Entering into a new lease contract for the same premises before the end of the lease term is a lease modification

IFRS 16 Leases applies for the first time to 30 June 2020 annual reporting periods. While many lessees are still grappling with the basics of how to capitalise leases on balance sheet, it should be noted that a once-off ‘set and forget’ approach is not appropriate, with lessees needing to consider whether there have been reassessments and modifications to leases in every reporting period for the duration of the lease term.

This article illustrates, using an example, how a new lease contract entered into for the same asset, prior to the end of the lease term, is accounted for as a lease modification, and not a new separate lease.

Background

Lessee enters into a three-year lease for office premises on 1 January 2018. There is a ‘hold over’ clause in the lease but Lessee has assessed that the lease term is only three years. Lease payments are $5,000 per month, payable in arrears.

The right-of-use asset for the leased premises is amortised on a straight-line basis over 36 months.

On 1 June 2020, a new lease agreement is entered into with the same lessor, for the same premises for three years beginning 1 January 2021. The original lease agreement remains in effect and unchanged until 31 December 2020. Lease payments for the new lease will be $6,000 per month, which is equivalent to current market rentals. There are no termination, renewal or purchase options on this second lease either.

Lessee’s incremental borrowing rate (IBR) on 1 January 2018 is 6% and on 1 June 2020 is 4%.

Is the lease considered a ‘new lease’ under IFRS 16?

If the new lease is considered a ‘separate lease’, this would mean accounting for the first lease, with $5,000 lease payments, until 31 December 2020, and then commencing accounting for a second three-year lease, with $6,000 lease payments, from 1 January 2021 through to 31 December 2023. The impact of this is that the 31 December 2020 financial statements do not include a lease liability or ROU asset. Both of the criteria below in IFRS 16, paragraph 44 need to be met in order to account for the modification as a separate lease.

A lessee shall account for a lease modification as a separate lease if both:

the modification increases the scope of the lease by adding the right to use one or more underlying assets; and
the consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope and any appropriate adjustments to that stand-alone price to reflect the circumstances of the particular contract.

IFRS 16, paragraph 44

In this case, there is no increase in scope of the lease, i.e. no additional right-of-use assets are added. The only change is an increase in the lease term. Therefore, the second lease is not accounted for as a separate lease under IFRS 16, paragraph 44.

Therefore, if an entity continues to use an existing asset, the new lease contract will be accounted for as a lease modification, and not a separate new lease contract.

Is the lease considered a ‘lease modification’ under IFRS 16?

Where a new lease is not accounted for as a separate lease, it is treated as a ‘lease modification’ under IFRS 16, paragraph 45. As the new lease is entered into on 1 June 2020, the modification date is 1 June 2020.

On 1 June 2020, Lessee therefore:

Remeasures the lease liability based on the remaining 7 months of $5,000 lease payments, followed by 36 payments of $6,000, i.e. all remaining cash flows are discounted at 4% (IBR on modification date) – refer IFRS 16, paragraph 45(c)
Recognises the difference between the carrying amount of the lease liability on 1 June 2020, and the remeasured amount above, as an adjustment to the right-of-use asset – refer IFRS 16, paragraph 46(b), and
Continues amortising the right-of-use asset over the remaining 43 months to 31 December 2023.

This treatment is supported by other authoritative references including:

IFRS 16 Illustrative Example 16, and
The March 2017 IASB Webcast titled ‘IFRS 16: Lease Modification-Lessees’ which also addressed increases in lease term, noting that the new lease is recognised and measured on the effective date of the modification (and not accounted for as a separate lease).

Workings

Using the 6% IBR at the commencement of the first lease on 1 January 2018, the PV of the remaining lease payments on 1 June 2020 (date of modification) is $34,310.

The carrying amount of the right-of-use asset on 1 June 2020 is $31,958.

Period	Opening balance ($)	Interest at 6% ($)	Payments ($)	Closing balance ($)
June 2020	34,310	172	(5,000)	29,482
July 2020	29,482	147	(5,000)	24,629
Aug 2020	24,629	123	(5,000)	19,752
Sep 2020	19,752	99	(5,000)	14,851
Oct 2020	14,851	74	(5,000)	9,925
Nov 2020	9,925	50	(5,000)	4,975
Dec 2020	4,975	25	(5,000)	NIL

The present value of the combined lease payments for the first lease (7 remaining payments of $5,000) and the second lease (36 payments of $6,000), using the revised IBR on 1 June 2020 of 4% is $232,110.

The adjustment for the remeasurement of the lease liability on 1 June 2020 is calculated as follows:

PV of modified lease $232,110
Less PV of original lease ($34,310)

$197,800

The journal entry to recognise the modification on 1 June 2020 is:

Dr Right-of-use asset $197,800
Cr Lease liability $197,800

The revised carrying amount of the right-of-use asset, after accounting for the modification on 1 June 2020 is:

Before modification $31,958
Modification adjustment $197,800

$229,758

The revised amortisation charge on the right-of-use asset will therefore be $5,343 (i.e. $229,758 / 43 months).