How to Account for a Lease Termination including Partial Lease Terminations under ASC 842
Lucas Russell 2021-07-28
Like many aspects of lease accounting on face value, the accounting appears straightforward. When a lease has been terminated in its entirety, the lessee should no longer recognize a right of use asset and a lease liability.
However, the devil is in the details. For example, what happens if the lessee still uses the leased asset for some months before the termination? Or is the lessee partially terminating the lease?
There are several scenarios that we’ll cover in this article to illustrate how to account for lease terminations and partial lease terminations under ASC 842.
Lease termination in its entirety
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.
The accounting for this scenario is relatively simple. The lessee derecognizes the right of use asset and a lease liability. Any difference between the right of use asset and lease liability value should be recorded in the income statement as a gain or loss. Without the gain/loss calculation, the journals would not balance.
If a termination penalty is incurred, that amount should be expensed to the income statement and included in the gain or loss on termination.
But what about if the termination is not immediate? Then it would follow the principles of modification accounting. The lessee would update the lease liability and right of use asset based of the future cash flows at a point in time.
Example 1 - lease termination
Wigwam LLC had entered into a ten-year lease agreement with Chopin Ltd to lease a specific machine to help with the manufacturing of guitars. 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. As stipulated in the lease contract, a lease termination incurs a $500,000 termination fee and, in doing so, will remove the obligation of future lease payments and have the ability to return the leased machinery.
At the beginning of year 3, the lease liability was valued at $2,457,000 and the right of use asset $2,500,053.
What are the journal entries required to terminate the lease?
Dr Lease liability $2,457,000
Cr Right of use asset $2,500,053
Dr (gain)/oss $43,053
Dr termination expense (loss) $500,000
Cr cash $500,000
Another way of present the journal entries is:
Dr Lease liability $2,457,000
Cr Right of use asset $2,500,053
Cr Cash $500,000
Dr (gain)/loss $543,053
Partial termination
A partial termination is when the lessee reduces its access to the right of use asset. For example, a lessee leases 3 floors in an office building and vacates one of the leased floors. Correspondingly it’s likely the lessee will have a reduction in lease payments. A gain/loss calculation is required when there is a reduction in the right of use asset.
What about a modification that reduces the lease term? Is that a partial termination? The answer to that is no. 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. No gain/loss calculation is required. If this treatment sounds slightly inconsistent, it is. The IASB decided that under IFRS 16, a reduction in the lease term does warrant a gain/loss calculation.
Partial terminations are one of the most complex areas of the lease accounting standard.
That’s because, unlike other modifications where there is no income statement impact, with partial lease termination, there is.
The accounting for this scenario is detailed in the lease accounting standard ASC 842 at 842-10-25-13:
Any difference between the reduction in the lease liability and the proportionate reduction in the right-of-use asset shall be recognized as a gain or a loss at the effective date of the modification.
So there are two ways available when calculating the partial termination of the lease:
- Remeasuring the Right-of-Use Asset Based on Change in Lease Liability
- Remeasuring the Right-of-Use Asset Based on the Remaining Right of Use
Like with any modification, the lessee is required to update the discount rate at the date effective. For further details on modification accounting, refer here.
Remeasuring the Right-of-Use Asset Based on Change in Lease Liability
When this method is adopted, the gain/loss calculation is based on the reduction percentage of the lease liability. This percentage is then applied to the lease liability and right of use asset. To do this, it is necessary to calculate the:
(a) the pre-modification liability before modification and
(b) the post-modification lease liability
This is calculated as a percentage (a-b)/a. This percentage is then applied to the pre-modification right of use asset. Finally, the difference between the post-modification lease liability and the right of use asset post-modification is taken to the income statement.
Here’s an example to help illustrate the accounting:
Example 2 - Partial termination based on change in lease liability
Curve Ltd enters into a lease agreement with Bowie Enterprises. The agreement is for three factories located in Los Angeles. Curve deems the arrangement is accounted for as one finance lease. The lease commences on January 1, 2020, for a 5-year term, with Curve paying in advance $10,000 per annum. The incremental borrowing rate at the time of commencement is 5%.
At the start of year two, Curve renegotiates the contract to lease only two of the factories. The lease payments are reduced to $7,000 per month. The incremental borrowing rate is 7% on the date of the modification.
What are the initial recognition entries for the lease liability and ROU asset at January 1, 2020?
| Date | Account | Debit | Credit |
|---|---|---|---|
| 1/1/2020 | ROU asset | $45,454.77 | |
| Lease liability | $45,454.77 |
The above is the XNPV of 5 payments of $10,000 over 5 years using a 5% discount rate
What are the entries for the partial termination at Janaury 1 2021?
