Lease modifications & other reductions: Accounting impacts

Accounting guidance for this situation can be found at ASC Section 420Exit or Disposal Cost Obligations. It should be noted that this guidance applies only to operating leases, not to capital leases. Also, this article does not address accounting issues for any leasehold improvements that may be abandoned in connection with the lease termination. IFRS 16 requires the calculation of a modified lease liability, and an adjustment to the asset value to reflect the partial termination with any variance recorded to gain or loss in the current period.

Upon the termination of a lease, the lessor can write off any lease acquisition costs that remain unamortized for tax purposes. The write-off of leasehold improvements on the lessor’s books, however, is not so straightforward. The lease may not specify the end date, instead it may include a term the lease will cover from a specified start date. Many times, leases will include additional optional lease terms, subsequent to the initial term. The lessee or lessor elects not to exercise an option even though it was previously determined that it was reasonably certain that the lessee or lessor would exercise that option.

A decrease in lease term is not considered a partial termination event. A partial termination should be recorded by adjusting the lease liability and right-of-use asset. The right-of-use asset should be decreased on a basis proportionate to the partial termination of the existing lease.

The GAAP Rules of Leasehold Improvement Depreciation

A lessee should use the rate implicit in the lease in instances where that rate is readily determinable. Periods covered by an option of lease extension in which the option to exercise is controlled by the lessor. Periods covered by an option of lease extension if the lessee is reasonably certain to exercise that ability. Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited (“DTTL”), its global network of member firms and their related entities. DTTL (also referred to as “Deloitte Global”) and each of its member firms are legally separate and independent entities. The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

• A decrease in lease term is not considered a partial termination event.
• The straight-line lease expense is calculated by dividing the undiscounted payments by the lease term.
• Lessee Corp will continue to classify the office building lease as an operating lease after the amendment.
• The subsequent accounting will depend on the classification of each of the lease components.

When you terminate a lease, the Generate Schedules process automatically updates the lease liability to be retired based on your settings. Generally, payments made to terminate a lease as described above will be deductible for tax purpose when paid. Yes, under ASC 842 – and you will also need to include the carrying value of the ROU asset at the end of the lease term if it has not been reduced to $0.

Full termination due to purchase

For more information about Crowe LLP, its subsidiaries, and Crowe Global, please read our Disclosure. At the end of Year 1, the right-of-use asset is $200,000 ($250,000 – $50,000) and the lease liability is $206,825 ($250,000 + $15,825 – $59,000). Cost minus depreciation reserve minus impairment reserve, if any, minus the lease liability to be retired. Based on the above remeasurement there is a debit to the lease liability of $13,553.14 and the balancing entry goes to the ROU asset. At the beginning of year 3, the lease liability was valued at $2,457,000 and the right of use asset $2,500,053.

If the lease includes an option to terminate, a similar analysis should be performed to determine the likelihood such option will be taken, including an analysis of the remaining lease payments compared to any early termination penalty. Similar to with options to extend, if the lessor has the option to terminate, such early termination should not be included. Generally, a government should account for the lease and nonlease components of a lease as separate contracts. If a lease involves multiple underlying assets, lessees and lessors in certain cases should account for each underlying asset as a separate lease contract. If determining a best estimate is not practicable, multiple components in a lease contract should be accounted for as a single lease unit. Question LG 5-7 discusses the income statement recognition by a lessor for a payment made to a lessee to induce the lessee to terminate an operating lease before the end of the lease term when the payment meets the definition of initial direct cost.

After this entry, the post-modification right-of-use asset would be $217,651 and the post-modification lease liability would be $213,651. We’re here to help you navigate the uncertainty of the COVID-19 pandemic and its impact on your business. We have developed a library of resources in our COVID-19 resource center to help you stabilize today and prepare for tomorrow. We have solutions that can help you manage not only your income taxes, but also your people, operations, business finances and technology.

8 Accounting for a lease termination – lessor

Upon exercising a termination option, organizations will need to reassess the remaining useful life, and evaluate potential impairment, of any leasehold improvements. For example, due to the revised lease term resulting from the termination option exercised, the period over which Entity A will receive economic benefits from its leasehold improvements is shortened. Consequently, Entity A must consider if any leasehold improvements that remain in use are impaired and shorten the remaining useful life of any leasehold improvements to the revised lease term of three months. However, when all or part of a leased property is sublet, an entity must consider whether a change in asset groupings has occurred. For example, in the scenario described, Entity A might conclude that the subletting of the single floor results in the ROU asset for that single floor being considered a new asset group.

Periods covered by a lessor’s option to terminate the lease if it is reasonably certain, based on all relevant factors, that the lessor will not exercise that option. The present value of total lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset. The lease liability represents the present value of all outstanding lease payments that are not yet paid.

What is a Right-of-Use Asset?

The remaining lease payments would consist of the upfront termination penalty of $100,000 and the three remaining monthly payments of $10,000. Entity A should update its discount rate considering a remaining lease term of three months and total lease payments of $130,000. Any change in the measurement of the lease liability would be recorded as an adjustment to the ROU asset. Terminating the lease of one asset before the end of the lease term and leasing a similar asset from the same lessor may not always be considered a full termination of the original lease. For example, if a lessee negotiates to terminate a lease of one floor of a building and concurrently negotiates a new lease of a different floor in the same building, this would be accounted for as a modification if the new lease was not priced at market. This is an important distinction to make because the accounting can vary significantly.

