During a bankruptcy proceeding, a debtor's existing lease agreements will be affirmed, amended, or rejected. Until the Court approves an action, the debtor should continue to accrue its lease payments and recognize the associated expense in accordance with ASC 840, Leases, even if it expects the accrued lease liability to ultimately be compromised. Lease liabilities should continue to be recognized until rejected leases are approved by the Court. Leases affirmed in the bankruptcy process without modification should continue to be accounted for under ASC 840. In most instances, bankruptcy law requires that any unpaid prepetition lease payments for affirmed leases become current and the continuing lease payments remain current throughout the proceedings. Leases that are amended by the lessor during the bankruptcy process should be accounted for under the lease modification guidance in ASC 840.

Finally, leases rejected in the bankruptcy process will usually result in the leased property being returned to the lessors. Unpaid lease payments, including any damages to lessors for terminating the leases (often calculated by formulas used by the Court), usually become allowed claims subject to compromise. The Bankruptcy Code places limits on the maximum amounts of allowed claims for certain types of executory contracts, including leases. Following the guidance in ASC 852-10, such claims should be recorded at the allowed claim amounts and not the amounts expected to be paid to the lessors.

Example BLG 3-3 describes how a reporting entity going through bankruptcy proceedings should account for a rejected lease agreement.

EXAMPLE BLG 3-3
Accounting treatment for a rejected lease agreement

Prior to entering into a Chapter 11 reorganization proceeding, a reporting entity with a December 31 year-end vacates office space subject to an operating lease, and pursuant to ASC 420, Exit or Disposal Cost Obligations, accrues a liability for the remaining lease payments, net of any expected subrental income. On November 30, the reporting entity files a petition for Chapter 11. During the bankruptcy proceeding, the operating lease is rejected by the reporting entity. The rejected lease claim is allowed by the Bankruptcy Court on January 2 for an amount less than the carrying amount of the existing liability.

What is the amount of the lease liability that the reporting entity should report in its December 31 financial statements?