In our last blog, we explained how to account for leases where the tenant must take additional property (or expand) in the future. Today’s blog addresses accounting for leases which include a termination at will option. It was inspired by the following question we received:
We have a lease with a landlord with escalated lease payments. However, the lease also comes with a termination right, which states “Tenant shall have the one-time right to terminate the lease at certain date”. Since there is no termination penalty and we have not installed any leasehold improvements, we assume we will terminate the lease at will. Since between the commencement date and termination date, there is no rent escalation, no straight-line schedule was prepared. Now the deadline to submit the termination notice has passed and we decided not to terminate. Does that mean we should start to prepare the straight-line schedule? Since the commencement date has been long passed, I am guessing we would have to true up the straight-line receivable to what it should be as of today assuming there is no termination right at all. Could you shed some light on this situation? Please let me know if I didn’t make it clear for you to understand. Thanks a whole bunch!
This is an excellent question, and as is always the case with excellent questions, there are significant accounting implications here. To address this, we will discuss the underlying accounting first, then, as we always do with our blogs, we will follow up with a comprehensive example.
Before we get into this, we would like to remind our readers that you can always send your lease accounting questions to us at email@example.com. (Click here for a blog we wrote in response to a question we received about how to account for a lease when early access is granted to part of a building at first, then the rest later).
At LeaseQuery, we do not just provide lease management software, we provide lease management AND accounting software. Trust us, there’s a difference. (Click here for a demo of our lease accounting software).
Now that we’ve addressed those housekeeping issues, let’s delve into today’s topic: accounting for leases which include a termination at will option.
Assume a tenant enters into a 10-year lease starting 1/1/2016 with monthly payments of 10,000 with annual escalations of 3%. The agreement states that the tenant may terminate the lease without penalty on December 31, 2019, but has to give at least 3 months’ notice prior to that date. If the tenant fails to give said notice, the lease will terminate on 12/31/2025. How do we account for this lease? Assume there are no improvements made to the asset and this is an operating lease.
Under GAAP, operating leases should be amortized over the fixed noncancelable lease term. (Click here to read our blog explaining when to amortize a lease).
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.
In the example, the noncancelable lease term is 48 months, and the total payments over that term is 502,035; this gives us monthly expense of 10,459. The amortization schedule for that lease is as follows:
Per the lease agreement, the tenant has to give the landlord notice of its intent to terminate the lease by 9/30/2019. If the tenant gives the notice, then the amortization schedule runs its course and the lease terminates on 12/31/2019. If, on the other hand, the tenant does NOT give notice to the landlord, then the lease technically renews, with a date starting on 10/1/2019 and ending on 12/31/2025.
Note that the “renewal” starts on 10/1/2019 because that is the date the option lapsed. The new lease is therefore a 75-month lease. The amortization schedule for the new lease would be as follows:
The annual expense is calculated as follows: Total Payments from 10/1/2019 is $906,412. This amount is divided by the new lease term of 75 months, giving you monthly expense of $12,086. This expense needs to be adjusted by the cumulative balance in deferred rent as of 9/30/2019 of $1,405, which when divided by the new lease term gives you an adjustment of $19. Total monthly expense for the new lease is therefore $12,067.
At this point we would like to explain that LeaseQuery handles this scenario effortlessly, as indicated in the screenshot below:
Note that the image above is a screenshot from LeaseQuery, our lease accounting software. The red line denotes the effective date of the renewal and shows that it happened in October 2019. Notice that the lease expense for the months prior to the “renewal” in September 2019 is $10,459, while expense for the month of October going forward is $12,067.
Also notice that LeaseQuery automatically calculates the new rent expense adjusted for the prior deferred rent of $1,405, and gives you the balances of both the short term and long term deferred rent. (To get a free trial of our Lease Management Software, click here).
Finally, note that if this lease had a tenant improvement allowance, the allowance would initially have been amortized over 48 months, then the unamortized balance would have been amortized over 75 months starting on October 1, 2019. (Click here and here to read our blogs explaining accounting for Tenant Improvement allowances and accounting for Tenant Improvement allowances when a lease is renewed).
There you have it, a detailed blog explaining how to account for leases when the tenant has an option to terminate the lease at will.
Once again, we would like to stress that if you have any questions about lease accounting, you can either leave a comment below at the end of this post, or drop us a note at firstname.lastname@example.org.
We write detailed blogs like this to demonstrate that our experts at LeaseQuery are not just real estate professionals, but also lease accounting experts. Trust us, there’s a difference.
Our clients have unlimited access to our accounting professionals, and we consult with them on complex lease accounting issues. We understand the challenges faced not just by real estate and equipment leasing professionals, but also the accounting departments supporting both groups. Our lease management software reflects our expertise.
If you liked this post, consider reading the following:
How To Transition From Current to the New Lease Accounting Rules: A Comprehensive Example.
To get a free trial of our Lease Management Software, click here.
About LeaseQuery: LeaseQuery is lease management software that helps companies manage their leases. Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc.), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A. Contact us here.