Subsequent changes to the term of a lease will require companies to consider whether the change results in a separate contract or a modification to the existing contract. If the change is considered a modification to the existing lease, the lease liability will be remeasured at that time. When a change to the contract results in both of the following, the change is considered a separate and new lease. The original lease would not be impacted by the new and separate lease.

• In the current economic environment, it has become increasingly common for organizations to explore opportunities to reduce or redeploy their real estate footprint .
• Generally, payments made to terminate a lease as described above will be deductible for tax purpose when paid.
• Correspondingly it’s likely the lessee will have a reduction in lease payments.
• However, at the start of year three, Wigwam no longer requires the machine and immediately terminates the lease due to a new way of manufacturing.

Instead, they must be capitalized and then amortized over the remaining term of that lease. Options should be reevaluated throughout the lease term when there is a significant change in circumstances or a significant event that impacts the likelihood of options being exercised. Subleases should be treated as transactions separate from the original lease.

Implementing the New FASB Lease Accounting Standard: Determining the Lease Term

Identifying lease payments to include in lease liabilities is no doubt a complicated process. Only with the right understanding, process and tools, can organizations have a better handle on their lease accounting strategies. A lessee that is a private business is allowed to use a risk-free discount rate for the lease. This rate is determined by using a period comparable with the lease term as an accounting policy election for all leases. Question LG 5-6 discusses the accounting by a lessor for a termination penalty paid by a lessee due to a modification of two leases between them with immediate exit of one property by the lessee at the lease modification date. However, an entity that early terminates a lease also should consider whether its decision to early terminate represents an indicator of impairment for the related ROU asset.

ASC 842 provides two alternatives to recognize the reduction in the asset. The LeaseQuery system utilizes the approach based on the proportionate adjustment to the lease liability, since a lessee would have this information readily available after calculating the modified liability. Like with any modification, the lessee is required to update the discount rate at the date effective. Partial terminations are one of the most complex areas of the lease accounting standard. A lessee should treat its selected method as an accounting policy election by class of underlying asset.

Using the previous facts, Entity A determines that with five years remaining on its office lease, the ROU asset for the single floor being subleased is its own asset group and is impaired. Entity A measures and recognizes an impairment charge of $18,000 at the end of year two. Immediately before the impairment, Entity A’s lease liability and ROU asset (using a discount rate of 5% to initially measure and record the lease at the lease commencement date) are both $35,460. The following calculations illustrate Entity A’s lease cost after the impairment.

Summary – Statement No. 87

The Board strives to determine that its standards address significant user needs and that the costs incurred through the application of its standards, compared with possible alternatives, are justified when compared to the expected overall public benefit. The Board considered the costs of both the individual provisions in this Statement and the Statement as a whole. The Board is cognizant that the costs of implementing the changes required by this Statement may be significant.

This scenario might come into play if the lessor is not interested in negotiating a lease termination and insists that the lessee perform as agreed. In this case, the fair value of the liability at the “cease-use date” should be recorded. This liability will be based on the remaining lease payments, reduced by estimated sublease rentals that could be reasonably obtained for the property-even if the lessee does not intend to enter into a sublease. The assumed sublease payments cannot reduce the remaining lease payments below zero.

This is because the sublet floor now has identifiable cash inflows and outflows for the same term as the remaining period left under the head lease. Entity A also should consider whether any leasehold improvements on the subleased floor should be included in the asset group. A liability for costs to terminate a lease before the end of its term should be recognized when the bank terminates the lease in accordance with the lease terms or has otherwise negotiated a termination. This liability should be measured at its fair value upon the termination of the lease. Calculating the fair value of the liability is essentially an exercise in discounting the cash flow at an appropriate discount rate. As a practical matter, the amount of time between the termination of the lease and any termination payment will be short and the amount of the payment will approximate fair value.

But one common thread for all companies that must comply is the increased complexity and work required to properly bring leases on balance sheets, along with effectively accounting for and reporting for these leases under thenew standards. Generally, a lessor cannot write off the remaining tax basis in any leasehold improvements until they are irrevocably disposed of or abandoned. While a tenant vacating the premises is not sufficient to satisfy this test, the physical removal of the improvements so that new improvements can be constructed for a future tenant is clearly sufficient. To the extent a landlord incurs costs to modify a lease (e.g., legal costs), those costs cannot be immediately expensed for income tax purposes.

Under GAAP, operating leases should be amortized over the fixed noncancelable lease term. If a tenant has the option to terminate at will, and if the tenant has no significant economic incentive to continue to utilize the asset after the terminate date, then the noncancelable lease term would exclude the period after the termination date. If the tenant elects to let the terminate option lapse, then that is essentially a renewal, and a new straight-line amortization schedule would be calculated from that date.

A lessor should recognize interest revenue on the lease receivable and an inflow of resources from the deferred inflows of resources in a systematic and rational manner over the term of the lease. The notes to financial statements should include a description of leasing arrangements and the total amount of inflows of resources recognized from leases. It’s measured by taking the lease liability and adding the initial direct costs and the prepaid lease payments, then subtracting any lease incentives offered . The discount rate for the lease initially used to determine the present value of the lease payments for a lessee is calculated based on information available at the commencement date.

Your company amortizes the right-of-use how to write a receipt over the lease term of five years. You expect your company to consume the asset’s future economic benefits evenly over the five years and you amortize the asset on a straight-line basis. Current liability at the start of the period minus the termination penalty, if any, with the interest due date in the current period.