Accounting for Lease Changes under ASC 842

At a glance:

• The main takeaway: After nonpublic companies adopted the FASB’s Accounting Standards Codification Topic 842, Leases (“ASC 842”) effective January 1, 2022, accounting for operating leases became more complex as operating leases are now capitalized on the balance sheet. Complexities are added when lease changes occur after the initial accounting for a lease.
• The impact on your business: When a situation occurs that amends the lease through an agreement between the lessee and lessor or there is a change in the assumptions and circumstances of the lease currently in place it can have significant impacts on the lease accounting, financial statements and potentially bank covenants.
• Next steps: Changes to leases are frequent in the government contracting world, stay on top of the accounting and understand their impact by consulting with Aprio’s Government Contracting team.

Schedule a consultation with Aprio’s Government Contracting specialists today.

The full story:

In the world of government contracting, the need to adjust leased space is a common occurrence. Did you win a recompete and need to extend your lease term? Did you lose a recompete and need to decrease your space? Was a task order added in the middle of your lease term and you need additional space? Under ASC 842, each of these scenarios should trigger a lessee to examine how the original lease is accounted for.  

Lease Modification

Lease modifications occur when the Lessee and Lessor make changes to the lease that ultimately result in adjustments to the scope and consideration of a lease. Depending on the circumstances of the modification, it may result in a new lease or a continuation of the original lease.

Per ASC 842-10-55-161, a Lessee should account for a modification as a new contract (lease) when both the following conditions are met (1) the modification gives the lessee additional rights not included in the original lease. (2) The lease payments increase commensurate with the standalone price of the additional right-of-use.

If a lease modification does not meet both two conditions discussed above, the lease will be accounted for as an existing contract. When this occurs, the lease will need to be remeasured, and all lease inputs will need to be reconsidered based on the modified existing contract, as of the date both the lessee and lessor agreed to the modification. The lease liability will then be adjusted based on the remeasurement and there will be an offset to the right-of-use asset with no profit and loss impact. This rule excludes lease terminations, which will have a profit and loss impact.

Lease Modification Example (New Lease):

A government contractor (the “Contractor”) is a lessee in a 5-year lease for 8,000 square feet of office space with a yearly escalation of 3%. The contractor is subsequently issued a new task order which requires additional in office personnel. As such, the Contractor and the Lessor enter into an agreement to modify the lease for the remaining 2 years to include an additional 3,000 square feet of office space at the same location. The per square foot cost of the additional space equals the originally agreed upon contractual term for years four and five.

Based on the facts and circumstances above, the Contractor is granted an additional right of use asset (3,000 sq ft per year), above and beyond the original contract (8,000 sq ft per year). Additionally, the payments for the additional space equal that of the original space, on a square foot basis. Ultimately, the lease modification should be accounted for as a separate lease.  The Contractor should account for the modification as a new contract (3,000 square ft per year for 2 years), separate from the original contract (8,000 square ft per year for 5 years). The accounting for the original lease should remain untouched and on the effective date of the modification, the Contractor will add the second lease.

Lease Modification Example (Continuing Lease):

A government contractor (the “Contractor”) is a lessee in a 5-year lease for 8,000 square feet of office space. The contractor is subsequently notified that a task order is terminated for convenience, decreasing the need for office space in the final two years by 50%. As such, the Contractor and the Lessor enter into an agreement to modify the lease for the remaining 2 years to decrease the leased space to 4,000 square feet.

Based on this information, the Contractor would reduce both the right of use asset and the lease liability proportional to the revised lease liability (50% in this case) for the final two years. The resulting difference in this reduction would be recognized as a gain or loss at the modification date.

Lease Reassessment

While lease modifications can be identified through agreed upon lease amendments between the lessee and the lessor, lease reassessments may arise when there is a change to the assumptions or circumstances surrounding the lease. This includes changes to the term of the lease, for example the lessee ultimately chooses to exercise a lease renewal option which the lessee previously believed they were unlikely to exercise. This could also relate to the occurrence of significant events or circumstances which may affect the lease, for example the company may make a business decision which has an impact on the ability to exercise a renewal option.

When a reassessment takes place, all inputs for the lease must be examined. This includes contractual lease payments, discount rate, asset fair value and expected life as of the date of reassessment.

Lease Reassessment Example:

A government contractor (the “Contractor”) is a lessee in a 10-year lease for office space with a provision for additional 5-year extension. At lease inception the Contractor determines that is it more likely than not that they will elect to extend the lease, and as such, the right-of-use asset is recorded based on a 10-year term. In year 9, prior to the end of the original lease term, the Contractor wins an award under a new contract vehicle and determines that the additional 5-years of office space will be necessary.

Based on the facts and circumstances above, at the date of determination that the additional lease period will be necessary, the contractor shall reassess all inputs for the lease and remeasure the lease liability. This includes the extended lease term with applicable contractual rates and discount rate at the date of reassessment. Further, this adjustment should have no income statement impact, once the new lease liability is determined the Contractor shall record an offset to the right-of-use asset.

The bottom line:

The implementation of ASC 842 marked a significant change in how entities accounted for their leases. Contact us today for a consultation with Aprio’s Government Contracting team who can help guide you through the various aspects of how to record your lease portfolio under these new guidelines and how it can impact your financial statements.

For more information about how these new guidelines might impact your financial statements schedule a consultation with Aprio’s Government Contracting specialists today.

Related Resources:

Self-audit Techniques for Government Contractor’s Financial Statement Audit

Federal Policies on Sustainability for Government Contractors: Part 1

Navigating FAR 31.205: Selected Costs: Penalties on Unallowable Costs