Welcome to lesson two. In this lesson,

we'll go through a couple of examples of modifications and

of a termination giving you an idea how some of these things work.

Let's start here with a modification,

where we have a newspaper,

The Daily Planet has got a 10 year lease on

the seventh floor of a high rise in Metropolis for 10 years.

Well, in year three the lease is modified to include the eighth floor.

Now this modification grants an additional right of use,

so it could be a new lease.

How do we tell whether it's a new lease or a modification?

Well, we're going to look at whether the lease payments increased and whether

that increase is commensurate with the standalone price.

So, let's say that the rent for the eighth floor

is 10 percent less than the rent for the seventh floor.

Does that mean that it's a modification and not a new lease?

Well, that increase in the rent,

the difference in the rent could be attributable to either a change in

market rents or maybe lessor reduced has less initial cost,

search costs, negotiating cost, credit checks, everything.

So, 10 percent you could sit there and argue no that's still

commensurate with the standalone price of the property for renting the property,

so we're going to account for the eighth floor as a new lease,

and we won't touch the lease of the seventh floor.

So, we're not going to combine the two,

we're going to treat them as just simply two separate leases.

Well, what if it's not a new lease?

What if we got the second floor for,

say 50 percent of the market rent,

of the standalone market rent?

That could be an idea that we've gotten a lease concession on

our original lease and now I'm going to treat that as a modification,

I'm going to combine the two and reclassify them together as a single lease.

So, I would redo the original classification and measurement,

I'm going to use these revised terms.

I'll determine whether the original arrangement takes a lease,

classify the lease, remeasure the lease,

go through the entire drill again for the entire lease,

even though the seventh floor was rented three years ago.

Let's look at another example here,

the Planet decides to extend the lease term by exercising

an option that was not included in the original lease term.

So, there was an option,

but it was not considered to be reasonably assured that it would be exercised,

so it was not included in the lease term.

Well, now they've decided to exercise that option.

And the additional obligation they're going to incur is 500,000.

There are no incentives or initial direct costs,

we're doing that for simplicity just so you can see just the impact of

increasing the right-of-use asset and

the obligation due to an extension on the lease term,

and here's the journal entry.

We'll, adjust the balances on the original lease by increasing the ROU asset

and the lease obligation by

the present value of the lease payments in the extension period.

Of course if there were incentives,

we would account for it just as we would otherwise we would

adjust the right-of-use asset for those amounts.

But here is your simplest case,

increase the right-of-use asset, increase the obligation.

Let's look now at a different type of situation.

Let's look at a partial termination.

The Daily Bugle has had a drop in circulation and they no longer need all of it's space.

So, the landlord agrees to end the lease for half of the space.

Daily Bugle will move out of that space and it will

become available for use by another tenant.

And the lease obligation is 250,000 so,

the balances is prior to the modification are 500,000 and 400,000,

the 250,000 will be the obligation after the modification.

So what are we going to do? We're going to

reduce both the lease obligation and the right-of-use asset.

If the new lease obligation is 250,000,

that's 50 percent of the existing lease obligation prior to the modification.

So we're going to reduce the lease obligation down to 250,000.

Well, if we do that,

we are also then going to reduce that right-of-use asset by 50 percent proportionally,

and that will be down to 200,000.

And now this is a termination.

So with the termination we can recognize a gain or loss.

In this case we would recognize again on the termination of $50,000.

So that's some basic examples of how to account for

a modification or a termination of a lease.

We'll move on next to talk about another complex topic in multiple elements.

Modification and Termination Examples

Accounting Analysis II: Measurement and Disclosure of Liabilities

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