Lease Modification under Ind AS 116

A change in scope of lease, or

A change in consideration for a lease,

shall result in lease modification both for the lessee and lessor under an operating lease. Where in the books of lessor, accounting for lease modification is not such an issue. Lessee will have to undergo significant changes in its financial reporting.

The effective date of lease modification

Before going further, first thing is to identify the date of lease modification. It is the date on which both parties (that is lessor and lessee) agrees to a lease modification (that is any change in scope or consideration of lease).

The Basics

Any change in either consideration or scope of lease (or both for that matter) amounts to lease modification in terms of Ind AS 116. The following paragraphs specify treatment of lease modification based on what kind of modification has happened:

(a) Para 44;

(b) Para 46(a); and

(c) Para 46(b)

Para 44 (P.44)

P.44 is specifically applicable where lease modification is treated as a separate lease altogether. A lessee shall account for a lease modification as a separate lease if:

➡ modification increases scope of lease by adding additional right-of-use assets; and

➡ consideration for such additional right-of-use assets commensurate with stand-alone price (in simple terms, that is consideration for right to use additional underlying asset is at market rates).

There will not be any impact on existing lease liability and right-of-use asset in case of separate lease.

Para 46(a) and Para 46(b)

P.44(a) and P.44(b) are applicable where lease modification is not accounted for a separate lease in terms of P.44. That is changes would have to be made in the existing lease liability and right-of-use asset. However, in case of decrease in scope of a lease, lessee is also required to account for any gain or loss on partial or full termination of the lease.

Mixed modification

Is there a possibility of application of P.44 and P.46 in single lease modification? The answer is "it is very much possible" that a lease modification may result in recognising separate lease as well as change in existing lease liability and right-of-use asset. A simple image illustration will help you here:

Accounting treatment of lease modification

I have prepared spreadsheets for ten possible modification scenarios which are summarised here under:

Summary of lease modification
	Description	Modification Type	Reference
1	Change in consideration	Change in consideration - Decrease	M-1
2	Extending lease term	Change in scope - Increase	M-2
3	Additional space at market rates	Change in scope - Increase	M-3
4	Additional space at off-market rates	Change in scope - Increase	M-4
5	Extension plus additional space at market rates	Change in scope - Increase	M-5
6	Shortening the lease term	Change in scope - Decrease	M-6
7	Reducing the leased space	Change in scope - Decrease	M-7
8	Reducing the leased space and shortening lease term	Change in scope - Decrease	M-8
9	Reducing the leased space and extending lease term	Change in scope - Decrease	M-9

But first, let's have basic leasing arrangement between lessor and lessee. We shall go through with a common basic lease arrangement for all types of modification scenarios.

Lease commencement date - 01-Jan-2001

Original lease term - 5 Years

Lease rentals - 100,000/- pa

Area - 5000 sq. ft.

Incremental borrowing rate (IBR) - 5% pa

This is how the working for this arrangement would look like

At the commencement date (that is 01-Jan-2001), lessee shall recognise lease liability and corresponding right-of-use asset with sum total of present value of future lease payments discounted at 5% pa. 

Right-of-use asset.........Dr    432,948

Lease liability................. Cr    432,948

Lease liability shall be adjusted with interest and rent paid. You can see (in the figure above) how at the end of the lease term lease liability has become NIL. RoU asset shall be depreciated over the period of lease on straight line basis irrespective of the method of depreciation followed by the lessee for any other class of assets. Again you can see how RoU asset has also become NIL at the end of the lease term.

Modification - 1: Change in consideration (reduction)

On 01-Jan-2003, both lessor and lessee reduced lease rent to 97,000/- pa going forward. IBR also changed from 5% pa to 6% pa. On 31-Dec-2002, lease liability and RoU asset stands at 272,325/- and 259,769/- respectively. 

On effective date of modification, lessee shall remeasure liability with corresponding change in RoU asset and this is how it would look like:

Remeasured lease liability at revised rent of 97,000/- comes out to be 259,282/-, as against carrying value of 272,325/- (a reduction of 13,043/-). 

Lease liability...........................Dr    13,043

Right-of-use asset..................Cr    13,043

Therefore, revised lease liability and RoU asset shall be 259,282/- and 246,726/-.

