With the adoption of ASC 842, Leases, the guidance in ASC 420-10 was modified to remove leases from its scope. See the Leases guide and PPE 4.2.5 for further details on the accounting for leases after the adoption of ASC 842. See PPE 6.5.3 for details regarding the accounting for other contract termination costs after the adoption of ASC 842.
Prior to adopting the new leases standard, lease termination costs were accounted for under ASC 420-10. The remainder of this section discusses the accounting prior to adoption of ASC 842.
ASC 420-10 also applies to costs to terminate an operating lease or other contract that existed prior to the entity's commitment to a plan of disposal. Circumstances in which there is a termination of an operating lease not involving a restructuring activity are also to be accounted for pursuant to ASC 420-10. Contract termination costs that may be incurred in connection with an exit or disposal activity are (a) costs to terminate the contract before the end of its term or (b) costs that will continue to be incurred under the contract for its remaining term without economic benefit to the entity (e.g., lease rental payments that will continue after an entity ceases to use the property).
ASC 420-10 provides guidance related to the recognition and measurement of liabilities for lease and contract terminations. Costs to terminate a contract before the end of its term should be recognized and measured at their fair value when the entity terminates the contract in accordance with the contract terms. Costs that will continue to be incurred under a noncancelable contract should be recognized and measured at fair value when the entity ceases using the right conveyed by the contract (e.g., the right to use a leased property or to receive future goods or services). When the contract is an operating lease that is terminated, a liability based on the remaining lease rental should be measured at its fair value when the entity ceases using the rights conveyed by the contract (the "cease-use" date) based on the remaining lease rentals, adjusted for the effects of any prepaid or deferred items recognized under the lease, and reduced by estimated sublease rentals that could be reasonably obtained for the property. Recording a liability at the cease-use date is only appropriate for the cease of use of functionally independent assets (i.e., the assets could be fully utilized by another party) when the lessee is permanently ceasing use. The liability for remaining rentals should be reduced by any estimated sublease rentals, net of direct costs incurred to obtain the sublease (but not reduced to an amount less than zero), regardless of whether the entity intends to enter into a sublease or whether the terms of the lease allow the lessee to sublease the asset. This is due to the fact that the lessor may be required by law to mitigate its damages, as is common in the US. However, ASC 420-10 limits the circumstances in which sublease rentals should reduce the liability by stating that entities must consider estimated sublease rentals only to the extent that they could reasonably be obtained for the property.
With respect to leases, a liability should be recognized at the cease-use date only if the terms of an operating lease are unfavorable relative to the terms of a new lease for similar property. This implies recognition of a liability only if the lease terms are not at prevailing market terms. When estimating the fair value of a liability for costs to terminate an operating lease, an issue arises regarding whether executory costs (that is, property taxes, insurance, maintenance costs) should be included as part of the fair value of the liability. Whether executory costs are considered costs required to be expensed as incurred under ASC 420-10 or costs of the lease termination is not normally relevant, as such costs are inherent in the terms of any lease or sublease and a third party lessee or sublessee would be required to assume them, either directly or indirectly, in connection with any lease or sublease of the property. Consequently, we believe it should be assumed that any obligation to pay executory costs in connection with the termination of an operating lease could be passed through to a subtenant on a sublease. Stated another way, payments for executory costs are generally at prevailing market prices and we would not expect these costs to increase the fair value of an exit liability. Therefore, they are not likely to be accrued at the cease use date. In addition, executory costs not directly related to the leased asset (e.g., personal property taxes or insurance on the lessee's assets located in the leased location) are not accruable as contract (lease) termination costs under ASC 420-10.
The FASB decided that ASC 420-10 would not be limited to lease termination costs and, as a result, the guidance in ASC 420-10 applies to all contract terminations. Accordingly, when an entity ceases using a property that is leased under an operating lease before the end of its term, the approach in ASC 420-10 contemplates that a liability should be recognized for lease termination costs when the leased property has no substantial future use or benefit to the lessee. Furthermore, ASC 420-10's "cease-use" date requires that the liability for all lease termination costs be recognized and measured when the rights provided for under the contract are no longer used by an entity in operations. This guidance, however, does not relate to the "impairment" of an operating lease or executory contract. The key point is that ASC 420-10 should not be analogized to losses on executory contracts. The SEC has stated that it is generally inappropriate to recognize impairments on executory contracts unless such losses are specifically prescribed in authoritative literature (e.g., a loss on a sub-lease arrangement not involving a disposal (ASC 840-20-25-15) or a firm commitment to purchase inventory that, when acquired, would be subject to an immediate lower of cost or market write-down (ASC 330-10)).
For further considerations of lease and other contract termination costs, see Question PPE 6-1, Question PPE 6-2, Question PPE 6-3, Question PPE 6-4, Question PPE 6-5, and Question PPE 6-6.
