ASC 842 Lease Termination Accounting Treatment
Understand the proper accounting treatment for lease terminations under ASC 842, from derecognizing balance sheet items to calculating the P&L impact.
The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) 842 establishes the U.S. GAAP for lease accounting, requiring companies to recognize most leases on their balance sheets. A lease termination occurs when a contract ends before its originally agreed-upon term. The accounting treatment for these terminations differs depending on whether one is the lessee (the entity using the asset) or the lessor (the entity owning the asset).
Lessee Accounting for Full Lease Termination
When a lessee fully terminates a lease, the primary accounting event is removing the lease from the balance sheet. This involves derecognizing both the Right-of-Use (ROU) asset and the corresponding lease liability. The ROU asset represents the lessee’s right to use the underlying asset, while the lease liability is the obligation to make lease payments.
A gain or loss is determined by the difference between the carrying amounts of the lease liability and the ROU asset. This amount is then adjusted by any termination penalties or incentives. For example, if a lease liability is $450,000 and the ROU asset is $420,000, the initial difference is a $30,000 gain.
If the lessee also pays a $50,000 termination penalty, the initial gain is reduced by this payment. This results in a final recognized loss of $20,000 on the income statement for that period.
The journal entry for this transaction debits the lease liability account ($450,000) and credits the ROU asset account ($420,000). It also credits cash for the penalty paid ($50,000). The balancing debit of $20,000 is recorded to a “Loss on Lease Termination” account.
Lessor Accounting for Full Lease Termination
From the lessor’s perspective, accounting for a full termination depends on the lease’s classification. For an operating lease, the lessor keeps the underlying asset on its balance sheet. The lessor removes any associated lease receivable or deferred rent balances and recognizes any termination payment received as income.
For sales-type and direct financing leases, the lessor derecognized the underlying asset at commencement and recorded a net investment in the lease. Upon termination, this net investment is derecognized. The underlying asset is then brought back onto the lessor’s books at the net investment’s carrying amount.
A gain or loss is the difference between the net investment’s carrying amount and any cash termination payment received. For instance, if a net investment is $200,000 and the lessor receives a $225,000 payment, it recognizes a $25,000 gain. The reacquired asset is recorded at $200,000.
Accounting for Partial Terminations and Scope Reductions
A partial termination, such as reducing leased office space, is treated as a lease modification. This requires adjusting the lease liability and the ROU asset to reflect the new, reduced scope of the contract, rather than derecognizing them entirely.
The lessee first remeasures the lease liability by calculating the present value of the revised future lease payments. This calculation must use an updated discount rate, which should be the rate implicit in the lease at the modification date or the lessee’s incremental borrowing rate.
Concurrently, the ROU asset is adjusted proportionately to the reduction in the lease’s scope. For example, if a lessee gives up 25% of its leased office space, the ROU asset’s carrying amount is reduced by 25%.
A gain or loss is recognized on the modification date, calculated as the difference between the reduction in the lease liability and the proportionate reduction in the ROU asset. For example, a $100,000 decrease in the lease liability with a $90,000 reduction in the ROU asset results in a $10,000 gain.
Required Disclosures for Lease Terminations
When a lease termination occurs, ASC 842 mandates specific disclosures in the financial statement footnotes. The primary requirement is a clear description of the termination, including the nature and terms of the agreement.
Companies must also disclose the financial impact by reporting the net gain or loss recognized in the income statement. This allows financial statement users to understand the profitability impact of the termination.
Further disclosure is required for any amounts related to the termination not part of the main gain or loss calculation. This can include payments for variable lease components or other charges settled as part of the agreement.