Leases and contracts aren’t always set in stone. As a business grows, expansion into a larger space may be needed. Or, it might make sense to extend the term of a lease to get more use out of expensive leasehold improvements. Payments may also change in unpredictable ways if they’re indexed to the CPI or to a business milestone.
Because such changes are common, FASB devoted a considerable chunk of the recent lease standard update, ASC 842, to remeasurement of leases.
Under the prior lease guidance, ASC 840, lessees remeasured the lease liability only when the lease was modified. But, under ASC 842, any of the following circumstances can trigger remeasurement by the lessee:
- Modifications to the lease that don’t qualify as a separate contract.
- Decision by a lessee to exercise a purchase option.
- Changes to amounts likely to be owed under a residual value guarantee.
- Resolution of contingencies that result in variable payments becoming fixed for the remainder of the lease term.
In contrast, lessors are only required to remeasure leases when they’re modified.
Leases with variable payments tied to external indices or rates may result in changes to payment amounts at regular intervals. Fortunately, in a recent update, FASB clarified that such leases only need to be remeasured if there is another reason for remeasurement. The difference in the payment can simply be recognized in the period that the payment occurs.
In all cases, remeasurement is done on a prospective basis, and any changes to the lease liability are offset to the right to use asset. If these adjustments bring the right to use asset to zero, any further adjustments are recognized through the income statement. The right to use asset can’t go negative.
Some lease modifications must be treated as new contracts. For example, a lessor may allow a lessee to expand a store into an adjoining vacant space. If the following two conditions hold, then the modification must be treated as a separate contract:
- The modification is for the right to use additional space, or an additional asset not named in the original contract, and
- The payment increase is proportional to the standalone cost, or is commensurate with the current lease payment.
If these two conditions are not met, this change will be treated as a modification to the original lease agreement. In this situation, both lessees and lessors will be required to remeasure the lease payments. Lessees will remeasure the lease liability as well, and lessors must reassess the lease classification because it may no longer fall into the original classification as a sales-type lease, a direct financing lease or an operating lease.
Purchase option exercise
Over the course of the lease term, lessees may change their intention to exercise a purchase option. This may result from actions under the lessee’s control, such as making substantial leasehold improvements, or it may be due to circumstances outside the lessee’s control, such as a change in market conditions.
If the change in circumstance is under the lessee’s control, the lessee will be required to reassess the lease term and the likelihood of exercising the purchase option. If the change is outside of the lessee’s control, remeasurement is not required.
Residual value guarantees
At the onset of a lease, a residual value guarantee is treated as an additional lease payment owed by the lessee. As such, if there is any change to the amount that the lessee will be likely to owe at the end of the lease term, remeasurement will be triggered.
Resolution of contingencies
Lease agreements sometimes include variable payments that depend on another measure or index. If the amount is based on an external index or rate, such as the CPI, those payments are included in the lease liability. However, variable payments based on performance metrics or other contingencies are not included in the initial measurement of the lease liability.
Some leases include performance targets or milestones, which – when achieved by the lessee – result in variable payments becoming fixed for the remainder of the lease term. Once that milestone or target is reached, then the lease liability is remeasured to include those payments for the remainder of the lease term.
Under ASC 842, advisors need to be aware of the circumstances that will require remeasurement of lease payments and lease liabilities. Deloitte has an excellent guide that explains in detail the process of remeasurement for lessees and lessors.