Director top 10 reporting issues - #4 Lease modifications
In this article we turn our attention to the fourth of the ten reporting issues that will typically require the greatest attention by directors – lease modifications.
Previous reporting issues covered: In the March 2021 edition of Accounting Alert we started our series on the top ten financial reporting issues that directors need to consider by examining how to account for unusual events with substantial impacts (such as COVID-19). In the April 2021 edition of Accounting Alert we looked at the second issue, which was selecting accounting policies and in the May 2021 edition of Accounting Alert we looked at the third issue, which was the classification of relationships with other entities.
Reporting issue number 4 – Lease modifications
For lessees reporting under New Zealand equivalents to International Financial Reporting Standards (“NZ IFRS”) or NZ IFRS Reduced Disclosure Regime, the introduction of NZ IFRS 16 Leases (“NZ IFRS 16”) required substantial work by accounting teams, while the recognition of lease liabilities and associated right-of-use assets impacted (in some cases substantially) the statement of financial position.
However, the complexity that NZ IFRS 16 has introduced for lessees isn’t limited to the initial recognition of lease liabilities and right-of-use assets – complexity also arises when there are modifications to leases.
Modifications can arise from a change in the estimated term of a lease, a change in variable lease payments dependent on a rate or an index, or the renegotiation of a lease.
When a lessee revises its estimate of the term of any lease (because, for example, it re-assesses the probability of exercising an extension or termination option), it:
- Adjusts the carrying amount of the lease liability to reflect the payments to make over the revised term, which are discounted using a revised discount rate
- Makes an equivalent adjustment to the carrying value of the right-of-use asset, with the revised carrying amount being amortised over the remaining (revised) lease term - if the carrying amount of the right-of-use asset is adjusted to zero, any further reduction is recognised in profit or loss.
When the variable element of future lease payments dependent on a rate or index (such as the consumer price index) is revised, the lessee must:
- Adjust the carrying amount of the lease liability to reflect the payments to make over the revised term, using the same discount rate as was used when the lease liability was initially recognised
- Make an equivalent adjustment to the carrying value of the right-of-use asset, with the revised carrying amount being amortised over the remaining (revised) lease term – if the carrying amount of the right-of-use asset is adjusted to zero, any further reduction is recognised in profit or loss.
When a lessee renegotiates the contractual terms of a lease with the lessor, the accounting depends on the nature of the modification.
Where the renegotiation results in one or more additional assets being leased for an amount commensurate with the standalone price for the additional rights-of-use obtained, the lessee must account for the modification as a separate lease.
Where the renegotiation increases the scope of the lease (whether that is an extension to the lease term, or one or more additional assets being leased), the lessee must:
- Remeasure the lease liability using the discount rate applicable on the modification date
- Make an equivalent adjustment to the right-of-use asset.
Where the renegotiation results in a decrease in the scope of the lease, the lessee must:
- Reduce the carrying amount of the lease liability and right-of-use asset by the same proportion to reflect the partial or full termination of the lease, with any difference being recognised in profit or loss
- Further adjust the lease liability to ensure that its carrying amount reflects the amount of the renegotiated payments over the renegotiated term, with the modified lease payments discounted at the rate applicable on the modification date
- Adjust the right-of-use-asset by the same amount.
To see how this works in practice, set out below are two examples – the first looks at an increase in lease payments due to a change in the Consumer Price Index and the second looks at a change in lease payments due to a reduction in the amount of floor space leased.
Example one - increase in lease payments due to the change in an index
Where a lease includes variable lease payments that depend on an index or a rate, the measurement of the lease liability at inception uses the index or rate as at the commencement date of the lease. When that index or rate changes (which results in amended lease payments), the lease liability must be remeasured.
As an example, Company A is the lessee in a 10-year lease of property, with annual lease payments of $50,000, payable at the beginning of each year.
The lease agreement specifies that lease payments will increase every two years on the basis of the increase in the Consumer Price Index (“CPI”) for the preceding 24 months. The CPI at the commencement date is 125. At the beginning of the third year of the lease, the CPI is 135.
The interest rate implicit in the lease is not readily determinable. Company A's incremental borrowing rate is 5%, which reflects the rate at which it could borrow an amount similar to the value of the right-of-use asset, for a 10-year term, with similar collateral.
At the commencement date, Company A makes the lease payment for the first year and measures the lease liability at the present value of the remaining nine payments of $50,000, payable annually in advance, discounted at the interest rate of 5%, which is $355,391.
The right-of-use asset is calculated as follows:
| Component of initial measurement | |
| Initial measurement of the lease liability | $355,391 |
| Plus: Lease payments made at or before commencement date | $50,000 |
| Plus: Initial direct costs incurred by the lessee | Nil |
| Plus: Estimated restoration costs | Nil |
| Less: Lease incentives received | Nil |
| Total | $405,391 |
The journal entry at the date of commencement of the lease is:
Dr Right-of-use asset $405,391
Cr Lease liability $355,391
Cr Cash $50,000 (lease payment for the first year)
Each year, Company A will make a cash payment of $50,000 (at the beginning of the year). The lease liability will decrease over the period of the lease as follows:
| Year | Opening | Payment | Post Payment | Interest (5% x post payment) | Closing (post payment + interest) |
| 1 | $355,391 | $17,770 | $373,161 | ||
| 2 | $373,161 | $50,000 | $323,161 | $16,158 | $339,319 |
| 3 | $339,319 | $50,000 | $289,319 | $14,466 | $303,785 |
| 4 | $303,785 | $50,000 | $253,785 | $12,689 | $266,474 |
| 5 | $266,474 | $50,000 | $216,474 | $10,824 | $227,298 |
| 6 | $227,298 | $50,000 | $177,298 | $8,865 | $186,162 |
| 7 | $186,162 | $50,000 | $136,162 | $6,808 | $142,971 |
| 8 | $142,971 | $50,000 | $92,971 | $4,649 | $97,619 |
| 9 | $97,619 | $50,000 | $47,619 | $2,381 | $50,000 |
| 10 | $50,000 | $50,000 | Nil | Nil | Nil |
After years one and two of the lease:
- A cash payment of $50,000 has been made (at the beginning of year 2)
- The right-of-use asset has been depreciated (on a straight line basis over the ten year lease term) by $81,078 = 2 years x $40,539 ($405,391/10) per year
- Interest expense of $33,928 ($17,770 + $16,158, per the table above) has been incurred.
