Lease modifications

1 Lease modificationsAccounting for changes to Lease contractsIFRS 16 September for changes 11 At a glance Key facts Key impacts 32 Key concepts What is a Lease modification? modifications are different from reassessments A separate Lease Discount rates Effective date of a modification 63 Lessee modifications Overview Discount rates Separate Lease Not a separate Lease Termination or break of a Lease Master Lease agreements 274 Lessor modifications Overview Discount rates Lessor modifications to finance leases Lessor modifications to operating leases Termination or break of a Lease 395 Effective date of a Lease modification 416 Transition issues Overview 46 Appendix I IFRS 16 at a glance 48 Appendix II List of examples 49 About this publication 51 Acknowledgements 51 Keeping in touch 52 2018 KPMG IFRG Limited, a UK company, limited by guarantee.

2 All rights reserved. accounting for changes Lease modifications are very common. For example, a lessee with a struggling business may seek to negotiate lower Lease payments or terminate some leases early. Or a lessor may wish to end a Lease early so that it can redevelop or redeploy the underlying asset. Whatever the reason for the change, the resulting accounting can be complicated. IFRS 16, the new leases standard, introduces detailed guidance on accounting for Lease modifications . This is good news, providing clarity and consistency in an area where there has been little guidance and much diversity in the past. A company adopting IFRS 16 using either a retrospective approach or a modified retrospective approach with the election to recreate the right-of-use asset from the commencement date will need to address historical Lease modifications now, as part of its transition project.

3 And all companies will need to prepare for Lease modifications that will take place after transition a key day two aspect of the new world of Lease accounting . This publication contains practical guidance and examples showing how to account for the most common forms of Lease modifications . We hope you will find it useful as you prepare to adopt the new standard in 2019. Kimber Bascom Ramon Jubels Sylvie Leger Brian O Donovan KPMG s global IFRS leases leadership team KPMG International standards Group2 | Lease modifications 2018 KPMG IFRG Limited, a UK company, limited by guarantee. All rights At a Key factsIFRS A Lease modification is a change in the scope of a Lease , or the consideration for a Lease , that was not part of its original terms and conditions. Common examples are: increasing the scope of the Lease by adding the right to use one or more underlying assets (see Examples 1, 2, 7, 8 and 14); decreasing the scope of the Lease by removing the right to use one or more underlying assets (see Example 3) or shortening the contractual Lease term (see Examples 8, 9, 15 and 17); increasing the scope of the Lease by extending the contractual Lease term (see Examples 4, 7 and 16); and changing the consideration in the Lease by increasing or decreasing the Lease payments (see Examples 1, 2, 3, 5, 6, 7, 14, 15, 16 and 17).

4 Changes that result from renegotiations of the original contract are Lease modifications . Adjusting the Lease payments (cash flows) by contractual rent adjustment mechanisms, and reassessing whether a lessee is reasonably certain to exercise (or not exercise) an option included in the original contract, are not Lease modifications . Lessee modificationsIFRS The new standard distinguishes between Lease modifications that represent, in substance, the creation of a new Lease that is separate from the original Lease and those that represent, in substance, a change in the scope of, or consideration paid for, the existing Lease (see Chapter 3). In a nutshell: separate Lease : account for the new Lease ; make no adjustment to the initial Lease ; and not a separate Lease : remeasure the initial If a lessee applies the recognition exemption for short-term leases, then a Lease modification will be considered a new Lease .

5 Lessor modifications Although the new standard introduces fewer changes for lessors, it does introduce requirements for Lease modifications . There is separate guidance on Lease modifications for finance leases and operating leases (see Chapter 4). Effective date of a Lease modification Lease modifications are accounted for at the effective date of the Lease modification. This is the date when both parties agree to the Lease modification and is usually the date when the modified contract is signed. For modifications that are not accounted for as separate leases, the Lease liability and right-of-use asset are remeasured at this date. Complex application issues arise if the modification is agreed on one date but the change in the right of use or consideration happens on a different date (see Chapter 5). 2018 KPMG IFRG Limited, a UK company, limited by guarantee.