Why there is no gain or loss?

Gain or loss shall only be recorded when there is a decrease in scope of lease. Scope of lease can be said to have been decreased in two cases only viz., where there is reduction in lease term or where there is reduction in RoU asset. In the above instance, this is not the case. 

Why RoU asset has not been remeasured like lease liability?

One can provide an alternative argument that RoU asset should also be remeasured on modification date and its revised carrying value should also be 259,282/- (equal to lease liability) and alternate JV could be:

Lease liability...........................Dr    13,043

Right-of-use asset..................Cr    487*

Gain on modification............Cr    12,556 (bal. fig.)

*(difference between 259,282/- and carrying value of RoU asset as at 31-Dec-2002 259,769/-) 

That would be wrong considering:

(a) as understood earlier, gain or loss can only be recognised where there is decrease in scope of lease which is not so in this case;

(b) The principle based on which Ind AS 116 has been framed is about recognising future lease liability in current balance sheet at its present value. RoU asset is the by-product of that lease liability. Therefore, any modification in lease should first be recognised with lease liability and corresponding change must be made in RoU asset.

Modification - 2: Extension of lease term

On 01-Jan-2003, both lessor and lessee extended the lease term by 2 years at rent of 105,000/- pa (for extended period). IBR also changed from 5% pa to 6% pa. On 31-Dec-2002, lease liability and RoU asset stands at 272,325/- and 259,769/- respectively. 

On effective date of modification, lessee shall remeasure liability with corresponding change in RoU asset and this is how it would look like:

Remeasured lease liability comes out to be 428,933/-, as against carrying value of 272,325/-. 

Right-of-use asset..................Dr    156,608

Lease liability...........................Cr    156,608

Therefore, revised lease liability and RoU asset shall be 428,933- and 416,377/-.

Modification - 3: Additional space at market rates

On 01-Jan-2003, both lessor and lessee agreed for additional space of 1000 sq. ft. at 21,000/- pa (market rate) with effect from 01-Jan-2004. IBR also changed from 5% pa to 7% pa. On 31-Dec-2002, lease liability and RoU asset stands at 272,325/- and 259,769/- respectively. 

On effective date of modification, lessee shall record a separate lease applying P.44.

Right-of-use asset..................Dr    37,968

Lease liability...........................Cr    37,968

The original lease of 5000 sq. ft. will not be impacted by this modification and will continue as it is.

Modification - 4: Additional space at non-market rates

On 01-Jan-2003, both lessor and lessee agreed for additional space of 1000 sq. ft at 15,000/- pa (market rate) with effect from 01-Jan-2004. IBR also changed from 5% pa to 6% pa. On 31-Dec-2002, lease liability and RoU asset stands at 272,325/- and 259,769/- respectively. 

Since, the additional space is leased out at non-market rates, it cannot be termed as separate lease. Accordingly, entity will have to apply P.46(b) and this is how it would look like:

Lease liability for original space of 5000 sq. ft. would be remeasured to account for change in IBR, which comes out to be 267,301/-.

Lease liability for additional space of 1000 sq. ft. at 6% IBR comes out to be 40,095/-. Therefore, combined lease liability shall be 307,396/- as against carrying value of 272,325/-.

Right-of-use asset..................Dr    35,071

Lease liability...........................Cr    35,071

The only difference in modification-3 and modification-4 is that the additional space is not at market rates in the latter. Therefore, consideration for such additional space cannot be said to be commensurate with the stand-alone price thereby making the case of non application of P.44. Since it is not at market rates, it is believed that the consideration of additional space is somehow compensated / influenced with consideration of original space and hence original lease has also been modified though only for change in IBR.

Modification - 5: Extension of lease term and additional space at market rates

On 01-Jan-2003, both lessor and lessee agree to modify lease as follows:

(i) extend the lease term of 5000 sq. ft. by 2 years at rent of 105,000/- pa (for extended period). IBR also changed from 5% pa to 6% pa. and

(ii) additional space of 1000 sq. ft. at rent of 21,000/- pa for 4 years with effect from 01-Jan-2004

Remeasured lease liability comes out to be 428,933/-, as against carrying value of 272,325/-. 

