The guidance indicates a company would consider the likelihood of exercising any termination or cancellation clauses at lease commencement, when determining the initial lease term and recording the initial valuation of the lease assets and liabilities. However, subsequent to this determination, there may be circumstances that change the initial determination of whether these options would be exercised, and if so, when.
If the early termination options require prior notice or if a decision to terminate has been agreed upon, this will generally require recalculation of the related lease asset and liability prior to the actual termination date (i.e. the accounting for the termination occurs when the decision is made, versus when the termination event occurs). However, for the purposes of this article the termination and the accounting recognition of the termination occur at the same time.
Full lease termination options broken down by lessee and lessor
The approaches discussed below are applicable for accounting for a full lease termination under ASC 842, IFRS 16, and GASB 87. From the perspective of a lessee, the accounting for the early termination of an operating lease is consistent with that of a finance lease.
Lessee
A full termination will result in the lessee relinquishing the right to use the entire leased asset. This requires the lessee to derecognize the full right-of-use asset and lease liability. Any difference between the balances of the lease asset and liability as of the date of termination will result in a gain or loss recognized on the income statement in the period of termination.
The lessor often stipulates within the agreement that the lessee must pay a penalty upon execution of the termination. If a lease termination penalty is applicable and not previously included in the calculation of lease payments, the lessee will factor such penalty into the gain or loss calculation.
Lessor
From the lessor perspective, a full lease termination also requires lessors to fully derecognize any associated lease assets (i.e. lease receivable) or lease liabilities (i.e. rent receivable, deferred inflow of resources, unamortized initial direct costs, etc.). Any variance between the related assets and liabilities would constitute a gain or loss on the income statement in the period of termination.
In addition to the termination of the leased asset, the arrangement could change such that the usage of the leased asset is reduced. This is accounted for as a partial lease termination. We will address the accounting for a partial termination, and the differences between the treatment within the respective standards, below.
Partial termination options broken down by standard
A partial lease termination occurs when the lessee’s right-of-use asset decreases in utilization (i.e. an organization leases five floors within an office building, then vacates one floor). Most often, lease payment amounts will decrease based on the partial reduction in utility incurred by the lessee. Thus, a partial termination will involve a reduction of the lease liability. We have outlined specific calculations for each standard below:
US GAAP
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.
After calculating the modified lease liability, the lessee should adjust the right-of-use asset value by a proportionate amount. For example, if the lease liability decreases by 5% based on the new payment terms, the lessee would calculate a 5% reduction in the right-of-use asset value. Any variance between the adjustment to the asset and the liability should be recorded in current period gain or loss.
IFRS
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. LeaseGuru powered by LeaseQuery can provide these calculations needed for IFRS 16 compliance. Try it for free by adding two leases.
GASB
GASB 87 requires lessees to remeasure the lease liability and lease asset based on the adjusted payment terms. The lessee will calculate the adjustment to the lease liability and recognize an adjustment of the same amount to the lease asset, with any difference reflected in gain or loss for the current period. For example, if the lease liability decreases by $100 based on the new payment terms, the lessee must decrease the right-of-use asset value by $100. Lessors reporting under GASB 87 will remeasure the deferred inflow of resources, as well as the lease receivable, in the same manner.
Full termination due to purchase
A lease can additionally cease if the lessee purchases the underlying asset from the lessor. As of the purchase date, the lessee would follow the guidance within the respective standard to establish a fixed asset on the balance sheet and remove the intangible right-of-use asset. We have identified the accounting requirements related to purchases as follows:
US GAAP
Under ASC 842 a lease that ends due to the lessee purchasing the underlying asset from the lessor does not constitute a lease termination. Instead, the lease is accounted for as a purchase. The lessee records the new fixed asset value as the carrying value of the leased asset plus or minus an adjustment equal to the difference between the purchase price and the lease liability balance at the time of purchase.
IFRS
Under IFRS, the exercise of an unplanned purchase option requires a reassessment of our lease liability and corresponding lease asset. Any variances to the asset and liability balances will be recorded as gain or loss.
GASB
Under GASB 87, as of the purchase date, the lessee would reclassify the intangible right-of-use asset to a fixed asset.
Because there are various options to terminate a lease, it’s important to understand the accounting treatment of an early termination under the respective new standard. While the information above helps outline what you need to know about lease termination options, implementing a lease accounting solution that handles termination scenarios will allow your company to account for these situations effortlessly and accurately.
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Do you have to disclose cash paid for termination penalties in the cash flow statement?
Thanks for the question Ernesta!
Yes, under ASC 842 a lessee is required to disclose the operating cash flows for all finance and operating leases, as well as the financing cash flows for finance leases. This should include all cash flow and supplemental non-cash information related to lease liabilities. Since both full and partial terminations require reduction of all or part of the lease liability, a cash flow statement disclosure will also be required in each case. For more disclosure information, refer to our blog where we discuss ASC842 disclosure requirements.