The journal entries for the end of year one are as follows:
Dr Depreciation $40,539
Cr Right-of-use asset $40,539
Dr Interest expense $17,770
Dr Lease liability $17,770
The journal entry at the beginning of year two is:
Dr Lease liability $50,000
Cr Cash $50,000
The journal entries for end of year two are as follows:
Dr Depreciation $40,539
Cr Right-of-use asset $40,539
Dr Interest expense $16,158
Dr Lease liability $16,158
At the beginning of the third year, before accounting for the change in future lease payments resulting from the change in the CPI and making the lease payment for the third year, the lease liability is $339,319, as can be seen in the lease liability table above.
At the beginning of the third year, the CPI is 135. The lease payment for the third year, which must be adjusted for the CPI, is $54,000 ($50,000 × [135/125]).
As there is a change in the future lease payments, resulting from a change in the CPI used to determine those payments, Company A must remeasure the lease liability to reflect those revised lease payments.
At the beginning of the third year of the lease, the lease liability will be the present value of eight payments of $54,000, payable annually in advance, discounted at 5% (the incremental borrowing rate at inception of the lease), which is $366,464. Company A must increase the lease liability by $27,145 ($366,464 - $339,319). The journal entry is:
Dr Right-of-use asset $27,145
Cr Lease liability $27,145
At the beginning of the third year, Company A also makes the lease payment for the third year. The journal entry is:
Dr Lease liability $54,000
Cr Cash $54,000
Journal entries made at the end of the third year will need to reflect the increased carrying values of the lease liability and right-of-use asset.
Example two - reduction in the amount of floor space leased
Where there is a change in the area leased, the lessee must adjust the lease liability and the right-of-use asset for the proportionate decrease in the leased area and for any changes to the lease liability.
As an example, Company B is the lessee in a 10-year lease for 5,000 square metres of office space. The annual lease payments of $50,000 are payable at the end of each year.
The interest rate implicit in the lease is not readily determinable. Company B’s incremental borrowing rate is 6%. There are no lease payments made at or before commencement date, initial direct costs incurred by the lessee, estimated restoration costs or lease incentives received.
At the beginning of year six of the lease, Company B and the lessor agree to amend the original lease to reduce the space to 2,500 square metres of the original space, for an annual rent of $30,000. At the beginning of year six, Company B’s incremental borrowing rate is 5%.
At the beginning of the lease, the lease liability is $368,004 (the present value of ten annual payments of $50,000 in arrears, at a discount rate of 6%). As there are no lease payments made at or before commencement date, initial direct costs incurred by the lessee, estimated restoration costs or lease incentives received, the right-of-use asset at the inception of the lease is also $368,004.
The journal entry at the date of commencement of the lease is:
Dr Right-of-use asset $368,004
Cr Lease liability $368,004
Each year, Company B will make a cash payment of $50,000. The lease liability will decrease over the period of the lease as follows:
| Year | Opening Value | Interest expense (6% x opening value) | Cash paid | Closing value (opening value + interest – cash paid) |
| 1 | $368,004 | $22,080 | $50,000 | $340,085 |
| 2 | $340,085 | $20,405 | $50,000 | $310,490 |
| 3 | $310,490 | $18,629 | $50,000 | $279,119 |
| 4 | $279,119 | $16,747 | $50,000 | $245,866 |
| 5 | $245,866 | $14,752 | $50,000 | $210,618 |
| 6 | $210,618 | $12,637 | $50,000 | $173,255 |
| 7 | $173,255 | $10,395 | $50,000 | $133,651 |
| 8 | $133,651 | $8,019 | $50,000 | $91,670 |
| 9 | $91,670 | $5,500 | $50,000 | $47,170 |
| 10 | $47,170 | $2,830 | $50,000 | Nil |
At the beginning of year six:
- The lease liability is $210,618 (from the table above).
- The right-of-use asset is $184,002 (depreciated on a straight line basis - $368,004 x [5 years / 10 year useful life])
- The new lease liability is $129,884 (the present value of five $30,000 annual payments in arrears at a 5% discount rate, which is Company B’s incremental borrowing rate at the beginning of year six).
At the effective date of the lease modification (the beginning of year six), Company B must determine the proportionate decrease in the carrying amount of the right-of-use asset - it is 50% (2,500 square metres under the modified lease / 5,000 square metres originally leased). The lease liability and right-of-use asset must then be decreased by that proportionate amount. The journal entry is:
Dr Lease liability $105,309 ($210,618 x 50%)
Cr Right-of-use asset $92,001 ($184,002 x 50%)
Cr Profit or loss $13,308 (balancing figure).
The lease liability and right-of-use asset must then be changed by the change in the lease liability. The journal entry is:
Dr Right-of-use asset $24,575 ($129,884 new lease liability - $105,309 [50% of the old lease liability of $210,618])
Cr Lease liability $24,575
In future editions of Accounting Alert, we’ll continue with our examination of the top 10 issues that directors need to consider.
For more on the above, please contact your local BDO representative.
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