Accounting Changes for Modifying Existing Lease Arrangements

In the wake of the pandemic, companies are finding they need to reevaluate their commercial real portfolios. This is the second in a series of three articles looking at some accounting advice from Deloitte. The first article can be found here.

Perhaps nothing changes, but allocation of resources could well change after a review. Maybe businesses decide they need less office space with people working at home, or perhaps a company has people working remotely and chooses to obtain distributed temporary or flexible space rather than single large buildings for hundreds or thousands of employees. 

The changing nature of the pandemic, with the surge in the Delta variant, has set some companies pushing back their office reopenings. More operational issues, and real estate implications, continue to be up in the air.

One tool available to an organization is the modification of lease arrangements. Perhaps the goal is to scale back the amount of office space under lease or even to expand to better accommodate current and future social distancing. A company might want to seek a reduction in rent.

The Financial Accounting Standards Board’s Accounting Standards Codification 842, known as ASC 842, would be the controlling standard. According to Deloitte, ASC 842 lease modification guidance is new to U.S. generally accepted accounting principles (GAAP). 

“Historically, accounting for lease modifications is an area you may have found an infrequent need to address,” as Thompson Reuters has noted. “As restrictions are lifted in some areas, some companies are allowing their employees to return to the office and are requiring additional leased space once again, while others have decided to permanently reduce their real estate footprint and expenses. With these volatile changes affecting both the economy and how entities conduct their business and with the impending implementation of the new leases standard for private companies, many are asking, ‘How should we account for lease modifications under ASC 842?’”

The way a company accounts for a modification depends on the contractual nature—whether it is done as a separate contract or a change to an existing one. There are two conditions, according to Thompson Reuters, that govern when a modification is done as a new contract: the lessee gets an additional right of use and that right has an increase in lease payments.

Sorting out the difference between modification or new contract may sound simple, but it can get difficult, according to Deloitte: “In others, applying the ASC 842 framework when the amendment results in multiple changes to an arrangement or affects different lease components can introduce unexpected complexity (e.g., reducing the term of one floor and extending the term of another).”

If a company is exiting a property before the lease term, there is other “accounting nuance.” An early termination might mean that the company immediately vacates the space. Otherwise, it could be considered a change in lease term only. Take 60 days to leave the premises and it might be that the lease term changes from the remaining portion to those two months.

There are other potential complications. “Knowing how the ASC 842 lease modification guidance works, as well as its potential pitfalls, is critical to allow for the proper accounting of a modified lease,” Deloitte notes.