If your termination penalty gets added into your gain/loss calculation, what’s the other side of the journal entry? You’d have this without the termination penalty:
cr: Asset 100
dr. accumulated amortization 25
dr: liability ST 72
dr: liability LT 0
cr: gain/loss 3
with the termination penalty:
cr: gain/loss 10
what’s the dr:?
Hi Kristin –
Without knowing more details of the specific agreement and transaction, I am wondering why cash is mmissing from the journal entry. Typically a termination penalty is a cash payment due at termination. If the decision for termination was made in advance of the termination itself, then the lease liability and ROU asset will need to be recalculated.
Thanks for reaching out!
We purchased equipment at FMV at the end of the lease. To clarify, the equipment will be recorded as a fixed asset and will need to be depreciated?
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 $0.
What if there are indication of impairment as of December 2020. On February 2021 the contract was terminated (Based on contract, lease period is until 2023). Do we need to impair the RoU as of December 2020 based on the fact on February 2021 ?
To determine the recoverable amount we calculate the value in use as of December 2020, how far the VIU should be calculate ? until end of lease term (2023) or termination of contract in February 2021?
Hi Sabrina,
Thank you for your question. If there were indications of impairment in December of 2020, then an impairment test at that time would be appropriate to assess the impairment value. The termination itself would be a separate action and processed on the date exercised (i.e. February 2021). The two events would be independent of one another as they are evaluated at their respective points in time. Let us know if we can clarify further.
We have a scenario-where the lease is surrendered in June’21(lease running from Jan’20-Jun’25 and surrendering the same in Jun’21) but termination penalty is paid from July’21 upto June’22 on a monthly basis of 1,000$. In this scenario-would my lease term be upto Jun’21? If that is the case, how do I factor my lease termination penalty payments-Would the entire amount(1000*12=12,000$) be included in the last month payments? Or is the lease term upto Jun’22 factoring the lease termination payments upto June’22 and I would have to write off the RoU equally from the effective date of modification upto July’21 being the surrender date? Would this be a hybrid accounting of Abandonment+Termination?
Hi B.Mahadev,
Thank you for your question. As the termination of the asset takes place in June 2021, that should be the end date for the lease. On the termination date (June 2021) you should recognize in full the obligation associated with the termination as a payable amount. This would be full recognition of the $12,000 termination fee set to be paid over a year after termination. The $12,000 obligation will impact the determination of whether a gain/loss is recognized in the termination journal entry. Rather than recognize cash on that date, you would credit Accounts Payable for what is owed and reduce that account each month when cash is paid.
Hello Kiley. Thanks for the very insightful synopsis
What happens when a partial termination (say 1 floor out of 5 floor after 6 years in a 10 year lease) is considered probable at the lease commencement date. In this case how to measure lease obligations and how to depreciate the ROU (assume no other costs). Short point here is the scope of lease (total area under lessee’s control) will reduce after 6 years. Therefore it does not seem ‘economically’ appropriate if the entity were to depreciate the ROU evenly over the 10 year lease term
If a lessee is or becomes “reasonably certain” they will exercise a termination option, the lease term ceases as of the termination date. Then the lease liability would be measured based on the shortened lease term, which the ROU asset and subsequent accounting are based on.
However, additonal informaton from the contract should be considered before making the final accounting determination, including:
Do both the lessee and lessor have the right to terminate the lease?
Do any contingencies exist for the lessee to have an option to terminate?
Does the lessee incur a penalty if terminating early?
Is there a required notice period to terminat?
Lastly, based on the judgement calls and analysis necessary to determine the accounting treatment of this scenario, it may be a good idea to consult with your auditors before making a final conclusion.
The management decided and abandoned the building space in December 2020, but the lease will not officially terminate until the end of October 2021. The lease agreement will stay intact, and we will continue to make the lease payments until October 2021. As of now, we have vacated the space and forfeited our access to it. How do we account for it?
Hi – Thank you for your question.
If the leased asset is determined to be abandoned in December 2020 (i.e the decision date,) but lease payments are still being paid, the amortization of the ROU Asset needs to be adjusted as of the decision date. This adjustment needs to reflect that, as of the cease use date (i.e. Oct 2021,) the ROU Asset carrying balance will be $0. This will align with $0 remaining lease payments as of the cease use date.
This blog provides further information and a detailed example regarding lease abandonment accounting: https://leasequery.com/blog/lease-abandonment-accounting/
Please let us know of any additional questions/ concerns.
What if the decision to terminate a lease in made in December, but the lease won’t officially terminate until the end of March. The lessor requires payment of all remaining lease payments as the penalty (over a year of payments) to terminate. Is that all recognized in December or spread out December – March? Or is it all recognized in December and no expense January thru March even though you are still occupying the space?
Hi Michelle,
Great question! The decision to terminate is the triggering event. When the decision to terminate is made in December, the lease liability and ROU asset are modified to reflect the new terms of the agreement, specifically the reduced term and any remaining payments and penalties due would need to be factored into the adjusted lease liability and ROU asset. The lessee should consider the penalty when determining whether to recognize a gain/loss at the end of the new lease term. At the end of the lease term, the balance of any remaining lease liability and ROU asset would both be written off and any different is recorded to gain or loss in the income statement.