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

As the modification does not grant an additional right of use, Lessee Corp would determine that the modification is not a separate new contract. Since the modified contract meets the definition of a lease, Lessee Corp would account for one new modified lease as of January 1, 20X4. Example LG 5-10 illustrates a lessee’s accounting for modification of an operating lease without a change in lease classification. In that case, the lessor’s use of the cash or accrual method of accounting are ignored. The remainder of this article provides a general discussion of the tax rules applicable to the modification or termination of lease agreements and the write-off of previously capitalized improvements and intangibles.

You measure the lease liability at the commencement date at $250,000 (the present value of five payments of $59,000 plus the present value of the termination option payment of $5,000). That’s because, unlike other modifications where there is no income statement impact, with partial lease termination, there is. Based on the above, Lessee Corp would expense $2.6 million as termination for the warehouse lease and recognize $9.4 million as straight-line rent expense during the remaining eight-year lease term for the office building lease.

A gain/loss calculation is required when there is a reduction in the right of use asset. An office lease agreement gives the lessee, or renter, the right to determine how office space is used for an established period in exchange for compensation to the lessor, or landlord. A lease can be canceled when either party assesses its right to terminate the lease and sees that it can do so without the other party’s permission and by paying a small financial penalty. The lease agreement document will often contain the terms under which either party can initiate a lease termination.

Lease Classification – Finance & Operating Leases

If you are not a public entity, you can elect the IBR to be the risk-free rate in place at the time of the lease commencement. The incremental borrowing rate is the interest rate that a lessee would be required to pay when borrowing over a similar term, and with a similar security, the necessary funds to obtain an asset with a similar value. For example, this could be the rent for the right to use office space. Ii) leases where the underlying asset has a low value when new – this election can be made on a lease-by-lease basis. Here are four transaction scenarios commonly observed in today’s real estate markets and questions organizations should ask about the scenarios’ financial reporting impacts.

Lease modifications generally include increasing or decreasing the remaining lease term or the amount of space leased or modifying the payment structure. A termination of an existing lease combined with a new lease involving the same premises will also be treated as a lease modification. The amortization period for the right-of-use asset is from the lease commencement date to the earlier of the end of the lease term or the end of the useful life of the asset.

Research on transition relief in IFRS 16

Next, Entity A concludes that neither a full nor partial termination has occurred because a reduction in lease term is not considered a reduction in the assets subject to the lease but rather a change in attribute of the lease. Consequently, Entity A treats the amendment as a modification of an existing lease. At lease commencement, Entity A concludes the lease term is five years; that is, Entity A concludes it is reasonably certain it will not exercise the termination option. However, due to unforeseen circumstances, Entity A decides to terminate the lease at the end of the second year. As a result, Entity A pays Entity B the one-time termination fee of $100,000 and pays monthly lease payments of $10,000 for the remaining three months during which time Entity A still has the right to access and use the property. When there is a reduction in the lease term, the lessee remeasures the lease liability based on the future lease payments; the balancing journal entry goes to the right of use asset.

• Cost minus depreciation reserve minus impairment reserve, if any, minus the lease liability to be retired.
• PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network.
• You measure the lease liability at the commencement date at $250,000 (the present value of five payments of $59,000 plus the present value of the termination option payment of $5,000).
• The lease liability should be measured at the present value of payments expected to be made during the lease term .

In the current economic environment, it has become increasingly common for organizations to explore opportunities to reduce or redeploy their real estate footprint . As a result, many organizations are amending or early terminating leases, or they are subleasing portions of their leased properties. If the termination penalty is $6,000, then the increase or decrease in liability is first calculated and then reflected in the accounting entries. 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).

Critical Lease Accounting Terms to Know for ASC 842/IFRS 16 Preparation

The IASB decided that under IFRS 16, a reduction in the lease term does warrant a gain/loss calculation. That is, termination accounting should not be applied, and the lessee should allocate the termination penalty to the remaining lease. If there are multiple components in the remaining lease, the lessee should allocate the termination penalty to these components based on their relative standalone price at the contract modification date. The subsequent accounting will depend on the classification of the remaining lease components. A modification of a lease may result in a partial termination of the lease. Examples of events that result in a partial termination include terminating the right to use one or more underlying assets and decreasing the leased space.

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. This occurs when, for whatever reason, the lessee abruptly terminates the lease. In doing so, the lessee no longer has access to the right of use asset and no future lease payments. Depending on the facts and circumstances of the lease agreement, the lessee may be required to make a termination payment.

Leases should be recognized and measured using the facts and circumstances that exist at the beginning of the period of implementation . However, lessors should not restate the assets underlying their existing sales-type or direct financing leases. Any residual assets for those leases become the carrying values of the underlying assets.

They also have a great affiliate network of an abundance of valuable resources for your business. The depreciation reserve balance is calculated using the default retirement convention of the asset category. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.

Contracts with Multiple Components and Contract Combinations

A GRV requires the lessee to guarantee the value of the underlying asset when it is returned to the lessor. When lessees provide such guarantees, they should include the amount they expect to pay under the guarantee in the lease payment. When that happens, the lessee uses an unchanged discount rate to remeasure the lease liability. A lessee should recognize a lease liability and a lease asset at the commencement of the lease term, unless the lease is a short-term lease or it transfers ownership of the underlying asset. The lease liability should be measured at the present value of payments expected to be made during the lease term . The lease asset should be measured at the amount of the initial measurement of the lease liability, plus any payments made to the lessor at or before the commencement of the lease term and certain direct costs.