Right-of-use asset..................Dr    156,608

Lease liability...........................Cr    156,608

Right-of-use asset..................Dr    71,131

Lease liability...........................Cr    71,131

The above illustration is combination of modification-2 and modification-3 and has been drafted only to establish the point, I was making for mixed modification. Thus, it is possible that a lease modification may attract both P.44 and P.46.

⃠   These five modification scenarios have covered both P.44 and P.46(b) as none of them contained decrease in scope of lease. In fact, all (except modification-1) have actually increased the scope either by way of extending lease term or extending underlying asset.

Modification - 6: Shortening of lease term

On 01-Jan-2003, both lessor and lessee agree to shorten the lease term by 1 year and all other things remained same.

On modification date, carrying value of lease liability is 272,325/- and carrying value of RoU asset is 259,769/-. The original remaining period was 3 years which now stands at 2 years only.

Remeasurement of lease liability:

Year	Amount	PVF @ 5%	PV
2003	100000	0.952380952	95238
2004	100000	0.907029478	90703

Revised lease liability = 185,941/- (that is sum total of present value of remaining lease payment of 100,000/- pa discounted at IBR of 5%)

Remeasurement of RoU asset:

Revised RoU asset = 173,179/- (259,769*2/3) ⇒ This is based on the principle that carrying value of RoU asset of 259,769/- on modification date was to be depreciated over remaining period of three years which now stands at 2 years only. 

Lease liability........................................Dr    86,384        (272,325-185,941)

Loss on modification..........................Dr    206          (bal. fig.)

Right-of-use asset...............................Cr    86,590    (259,769-173,179)

Subsequent treatment of lease liability and RoU asset shall be as follows: 

 

Year	Amount	PVF @ 5%	PV	Interest	Payments	Liability	Depreciation	ROU
2003	100000	0.952380952	95238	9297	-100000	95238	86590	86590
2004	100000	0.907029478	90703	4762	-100000	0	86590	0

Modification - 7: Reducing the leased space

On 01-Jan-2003, both lessor and lessee agree to reduce the leased space by 1000 sq. ft. with effect from 01-Jan-2004.

On modification date:

Particulars	5000 sq. ft.	4000 sq. ft.	1000 sq. ft.
Lease liability	272325	217860	54465
RoU	259769	207815	51954

Leased area of 1000 sq. ft. have been relinquished with effect from 01-Jan-2004 and remaining area of 4000 sq. ft. shall continue as it is. 

Remeasurement of lease liability of relinquished space (1000 sq. ft.):

Present value of one payment of 20,000/- discounted at 5% pa. = 19048/-

Remeasurement of RoU asset of relinquished space (1000 sq. ft.):

Revised RoU asset = 17,318 (51,954*1/3) ⇒ This is based on the principle that carrying value of RoU asset (of 1000 sq. ft.) of 51,954/- on modification date was to be depreciated over remaining period of three years which now stands at 1 year only. 

Relinquished one floor	Lease Liab.	RoU
Value pre-modification	54465	51954
Value post- modification	19048	17318
Net Reduction	35417	34636

Lease liability........................................Dr    35,417

Loss on modification..........................Dr    781        (bal. fig.)

Right-of-use asset...............................Cr    34,636 

Remaining leased space of 4000 sq. ft. shall be accounted for as follows:

Year	Amount	Interest (5%)	Payments	Liability	Depreciation	ROU
2002				217860		207815
2003	80000	10893	-80000	148753	69272	138543
2004	80000	7438	-80000	76190	69272	69272
2005	80000	3810	-80000	0	69272	0

Modification - 8: Reducing the leased space and lease term

On 01-Jan-2003, both lessor and lessee agree to reduce the leased space by 1000 sq. ft. with effect from 01-Jan-2004 and lease term of remaining 4000 sq. ft. by one year.    

On modification date:

Particulars	5000 sq. ft.	4000 sq. ft.	1000 sq. ft.
Lease liability	272325	217860	54465
RoU	259769	207815	51954

(i) Leased area of 1000 sq. ft. have been relinquished with effect from 01-Jan-2004:

Remeasurement of lease liability of relinquished space (1000 sq. ft.):

Present value of one payment of 20,000/- discounted at 5% pa. = 19048/-

Remeasurement of RoU asset of relinquished space (1000 sq. ft.):

Revised RoU asset = 17,318 (51,954*1/3) ⇒ This is based on the principle that carrying value of RoU asset (of 1000 sq. ft.) of 51,954/- on modification date was to be depreciated over remaining period of three years which now stands at 1 year only. 

Relinquished one floor	Lease Liab.	RoU
Value pre-modification	54465	51954
Value post- modification	19048	17318
Net Reduction	35417	34636

Lease liability........................................Dr    35,417

Loss on modification..........................Dr    781        (bal. fig.)

Right-of-use asset...............................Cr    34,636 

(ii) Lease term of remaining leased area of 4000 sq. ft. have been reduced by one year:

Year	Amount	PVF @ 5%	PV	Interest	Payments	Liability	Depreciation	ROU
2003	80000	0.952380952	76190	7438	-80000	76190	69272	69272
2004	80000	0.907029478	72562	3810	-80000	0	69272	0

Lease liability for 4000 sq. ft. shall be 148,752/- (present value of lease payments of 80,000/- pa for next 2 years discounted at 5% pa). RoU for 4000 sq. ft. shall be 138,543/- (2/3rd of 207,815/-) ⇒ This is based on the principle that carrying value of RoU asset (of 4000 sq. ft.) of 207,815/- on modification date was to be depreciated over remaining period of three years which now stands at two years only.

4000 sq. ft.	Lease Liab.	RoU
Value pre-modification	217860	207815
Value post- modification	148752	138543
Net Reduction	69108	69272

Lease liability........................................Dr    69,108

Loss on modification..........................Dr    164        (bal. fig.)

Right-of-use asset...............................Cr    69,272

Modification - 9: Reducing the leased space and increasing lease term

On 01-Jan-2003, both lessor and lessee agree to reduce the leased space by 1000 sq. ft. with effect from 01-Jan-2004 and increase lease term of remaining 4000 sq. ft. by two years.    

On modification date:

Particulars	5000 sq. ft.	4000 sq. ft.	1000 sq. ft.
Lease liability	272325	217860	54465
RoU	259769	207815	51954

(i) Leased area of 1000 sq. ft. have been relinquished with effect from 01-Jan-2004:

Remeasurement of lease liability of relinquished space (1000 sq. ft.):

Present value of one payment of 20,000/- discounted at 5% pa. = 19048/-

Remeasurement of RoU asset of relinquished space (1000 sq. ft.):

Revised RoU asset = 17,318 (51,954*1/3) ⇒ This is based on the principle that carrying value of RoU asset (of 1000 sq. ft.) of 51,954/- on modification date was to be depreciated over remaining period of three years which now stands at 1 year only. 

Relinquished one floor	Lease Liab.	RoU
Value pre-modification	54465	51954
Value post- modification	19048	17318
Net Reduction	35417	34636

Lease liability........................................Dr    35,417

Loss on modification..........................Dr    781        (bal. fig.)

Right-of-use asset...............................Cr    34,636 

(ii) Lease term of remaining leased area of 4000 sq. ft. have been increased by two years:

Year	Amount	PVF @ 5%	PV	Interest	Payments	Liability	Depreciation	ROU
2003	80000	0.952380952	76190	17318	-80000	283676	67263	269051
2004	80000	0.907029478	72562	14184	-80000	217860	67263	201788
2005	80000	0.863837599	69107	10893	-80000	148753	67263	134525
2006	80000	0.822702475	65816	7438	-80000	76190	67263	67263
2007	80000	0.783526166	62682	3810	-80000	0	67263	0

Lease liability for 4000 sq. ft. shall be 346,357/- (present value of lease payments of 80,000/- pa for next 5 years discounted at 5% pa).

4000 sq. ft.	Lease liability
Value pre-modification	217860
Value post-modification	346357
Increase in liability	128497

RoU for 4000 sq. ft. shall be 336,312/- (207,815/- + 128,497/-).

To sum, I have tried to cover all possible modification scenarios in an illustrated way. These cases cover application of both P.44 and P.46 of Ind AS 116. There is no difference in IFRS 16 so far as lease modification is concerned. Thus, one can use these illustrations in IFRS as well.