Question PPE 6-1 (prior to ASC 842)
An exit plan includes a reduction in the operations currently performed in a leased facility comprised of five floors. The lease is an operating lease, expiring three years from the date management commits to an exit plan and communicates the plan. At that date, all five floors are fully used in operations and will continue to be used for one year. When the exit plan is completed in one year, only three floors of the leased space will be used. The remaining two floors will be permanently idle. Assuming all other provisions of ASC 420-10 have been met, may the company recognize a liability at the communication date for the exit costs associated with the two floors of the building that will be permanently idle?
No. As of the communication date, the company has not incurred a liability. Communication of a commitment to cease using two floors of the building in the future does not, in and of itself, create a current obligation of the company. Further, those floors continue to be used in operations for one year from the commitment date. Under ASC 420-10, contract termination costs that continue to be incurred under the contract for its remaining term without economic benefit to the entity can be recognized when the company ceases using the right conveyed by the contract. Accordingly, in year two, the company may be able to recognize the liability for costs associated with the permanently idle floors of the building, once the company ceases using those floors. In addition, the company must prove that the two floors of the building are functionally independent from the rest of the building (e.g., they have a separate entrance to the floor) and will not be used in operations (e.g., they are not being used as storage). The measurement is based on the fair value of the remaining lease rentals, reduced by estimated sublease rentals that could be reasonably obtained for the property.
Question PPE 6-2 (prior to ASC 842)
A lessee of commercial office space leases several floors of a multi-tenant office building. The lessee has ceased using certain floors and portions of other floors in the building. Should a liability for contract termination costs be recognized under ASC 420-10?
A liability should be recognized under ASC 420-10 for the costs associated with one or more floors or portions of floors, provided they are functionally independent assets (i.e., they could be fully utilized by another party because, for example, they have separate entrances, access to restrooms, etc.) and the lessee intends to cease using them permanently. Usage would not be considered to cease permanently if the lessee intends to resume using the assets prior to the end of the lease term, the assets cannot be leased in its present condition, or the lessee has not determined whether it will resume using the assets at a loss. If usage is not considered to cease permanently and the lessee subleases the assets, ASC 840-20-25 would apply at the time the asset is subleased.
Notwithstanding the FASB's use of the term "operating lease or other contract," we believe that it did not intend to change the accounting based on whether a lessee leased a group of functionally independent assets in a single lease transaction or in a number of related lease transactions, all entered into at the same time. Accordingly, we believe the accounting should be the same for both situations. ASC 420-10 should be applied to the functionally independent assets on an asset-by-asset basis.
Question PPE 6-3 (prior to ASC 842)
If Company A ceases use of a leased building, should it calculate the fair value of the liability under ASC 420-10 by reducing the remaining lease rentals by the current fair market rental for equivalent space, assuming that the leased building could be subleased at the current fair market rental, regardless of whether the terms of the lease allow the lessee to sublease the asset?
Yes. We believe that, even if the terms of the lease preclude the lessee from subleasing the building, potential sub-lease rentals should be considered in measuring the liability if the building could be re-leased by the lessor to another lessee during the remaining term of the lease and the lessor is legally required to mitigate the amount of damages in the event of lessee default, as is typical in the United States.
In determining the amount of sublease rentals that could be obtained for the building, we believe Company A should consider all of the relevant facts and circumstances. These would include, among others: (1) the length of the remaining term of the lease, (2) the cost to obtain one or more lessees or sublessees, including brokerage commissions and leasehold improvements that would be required, and (3) any other market or other external impediments to re-leasing or subleasing the property. Company A should not consider any internal or self-imposed impediments to subleasing, such as (1) precluding a competitor from being a sublessee candidate, or (2) deciding to forego the pursuit of sublease rentals in order to focus its efforts on its primary business. Company A should consider the current fair market rental for equivalent property and assess the ability to obtain sublease rentals for the specific property under lease within the context of the overall local real estate market. A liability should be recognized at the cease-use date only if the terms of an operating lease are unfavorable relative to the terms of a new lease for similar property.
An expected present value technique will often be the best measure to estimate the liability.
Question PPE 6-4 (prior to ASC 842)
On January 1, 20X6, Company A commits to a plan to exit a facility on June 30, 20X6. The facility is subject to an operating lease that Company A will continue to use until June 30, and will then sub-lease to an unrelated third party. The lease facility is part of a larger asset group, for which there is no impairment. Company A will meet the criteria within ASC 420 for recognizing a liability associated with the lease only when Company A reaches the cease-use date of June 30, 20X6. Payments received by Company A under the sublease will be less than the amount paid by Company A under the original lease and are believed to represent estimated sublease rentals that could be reasonably obtained for the property. Company A has $100 of leasehold improvements (net of accumulated amortization) associated with the leased building at January 1, 20X6, with four years of original useful life remaining. The fair value of the leasehold improvements is expected to be de minimus at the date of exit.
How should Company A account for their leasehold improvements?
Company A should review its amortization estimates on January 1, 20X6, pursuant to ASC 250, and accelerate amortization over the revised remaining useful life of six months, through June 30, 20X6. Company A's plan to exit the building earlier than anticipated and enter into the sublease at a loss provides evidence that the useful life of the leasehold improvements is shorter than the remaining original life of four years.
Question PPE 6-5 (prior to ASC 842)
In 20X3, a company reached a decision to exit a leased facility. The company met the "cease-use" criteria in accordance with ASC 420-10, and properly recorded a liability based on the remaining lease rentals reduced by the estimated sub-lease rentals that could be reasonably obtained for the property. After the restructuring, the company executed a sub-lease for this space. In July 20X5, the company and the sub-lessee failed to renew the sub-lease agreement and the sublessee vacated the facility. At the same time, the company had positive news related to their business that would require additional physical capacity. In September 20X5, as part of their annual long-term strategic plan, company management and the Board decided they would no longer seek to sub-let the remaining space and instead use the remaining space for their own business needs. What criteria should the company use to evaluate when to reverse a restructuring accrual?
ASC 420-10-40-1 makes it clear that a liability should be reversed if an event or circumstance occurs that discharges or removes an entity's responsibility to settle a liability for a cost associated with an exit or disposal activity recognized in a prior period. ASC 420-10, however, is not clear as to what criteria should be used to evaluate when the accrual should be reversed. We believe that the guidance provided in ASC 420-10 in determining when to recognize costs associated with exit or disposal activities should also be considered to determine when, if applicable, such a charge should be reversed.
The reversal of the exit activity is initiated when either (1) management, having the authority to approve the action, commits to a plan that utilizes the space or (2) management otherwise begins to use the space. Therefore, in this set of facts and circumstances, the liability would be reversed in September 20X5 once the Board approved the action to re-enter the space and could no longer assert the accrual for an exit activity was necessary.
Question PPE 6-6 (prior to ASC 842)
Company A leases three floors of office space over a ten year non-cancelable operating lease term. In year five, Company A decides to downsize its operations and vacate one of the floors. Each of the leased floors is considered functionally independent. On June 30, 20X1, approximately one month before vacating the floor, Company A enters into a sublease with an unrelated third party, whereby the floor Company A is planning to vacate is leased for a period of three years of the remaining five years of the head lease term. The sublease rent per square foot is less than the head lease rent per square foot paid by Company A, and the sublessee does not have any renewal options. On July 31, 20X1, Company A downsizes its operations and vacates the leased floor.
For the sublet space, should the Company account for the transaction as the termination of a contract under ASC 420, Exit or Disposal Cost Obligations, or as a loss on a sublease in accordance with ASC 840-20-25-15?
Company A should first evaluate whether its sublease constitutes a permanent or temporary exit of the vacated floor. Consideration should be given to management's plans and intent for the two years remaining on the lease term after the end of the sublease. If management considers the exit to be temporary because management intends to reoccupy the space at some future date or has not made a decision to permanently exit the space, the threshold for applying ASC 420-10 for a contract termination is not met. Accordingly, ASC 840-20-25-15 would be applicable. Under ASC 840-20-25-15, at June 30, 20X1 (the date of the execution of the sublease), a loss on sublease would be recorded.
If management commits to exiting the space permanently, Company A should make an accounting policy election to either (a) record a liability upon execution of a sublease in accordance with ASC 840-20-25-15 or (b) record a liability upon its cease-use date in accordance with ASC 420-10. If Company A's policy is to account for the loss on a sublease in accordance with ASC 840-20-25-15, a liability should be recorded on June 30, 20X1 (the execution date of the sublease). The liability should be measured based on the three-year sublease period. On July 31, 20X1, when Company A ceases using the floor, ASC 420-10 applies and the liability would be adjusted to its fair value in accordance with ASC 420-10. The liability would be based on the remaining lease rentals, over the remaining five-year term of the head lease, reduced by actual or estimated sublease rentals at the cease-use date.
If, on the other hand, Company A's policy when permanently exiting a space is to follow ASC 420-10, a loss should not be recorded upon execution of a sublease. Company A would record a liability under ASC 420-10 for the termination of the contract on July 31, 20X1, the cease-use date. Under either accounting policy election, the liability balance under ASC 420-10 would be the same at July 31, 20X1.
The cease-use date is the date Company A physically vacates the space. Only when Company A executes a sublease on the same date it ceases using the space would the execution and cease-use dates coincide.