| Date | Account | Debit | Credit |
|---|---|---|---|
| 1/1/2021 | Lease liability | $11,862.27 | |
| ROU asset | $11,580.75 | ||
| Gain/loss | $281.51 balancing entry |
Workings:
Step 1 - Calculate the lease liability before modification
Minimum future lease payments before modification
| Year 2 - January 1 2021 | Year 3 - January 1 2022 | Year 4 - January 1 2023 | Year 5 - January 1 2024 |
|---|---|---|---|
| $10,000 | $10,000 | $10,000 | $10,000 |
Discount rate: 5%
Net present value (XNPV): $37,232.48
Step 2 - calculate the lease liability post-modification
Minimum future lease payments after modification
| Year 2 - January 1 2021 | Year 3 - January 1 2022 | Year 4 - January 1 2023 | Year 5 - January 1 2024 |
|---|---|---|---|
| $7,000 | $7,000 | $7,000 | $7,000 |
Discount rate: 7%
Net present value (XNPV): $25,370.21
Step 3 - Calculate the percentage decrease of the lease liability pre and post-modification
| Lease liability pre-modification | $37,232.48 | x |
|---|---|---|
| Lease liability post modification | 25,370.21 | y |
| Movement | 11,682.27 | z(x-y) |
| % Movement | 31.86% | z/x |
Step 4 - Apply the percentage change to the ROU asset
| Total amortization days at Initial recognition | 1827 | y |
|---|---|---|
| ROU Asset value at Initial recognition | $45,454.77 | x |
| Daily amortization rate | $24.88 | y/x |
| 366 x $24.88 Amortization per annum (January 2021 less January 2020) |
$11,580.75 | z |
| ROU Asset | $36,383.88 | x - z |
ROU Asset post percentage application
| ROU value pre-modification | 36,348.88 | x |
|---|---|---|
| Apply lease liability decrease percentage | 31.86% | y |
| ROU Asset decrease | $11,572.83 | z(x*y) |
| ROU post modification value | $24,751.18 | x-z |
Step 5 - Calculate gain/loss journals
| Account | $ |
|---|---|
| Lease liability | $11,682.27 |
| ROU Asset | $11,572.83 |
| Gain/loss | 289.44 |
Remeasuring the Right-of-Use Asset Based on the Remaining Right of Use
Under this method, the percentage calculation is based on the right of use asset. The calculation follows two steps:
- Calculate the percentage decrease of the right of use asset and apply it to the right of use asset and lease liability: The lessee determines the proportionate decrease in the carrying amount of the right-of-use asset based on the remaining right-of-use asset. For example, the lessee reduces its leased footage of a factory from 10,000 square feet to 5,000 square. That would result in a 50 percent reduction compared to the original right-of-use asset.
- Remeasure the lease liability and right of use asset based on the modified lease payments.
To help illustrate how to the accounting under this method, see the following example:
Example 3 - Partial termination based on decrease in asset size
Aphex Enterprises enters into a lease agreement with JAAR Ltd to rent 3 floors of commercial office space. The agreement commenced on 1 July 2019, with Aphex transitioning to ASC 842 on 1 January 2019. The length of the agreement is 5 years with $12,000 paid each year at the start of each month, the incremental borrowing rate for Aphex is 4%
At the start of year 2 (1/7/2020) Aphex has to make three-quarters of their staff redundant, as a company and only requires 1 floor for the remainder of the term, the lessor JAAR Ltd agrees to a reduction in floor space with fixed payments being $375 per year. The incremental borrowing rate at the time is 5%.
What are the initial recognition entries for the lease liability and ROU Asset?
| Date | Account | Debit | Credit |
|---|---|---|---|
| 1/7/2019 | ROU Asset | $55,554,06 | |
| Lease liability | $55,554,06 |
What are the journal entries for the partial termination - asset size at 1/7/2020?
| Date | Account | Debit | Credit |
|---|---|---|---|
| 1/7/2020 | Lease liability | $30,351.73 | |
| ROU Asset | $29,764.75 | ||
| Gain/loss | $586.98 balancing entry |
| Date | Account | Debit | Credit |
|---|---|---|---|
| 1/7/2020 | Lease liability | $13,553.14 | |
| ROU Asset | $13,553.14 |
Workings:
Step 1 - Calculate ROU before modification
| Total days amortization days at Initial recognition | 1827 | y |
|---|---|---|
| ROU Asset value at Initial recognition | $55,554.06 | x |
| Daily amortization rate | $30.41 | y / x |
| 366 x $30.41 Amortization per annum (1 July 2020 less 1 July 2019) |
$11.129.06 | z |
| ROU Asset | $44,425.01 | x - z |
Step 2 - apply the ROU asset % reduction
| ROU Asset | $44,425.01 | p |
|---|---|---|
| Asset reduction | 33% | 3 floors / 1 floor |
| Apply % reduction | $14,660.25 | p x 33% |
| Journal | $29,764.75 | $44,425.01 - $14,660.25 |
Asset has reduced from 3 floors to 1 floor resulting in a 33% decrease.
Step 3 - calculate the lease liability pre-modification and apply ROU % adjustment
| Year 2 - 1 July 2020 | Year 3 - 1 July 2021 | Year 4 - 1 July 2022 | Year 5 - 1 July 2023 |
|---|---|---|---|
| $12,000 | $12,000 | $12,000 | $12,000 |
Discount rate: 4%
| Lease liability before modification | $44,301.09 | p |
|---|---|---|
| Asset reduction | 33% | 3 floors / 1 floor |
| Apply % reduction | $14,949.36 | p x 33% |
| Journal | $30,351.73 | $44,301.09 - $14,949.36 |
Step 4 - calculate gain/loss
Lease liability reduction a Dr of $30,551 whilst the ROU asset Cr is $29,764, as a result, the balancing entry will be a Cr of $586.98
Step 5 - lease liability true-up
| Year 2 - 1 July 2020 | Year 3 - 1 July 2021 | Year 4 - 1 July 2022 | Year 5 - 1 July 2023 |
|---|---|---|---|
| $375 | $375 | $375 | $375 |
Discount rate: 5%
| Lease liability after modification | $1,396.22 | NPV using updated discount rate and future payments |
|---|---|---|
| Lease liability value after ROU % | $14,949.36 | ROU Carrying amount post asset % decrease |
| Journal | $13,553.14 | ($14,949.36 - $1,396) |
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.
Conclusion
The accounting for terminations and partial terminations is the most complex area when calculating the values of the lease liability and right of use asset. The devil is certainly in the detail. An alternative to these manual calculations using Cradle’s lease accounting software. Simply add a modification and these calculations will be automatically taken care of.
If you would like further information on the fundamentals of lease accounting I’d recommend the following articles: