A lessor’s accounting for the underlying asset at the end of the lease term is described in ASC 842-30-35-5
At the end of the lease term, a lessor shall reclassify the net investment in the lease to the appropriate category of asset (for example, property, plant, and equipment) in accordance with other Topics, measured at the carrying amount of the net investment in the lease. The lessor shall account for the underlying asset that was the subject of a lease in accordance with other Topics.
If a lease is fully terminated prior to the end of the lease term, a lessor should follow the guidance in ASC 842-30-40-2
If a sales-type lease or a direct financing lease is terminated before the end of the lease term, a lessor shall do all of the following:
a. Test the net investment in the lease for impairment in accordance with Topic 310
on receivables and recognize any impairment loss identified
b. Reclassify the net investment in the lease to the appropriate category of asset in accordance with other Topics, measured at the sum of the carrying amounts of the lease receivable (less any amounts still expected to be received by the lessor) and the residual asset
c. Account for the underlying asset that was the subject of the lease in accordance with other Topics.
If a lessee continues to use the asset or a portion of the asset for a period time after the lease termination is agreed upon, the termination should be accounted for as a lease modification based on the modified lease term (through the planned exit date). For example, if the lessee and lessor agree to terminate a lease in six months with a termination penalty, the lease should be accounted for as a modified lease with a six-month term.
Question LG 5-6 discusses the accounting by a lessor for a termination penalty paid by a lessee due to a modification of two leases between them with immediate exit of one property by the lessee at the lease modification date.
Question LG 5-6
Lessor Corp is 2 years into a 7-year operating lease for an office building and 3 years into a 5-year operating lease for a warehouse with Lessee Corp. Lessor Corp and Lessee Corp agree to concurrently amend the two leases such that Lessee Corp will (a) extend the term of office building lease by three more years (i.e., a total remaining lease term of eight years), (b) vacate the warehouse immediately at the amendment date, and (c) pay Lessor Corp a termination penalty of $2 million at the lease amendment date. Lessee Corp will continue to classify the office building lease as an operating lease after the amendment.
How should Lessor Corp account for these lease amendments?
While this fact pattern is not addressed exactly in the leases standard, we believe the guidance in ASC 842-10-25-15
can be applied by analogy.
Under ASC 842-10-25-15
, if an operating lease is modified and the modification is not accounted for as a separate contract, a lessor should account for the modification as a termination of the existing lease and creation of a new lease at the modification date. If the new lease created is an operating lease, the lessor should include any prepaid or accrued rent balance from the original lease as part of the lease payments for the modified lease.
Based on an analogy to ASC 842-10-25-15
, we believe Lessor Corp should account for the $2 million payment received from Lessee Corp for the warehouse lease termination as prepaid rent and include it as part of the lease payments for the modified office building lease. Lessor Corp would subsequently recognize $2 million lease income on a straight-line basis over the remaining eight-year lease term.
Note about ongoing standard setting
In October 2020, the FASB issued an exposure draft for targeted improvements and amendments to the leases standard. Under the proposed guidance, a reporting entity would not have to apply modification accounting if a lease component is terminated and the economics of the remaining lease components remain substantially the same as before the partial termination of the contract. As of the cut-off date of this guide, the proposed amendments have not yet been issued. Reporting entities should continue to monitor the status of these proposed amendments and any additional updates to the leases standard.