6 All rights Key impacts Identifying all Lease agreements and extracting Lease data. Lessees will now recognise most leases on-balance sheet. This may require a substantial effort to identify all leases with payments that should be included in the Lease liability, and whether subsequent modifications result in accounting for a separate Lease and/or remeasurement of the Lease liability and the right-of-use asset. New estimates and judgements. The new standard introduces new estimates and judgements that affect the measurement of Lease liabilities. A lessee determines the liability at commencement and may be required to revise it when the Lease term is modified. This will require ongoing monitoring and increase financial statement volatility. Balance sheet volatility. The new standard introduces financial statement volatility to assets and liabilities for lessees and lessors, due to the requirements to account for Lease modifications .

7 This may impact a company s ability to accurately predict and forecast results and will require ongoing monitoring (see Chapters 3 and 4). Changes in contract terms and business practices. To minimise the impact of the new standard , some companies may wish to reconsider certain contract terms and business practices changes in the structuring or pricing of a Lease agreement, including the inclusion of options in the contract to avoid subsequent Lease modifications . The new standard is therefore likely to affect departments beyond financial reporting including treasury, tax, legal, procurement, real estate, budgeting, sales, internal audit and IT. New systems and processes. Companies should ensure that they have systems and processes enabling them to identify and measure completely and in a timely manner the commencement of new leases, and the modification, reassessment or impairment-triggering events of existing ones.

8 This becomes even more important when leasing is decentralised and undertaken by non-accountants. Transition considerations. A key early decision is which transition option to adopt. The extent of information required by lessees in 2019 will depend on the transition approach chosen under a modified retrospective approach, if the lessee elects to measure the right-of-use asset at an amount equal to the Lease liability, then no historical information about modifications before the date of initial application is needed. Under the retrospective approach, or if a lessee using the modified retrospective approach elects to recreate the right-of-use asset from the commencement date, modifications will need to be reconstructed. Careful communication with stakeholders. Investors and other stakeholders will want to understand the new standard s impact on the business.

9 Areas of interest may include the effect on financial results, the costs of implementation and any proposed changes to business practices. Sufficient documentation. The judgements, assumptions and estimates applied in determining how to measure the Lease liability at the commencement date, as well as when a modification occurs, will need to be At a glance Key impacts 4 | Lease modifications 2018 KPMG IFRG Limited, a UK company, limited by guarantee. All rights Key concepts Lease modifications come in many shapes and sizes but a few key concepts are central to accounting for all of What is a Lease modification?IFRS , 44 46, 79 80 A Lease modification is a change in the scope of a Lease , or the consideration for a Lease , that was not part of its original terms and conditions. Common Lease modifications include, for example: increasing the scope of the Lease by adding the right to use one or more underlying assets; decreasing the scope of the Lease by removing the right to use one or more underlying assets or shortening the contractual Lease term; increasing the scope of the Lease by extending the contractual Lease term; and changing the consideration in the Lease by increasing or decreasing the Lease payments.

10 Changes that result from renegotiations and changes to the terms of the original contract are Lease modifications are different from reassessmentsIFRS There is a difference between scenarios that result in the remeasurement of existing Lease assets and Lease liabilities due to: reassessment of estimates used in Lease accounting ; and Lease modifications . After the commencement date, Lease reassessments take place, for example, when there are changes in the Lease payments (cash flows) based on contractual clauses included in the original contract. IFRS (c), 39 43, B42 The new standard provides guidance on when a lessee should reassess the Lease liability and right-of-use asset. However, it is silent for lessors. 2018 KPMG IFRG Limited, a UK company, limited by guarantee. All rights 43 Common examples of scenarios that result in reassessments for lessees include changes in the: assessment of the Lease term; assessment of whether a purchase option will be exercised; expected amount payable under a residual value guarantee; future Lease payments from a change in the index or rates used to determine those payments; Lease payments resulting from a change in floating interest rates; or variable Lease payments becoming fixed or in-substance fixed (b), 39 After the commencement date, a lessee remeasures the Lease liability to reflect changes to the Lease payments.