Lease termination is when a lessee or lesser decide to break the lease agreement before the agreement is over. There can be several reasons for terminating the lease. For example, the tenant might terminate it because of the conditions of the rental property, safety concerns, privacy violation, and additional charges. The landlord might also desire to terminate the lease because the payments are not made or there are structural damages, illegal activities, or noise nuisance.
The lease agreement usually provides for notice requirements in case of termination, any penalties that might need to be paid, or an option to change the agreement terms. In any case, both will need to make records of this termination in their accounting books and we will guide you through the process.
What Lessee Should Know
If the entity leasing the asset decides to fully terminate the lease agreement, the business would need to derecognize the full lessee’s right to hold, operate, or occupy a leased item and a liability associated with the lease. To determine how this discontinuation will be reflected on its Income Statement, the business will gage the difference between asset account balance and liability account balance associated with this lease. The result might be positive or negative, which will translate into a loss or gain for the business. It should be noted that the lessor might request the entity to pay a penalty as specified in the agreement. This penalty would need to be accounted for when calculating the loss or gain.
The lease discontinuation might also occur due to the fact that the lessee is able to buy the leased asset. The way this termination would be recorded in the business books will depend on what accounting standards it follows. For example, under the IFRS, the business will record the termination of the lease will be recorded as a gain or loss. This will be determined based on the reassessment of the lease liability account and the lease asset.
If the company adheres to the GAAP and buys the leased asset, it is not considered a termination. Thus, the business would record it as a purchase of a new asset. The value of this asset will be calculated by adding the difference between the remaining lease liability and the purchase price when the asset is bought to the leased asset carrying value. With GASB, one would just recognize the intangible lessee’s right to hold, operate, or occupy a leased item as a tangible asset.
What Lessor Should Know
The termination process for lessor is very similar to that of a lessee. If the lease is fully terminated, the lessor would completely derecognize any lease assets, such as the associated amount in Lease Receivable account, and/or lease liabilities, such as unamortized initial direct costs and rent receivable. Just like lessee, to determine how this termination will be reflected on the lessor’s Income Statement, it will calculate the difference between Lease Asset account balance and the Liability account balance on the date of the lease termination. The lease can also be terminated partially. We will discuss this next.
Partial Lease Termination
There is also an option to terminate the lease only partially. The way one would record this type of termination will depend on the accounting standards the company adheres to. Let’s review the most common ones.
- According to the International Financial Reporting Standards, the liability and asset value should be changed to accurately represent the partial lease discontinuation. Any difference will be recorded in the Income Statement for the period as gain or loss.
- If the Generally Accepted Accounting Principles are used as a guide, then one of the methods to reflect the change would be to make a proportionate adjustment in the right-of-use asset value based on the reduction in the liability. As in any other case, the difference between the two would be noted on the financial statements as gain or loss.
- The Governmental Accounting Standards Board, on the other hand, requires to measure both the liability and the asset again according to the new payment terms and apply the liability adjustment amount to the asset to show the change. Any variations will be considered a loss or gain.
As you can see, there are many nuances around the discontinuation of lease. The details might vary based on the specifics of lease terms, accounting standards and requirements, as well as other factors. If you do not have previous experience with this, we recommend turning to a knowledgeable accountant for assistance and guidance.
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Author: Charles Lutwidge