending the lease term

Broadly speaking, a lease modification is accounted for in one of two ways:

1. It is treated as a separate lease (IFRS 16 44); or Lease modifications extending the lease term

2. It is not treated as a separate lease (IFRS 16 45-46). Lease modifications extending the lease term

As can be seen from the diagram above, a modification will only be treated as a separate lease if it involves the addition of one or more underlying assets at a price that is commensurate with the stand alone price of the increase in scope1. All other modifications are not accounted for as a separate lease.

The distinction between accounting for a modification as a separate lease or not as a separate lease is important because it affects (i) when and (ii) the amount at which the modified right-of-use asset and lease liability are recognised.

If a modification is a separate lease, a lessee applies the requirements of IFRS 16 to the newly added leased asset independently of the original lease.

In contrast, if a modification is not a separate lease, the accounting reflects that there is a linkage between the original lease and the modified lease. One of the consequences of this is that a lessee has to allocate the modified consideration to each separate lease component in the modified contract on the effective date of the modification (this is the date when both parties agree to a lease modification), resulting in a remeasurement of the existing lease liability and right-of-use asset on that date.

Extending a lease – when should the additional right-of-use asset and lease liability be recognised?

It is very common for entities to extend their leases before expiry of the lease. A question arises as to when the right-of-use asset and lease liability relating to the extended period should be recognised:

  • Upon conclusion of negotiation? or Lease modifications extending the lease term
  • At the start of the extended period? Lease modifications extending the lease term

In cases where the original lease does not contain any extension options, the negotiation to extend a lease constitutes a modification as defined. As the modification does not add the right to use one or more underlying assets – it merely extends the entity’s right to use an existing leased asset to which it already has access – the modification is not accounted for as a separate lease. Instead, the modification is accounted for at the effective date of the lease modification, which is the date when both parties agree to a lease modification (IFRS 16 45).

CASE – Extending a lease – Timing of recognition right-of-use asset and lease liability

Entity C has a lease that runs from 1 January 2019 to 31 December 2020 with no extension or early termination options. Six months before expiry, on 1 July 2020, Entity C and the lessor agree to extend the lease for another two years after expiry.

Lease modifications extending the lease term

Consider this!

Since the original lease does not contain any extension options, the agreement to extend the lease constitutes a modification as defined. As the modification does not add the right to use one or more underlying assets, it is accounted for at the effective date of the lease modification, which is 1 July 2020.

Accordingly, Entity C remeasures the existing lease liability on 1 July 2020 to include the lease payments for the extended period (2021 and 2022) using a revised discount rate (IFRS 16 45(c)). A corresponding adjustment is made to the right-of-use asset (IFRS 16 46(b)).

The ‘additional’ right-of-use asset and lease liability relating to the extended period are therefore recognised on the date of modification and are not deferred until the start of the extended period.

KEEP IN MIND – Is an extension of lease term identified as a modification by your system or other processes? At what date does your system recognise the additional right-of-use asset and lease liability? In addition to asking you for the start date of the extended period, does the system require you to input the effective date of the modification?

Extension via a new contract

If a lessee enters into a new contract with a lessor (i.e. the original lease agreement remains unchanged) that has the effect of extending the lease term of the existing lease without adding the right to use one or more underlying assets, the new contract should be accounted for as a modification of the existing lease.

In other words, extending the contractual term of a lease meets the definition of a lease modification regardless of whether the extension is effected through an amendment of the existing lease or entering into a new contract.

CASE – Extension via a new contract

Entity D leases a retail shop for three years from 1 January 2019 to 31 December 2021. The lease does not have any renewal or early termination options. On 31 December 2020, the lessor calls for an open tender and Entity D decides to match the highest tender price. As a result, Entity D and the lessor enter into a new lease agreement for the same shop for three years to start after expiry of the current lease. The original lease remains unchanged.

Lease modifications extending the lease term

Consider this!

The substance of the transaction is that Entity D and the lessor have agreed to extend the lease of the current retail shop for three years. Extending the lease term constitutes a modification regardless of whether the extension is effected through an amendment of the existing lease or entering into a new contract.

Since the modification does not involve the addition of the right to use one or more underlying assets, the modification is accounted for on the effective date of modification, i.e. on 31 December 2020 (IFRS 16 45).

Accordingly, Entity D remeasures the existing lease liability on 31 December 2020 to include the lease payments covered by the new lease (from 2022 to 2024) using a revised a discount rate. A corresponding adjustment is made to the right-of-use asset. As such, the 2020 annual financial statements will reflect this increased right-of-use asset and lease liability. The profit or loss from 1 January 2021 onwards will include the depreciation and interest expense of the additional right-of-use asset and lease liability.

The right-of-use asset and lease liability relating to the new lease are recognised on the effective date of modification and are not deferred until the start of the period covered by the new lease.

Extension plus a new asset – at market rates

When a modification involves both an extension of the existing lease and an addition of another leased asset, an entity should assess whether the existing leased asset and the newly leased asset are separate lease components. Lease modifications extending the lease term

The right to use an underlying asset is a separate lease component if: Lease modifications extending the lease term

  1. the lessee can benefit from use of the underlying asset either on its own or together with other resources that are readily available to the lessee, and
  2. the underlying asset is neither highly dependent on, nor highly interrelated with, the other underlying assets in the contract. (IFRS 16 B32)

If the existing leased asset and the newly leased asset are separate lease components in terms of the above criteria, then each of them should be accounted for as a separate lease (IFRS 16 12). This entails applying the modification guidance to each of the existing and newly added leased assets separately.

