Written by Jank Garcia, CPA - Audit Manager, Financial Institutions Group

Lease accounting under accounting standards update (ASC) 842 often turns on a critical classification determination: is the change a true modification, or should it be treated as a brand new lease? That distinction sounds simple, yet it’s one of the most common areas where companies quietly drift off course. Gain an understanding of the differences as Doeren Mayhew’s credit union and bank pros provide clarity in distinguishing a modification from a separate contract, why the difference matters and how to account for it properly. 

Evaluating the Lease 

Before applying the lease modification framework, an entity must first reassess whether the modified contract is, or contains, a lease in accordance with ASC 842-10-15-6. When the terms and conditions of a contract are changed, an entity must determine whether an identified asset continues to exist, and if the customer retains the right to control the use of that asset. If, as modified, the arrangement no longer conveys the right to control the use of an identified asset, lease accounting ceases and the arrangement is accounted for under other applicable generally accepted accounting principles (GAAP). Conversely, if the modified terms introduce a lease where one did not previously exist, the arrangement is accounted for as a new lease from the effective date of the change. This gating step is critical because it determines whether the accounting follows lease modification guidance in ASC 842-10-25-8 through ASC 25-13 or instead results in termination and/or new lease accounting. 

Understanding Lease Modifications 

ASC 842-10-25-8 

ASC 842-10-25-8 establishes the criteria for determining whether a lease modification is accounted for as a separate contract or as a modification of the existing lease. Lease agreements are sometimes modified subsequent to their origination date. A lease modification is defined as a change to the terms and conditions of a contract resulting in a change in the scope of, or the consideration for, a lease that was not part of the original terms and conditions.  

For example, a lease modification would include one of the following: 

• Adding or terminating a right to use one or more underlying assets,
• Extensions or contractions of the lease term,
• Contract amendments to increase or reduce remaining future lease payments.  

A lease modification accounted for as a separate contract would: 

• Grant the lessee an additional right-of-use not previously included in the original lease.
• Lease payments would increase with the standalone price for the additional right-of-use (adjusted for the circumstances of the particular contract). 

ASC 842-10-25-9 

If a lease is modified, and that modification is not accounted for as a separate contract in accordance with ASC 842-10-25-8, the entity shall reassess the classification of the lease in accordance with paragraph ASC 842-10-25-1 as of the effective date of the modification. 

When a lease modification is not accounted for as a separate contract, lessees will: 

• Reassess the classification of the modified lease as of the effective date of the modification.
• Reallocate the remaining consideration in the contract to the lease components and non-lease components (if any) in accordance with ASC 842-10-15-28.
• Remeasure the lease liability using the discount rate in effect as of the effective date of the modification. 

On the other hand, if the lease is considered to be a separate contract the entity shall classify each separate lease component at the commencement date. 

Example of a Lease Modification 

A lessee is currently leasing a branch under a 10-year lease for $100,000 in annual payments, paid in arrears. At the start of year six, the lessee and lessor agree to modify the lease to extend the lease term by an additional five years, bringing the total lease term from 10 to 15 years. The annual lease payments for year six through year 15 will be $110,000. The lessee’s incremental borrowing rate is 6% at the lease commencement date, and 7% at the effective date of modification. This is also assuming the modification does not change the operating lease classification of the arrangement, and the carrying value of the lease liability was $421,236 at the modification date. 

The lessee would remeasure the lease liability at the effective date of the modification at $772,594 (based on $110,000 in annual payments for 10 years, discounted at 7%). Accordingly, the lease liability needs to be increased by $351,358 ($772,594 remeasured liability minus $421,236 carrying value). The right-of-use asset is increased by an equivalent amount, and no gain or loss is recorded unless the modification includes a full or partial termination (i.e., a decrease in scope), in which case a gain or loss is recognized to the extent the reduction in the lease liability differs from the proportionate reduction in the right-of-use asset. 

Because the modification does not represent a separate contract, and does not involve a decrease in scope, the adjustment is recorded as an increase to both the lease liability and the right-of-use asset. Thus, the lessee would book the following journal entry to record this lease modification on the modified date: 

• Dr. Right of use asset: $351,358    
• Cr. Lease Liability: $351,358 

A Critical Step in Producing Accurate Financial Statements 

The key distinction lies in the timing of the balance sheet recognition. When a lease is modified and not accounted for as a separate contract, the existing lease is remeasured as of the effective date of the modification, and any resulting adjustment to the lease liability is recorded as a corresponding adjustment to the right-of-use asset (subject to partial termination considerations). A separate contract, by contrast, triggers recognition of a new right-of-use asset and liability recognized at the commencement date of the new, separate lease (typically the effective date of the modification for the added right-of-use).The timing difference is the practical outcome of classifying the arrangement correctly, and it’s why distinguishing between a modification and a separate contract is more than a technical exercise—it’s essential to producing accurate financial statements.  

Needing assistance in distinguishing lease modifications? Rely on Doeren Mayhew’s pros to help understand and account for them.