If a right-of-use asset is determined to be impaired, the impairment is immediately recorded, thereby reducing the carrying amount of the asset. Its subsequent measurement is calculated as the carrying amount immediately after the impairment transaction, minus any subsequent accumulated amortization. The lease liability is increased by the interest incurred in the period, and the carrying amount is reduced by the lease payment. The lease transfers ownership of the underlying asset to the lessee by the end of the term outlined in the lease.

The policy should be applied consistently to all modifications that decrease the scope of a lease. Because the write-off of improvements is not the result of a sale, disposition, exchange or involuntary conversion, the loss should be reported as an ordinary loss, not a loss from the sale of business property. This treatment is favorable for taxpayers that have net gains from the sale of business property in the same tax year as the write-off. If an amount received from a tenant is instead to release the tenant from a requirement in the lease that the premises be restored on termination of the lease, that payment may qualify as capital gain rather than ordinary income. This cost will include the interest charge and right of use amortization into a single expense recognized on a straight-line basis.

A full fte meaning 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 right-of-use asset is a lessee’s right to use an asset over the life of a lease. The asset is calculated as the initial amount of the lease liability, plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives received.

These materials were downloaded from PwC’s Viewpoint (viewpoint.pwc.com) under license.

However, if the same conditions apply and the renewal period occurs inside the lease term, the penalty fee should be excluded from the recognized lease payments. Under ASC 842 a lease that ends due to the lessee purchasing the underlying asset from the lessor does not constitute a lease termination. 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. 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.

The gross amounts of each portion of the transaction should be disclosed. Once entered, they are only hyphenated at the specified hyphenation points. Hearst Newspapers participates in various affiliate marketing programs, which means we may get paid commissions on editorially chosen products purchased through our links to retailer sites. The support and “build each other up together” examples in action are so very much appreciated in this challenging industry. The Broker List is a great resource to any person in the Commercial Real Estate industry, whether in management, marketing or sales. As a member of their site, you will immediately find lots of helpful tools at your fingertips and helpful staff to assist you with any questions that you may have.

Any difference between the right of use asset and lease liability value should be recorded in the income statement as a gain or loss. On January 1, 20X2, Lessee Corp and Lessor Corp amend the original lease contract to decrease the leased space from 100,000 square feet to 50,000 square feet, effective immediately. Commensurate with the reduction in leased space, the annual lease payment will be reduced from $100,000 a year to $50,000 a year. Lessee Corp is also required to pay Lessor Corp a one-time termination penalty of $30,000 along with its next lease payment.

For instance, property taxes on the lease would qualify as a noncomponent. Ii) the right-of-use asset relates to a class of PPE to which the lessee applies IAS 16’s revaluation model, in which case all right-of-use assets relating to that class of PPE can be revalued. IFRS 16 was issued in January 2016 and applies to annual reporting periods beginning on or after 1 January 2019. I receive leads from all over the country and theBrokerList is my go to source to find brokers that can assist with my out of state needs. She guided me through the process step by step, helped me structure my blog posts, suggested structuring techniques and showed me all the ins and outs to get the maximum exposure for my blog. The proof…I received numerous compliments and then received many followers and likes.

• At the start of year two, Curve renegotiates the contract to lease only two of the factories.
• If a lessee changes its assessment of how certain it is not to terminate the lease early, it should remeasure the lease liability and discount the new lease payments with the appropriate rate .
• When a lease modification occurs, the lease classification should be reevaluated and the lease remeasured.
• If the rate implicit in the lease is not readily determinable, a lessee should use its internal incremental borrowing rate.

The objective of this Statement is to better meet the information needs of financial statement users by improving accounting and financial reporting for leases by governments. It establishes a single model for lease accounting based on the foundational principle that leases are financings of the right to use an underlying asset. An amendment to a lease contract should be considered a lease modification, unless the lessee’s right to use the underlying asset decreases, in which case it would be a partial or full lease termination. A lease termination should be accounted for by reducing the carrying values of the lease liability and lease asset by a lessee, or the lease receivable and deferred inflows of resources by the lessor, with any difference being recognized as a gain or loss.

An event specified in the lease contract that requires an extension or termination of the lease takes place. Prepaid Lease Payments – Lease payments made to the lessor before or at the commencement of the lease. If the rate implicit in the lease is not readily determinable, a lessee should use its internal incremental borrowing rate. I’ve been there, both with the lease terms and trying to make sense of a new language. The first time I attended a technical session, I heard about parsing the JSON so you could write a script to call out the https of something. It was like a time in college when I went to a hypnosis show and people in the audience were hypnotized into speaking gibberish.

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. The subsequent accounting for the remaining lease components will depend on their classification. On the commencement date, a lessee should determine how certain they are to exercise an option to purchase the underlying asset. The lessee should include the exercise price of the purchase option in the lease payments if they are reasonably certain they will utilize the purchase option. However, if a lessee changes its assessment of how certain it is to exercise the purchase option, it should remeasure the lease liability and discount the new lease payments with the appropriate rate .