Lessor Accounting for a Lease Termination

A lease termination is the premature end of a lease contract, an event requiring specific accounting treatment by the lessor, the owner of the asset. The Financial Accounting Standards Board (FASB) provides guidance under Accounting Standards Codification (ASC) 842 to govern these events. The required accounting procedures depend on the original classification of the lease as either an operating, sales-type, or direct financing lease. The primary goal is to properly remove all related balances from the books and recognize any resulting financial impact in the correct period.

Key Principles in Lessor Termination Accounting

The central objective when a lessor accounts for a lease termination is the derecognition of any existing balances related to that lease from the balance sheet. This process removes assets and liabilities that are no longer relevant once the contract is voided. For instance, any recorded net investment in a sales-type or direct financing lease, or any deferred rent connected to an operating lease, must be written off.

A frequent component of early terminations is a payment from the lessee to the lessor for exiting the contract early. This termination fee is recognized by the lessor as income in the period the termination becomes effective, not necessarily when the cash is received. This income is included as part of the overall gain or loss on termination.

Lessors often capitalize initial direct costs, such as commissions or legal fees, and amortize them over the lease term. Upon early termination, any unamortized portion of these initial direct costs is immediately written off and recognized as an expense. Similarly, if the lessor provided any lease incentives, the unamortized balance is also written off against the income recognized from the termination.

Accounting for an Operating Lease Termination

When an operating lease is terminated, the lessor’s primary accounting action involves the underlying asset. The asset, which was likely classified separately as “property on operating lease,” is reclassified back to its standard fixed asset category, such as Property, Plant, and Equipment. A notable aspect of this reclassification is that the carrying amount of the asset itself does not change at the moment of termination.

The accounting entries for an operating lease termination clear all related accounts. For example, if the lessor had a deferred rent revenue liability or an accrued rent receivable, these balances are removed from the books. Any unamortized initial direct costs are also written off as an expense, and the termination fee from the lessee is recorded as income.

To illustrate, consider a lessor who terminates an operating lease for a building and receives a $50,000 termination fee. At the termination date, there is a $5,000 deferred rent revenue balance and $2,000 in unamortized initial direct costs. The journal entry would involve debiting Cash for $50,000, debiting Deferred Rent Revenue for $5,000, and debiting an expense account for the $2,000 write-off. A credit to a gain on lease termination account for $57,000 would balance the entry, and the underlying building asset would then be reclassified.

Accounting for a Sales-Type or Direct Financing Lease Termination

The accounting for terminating a sales-type or direct financing lease differs from an operating lease. The central element on the lessor’s balance sheet for these leases is the “net investment in the lease.” Upon termination, the primary accounting event is the derecognition of this entire net investment. The underlying asset is then brought back onto the lessor’s books and recorded at its fair value at the termination date.

The financial impact of the termination is captured as a gain or loss. This is calculated by comparing the carrying amount of the net investment in the lease with the fair value of the underlying asset being brought back onto the books. Any termination payment received from the lessee is factored into this calculation, increasing the gain or decreasing the loss.

For example, assume a lessor has a net investment in a sales-type lease with a carrying amount of $150,000. The underlying equipment has a fair value of $120,000, and the lessee pays a $10,000 termination fee. The lessor’s loss is calculated as the net investment ($150,000) minus the asset’s fair value ($120,000) and the termination fee ($10,000), resulting in a $20,000 loss. The journal entry would debit the equipment for $120,000, debit cash for $10,000, debit a loss on lease termination for $20,000, and credit the net investment in the lease for $150,000.

Financial Statement Presentation and Disclosures

On the income statement, the net gain or loss resulting from the termination is presented as a single line item within income from continuing operations. This figure consolidates various elements, including the termination fee received, the write-off of any unamortized initial direct costs, and the gain or loss from derecognizing the lease.

On the balance sheet, the changes are also distinct. For a sales-type or direct financing lease, the “net investment in the lease” asset is removed. For an operating lease, the change is the reclassification of the underlying asset from a lease-specific category back into the general Property, Plant, and Equipment account.

ASC 842 also requires specific disclosures in the notes to the financial statements. Lessors must provide qualitative information describing the termination, including the principal circumstances surrounding the event. Quantitatively, the amount of the net gain or loss recognized in the income statement due to the termination must be disclosed.