CASE – Extension of lease plus a new asset – at market rates

Entity E leases 10,000m2 of office space for two years from 1 January 2019 to 31 December 2020. On 31 December 2019, Entity E and the lessor amend the lease to:

  1. extend the lease of the existing 10,000m2 for five years; and
  2. lease an additional 3,000m2 for five years, starting from 1 January 2021.

The two office spaces are assessed as separate lease components in accordance with IFRS 16 B32. The consideration for the entire modification is commensurate with the sum of the market price of both components.

Lease modifications extending the lease term

Consider this!

As the two office spaces are assessed to be separate lease components, they are accounted for as separate leases and the modification guidance is applied to each of them separately.

The modification to include the additional 3,000m2 is accounted for as a separate lease because it increases the scope of the lease by adding the right to use an underlying asset (extra space) at market rates. Accordingly, the new right-of-use asset and lease liability relating to the additional 3,000m2 are recognised at the new lease’s commencement date, i.e. at 1 January 2021.

The modification to extend the lease term of the existing 10,000m2 is not accounted for as a separate lease because it does not involve the addition of the right to use one or more underlying assets. Instead, consistent with the first two examples above, the extension is accounted for on the effective date of the modification, i.e. on 31 December 2019. Entity D remeasures the existing lease liability on 31 December 2019 to include the lease payments covered by the extended period (from 2021 to 2025) for the existing 10,000m2 using a revised a discount rate. A corresponding adjustment is made to the right-of-use asset. The 2019 annual financial statements will reflect this increased right-of-use asset and lease liability.

Extension plus a new asset – not at market rates

When a modification occurs through the addition of a right-of-use asset (e.g. leasing an extra floor of office space) at an off-market rate, the modification must be accounted for at the effective date of the modification in accordance with IFRS 16 45.

Off-market pricing could happen when, for example, due to changes in market conditions the lessee is paying above-market rent for an existing lease of property. If the lessee decides to lease another property from the same lessor, instead of adjusting the existing lease to market rent and paying market rent for the new property, both parties might agree to charge below-market rent for the new property such that on an aggregate basis the lessee is paying market rent for both leases.

IFRS 16 45 requires a lessee, at the effective date of the modification, to:

  1. determine the lease term of the modified lease; Lease modifications extending the lease term
  2. allocate the consideration in the modified contract; and Lease modifications extending the lease term
  3. remeasure the lease liability.

Following the allocation of the consideration in the modified contract to the separate lease components (including the new and the existing lease components) at the effective date of the modification, the lessee remeasures the lease liability for the existing right-of-use asset.

Given the lack of clear guidance in IFRS 16, the treatment chosen is that the right-of-use asset and lease liability relating to the newly added leased asset should be recognised only when it is made available for use by the lessee (i.e. at the commencement date of that separate lease component), even if this date is later than the effective date of the modification (IFRS 16 22). The amounts recognised would reflect the consideration allocated to this lease component at the effective date of the modification.

CASE – Extension of lease plus a new asset – not at market rates

Entity F leases 10,000m2 of office space for two years from 1 January 2019 to 31 December 2020. On 31 December 2019, Entity F and the lessor amend the lease to:

  1. extend the lease of the existing 10,000m2 for five years; and
  2. lease an additional 3,000m2 for five years, starting from 1 January 2021.

The consideration for the additional space is not commensurate with the stand alone price of the additional space. The original 10,000m2 and the additional 3,000m2 of office space are separate lease components in accordance with IFRS 16 B32.

Lease modifications extending the lease term

Consider this!

Since the increase in consideration for the increase in scope (the additional 3,000m2) is not at market rate, Entity F applies IFRS 16 45 to account for the modification. Accordingly, on 31 December 2019 which is the effective date of the modification, Entity F allocates the revised rentals for the modified contract to the two lease components, i.e. the existing 10,000m2 and the additional 3,000m2 of office space, based on their relative stand alone prices at that date.

Following the allocation of the consideration to the separate lease components, Entity F accounts for each lease component independently (IFRS 16 12). Consequently, Entity F remeasures the lease liability and the right-of-use asset relating to the existing 10,000m2 on 31 December 2019 using a revised discount rate. The 2019 annual financial statements will therefore reflect a revised right-of-use asset and lease liability for the existing 10,000m2 of office space.

As regards the lease of the additional 3,000m2, we believe that the related right-of-use asset and lease liability should be recognised at the commencement date of that separate lease component, i.e. on 1 January 2021 when this space is made available for use by Entity F. The amount recognised reflects the consideration allocated to this additional space on the effective date of modification of the original lease.

KEEP IN MIND – from the two cases for Extension of lease plus a new asset, you can see, regardless of whether the additional office space (leased asset) is accounted for as a separate lease for the purposes of the modification guidance, as long as it is a separate lease component from the existing leased asset, it will only be recognised on the commencement date which is the date when the additional asset is made available for use by the lessee.

Nevertheless, the measurement basis for both the pre-existing and the additional leased asset is different. If the modification is not accounted for as a separate lease, the modified consideration will be allocated to the pre-existing and the additional lease components on a relative stand alone price basis. On the contrary, if the modification is accounted for as a separate lease in accordance with IFRS 16 44, no reallocation is made.

Lease modifications extending the lease term

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