Accounting for Lease Termination Costs
It is not unusual for a bank to lease facilities, especially for branch locations. What happens if the bank concludes the leased space no longer serves its needs or is not economically viable before the end of the lease term and then acts on this conclusion? What is the relevant accounting guidance and what happens from an income tax perspective?
Accounting guidance for this situation can be found at ASC Section 420 Exit or Disposal Cost Obligations. It should be noted that this guidance applies only to operating leases, not to capital leases. Also, this article does not address accounting issues for any leasehold improvements that may be abandoned in connection with the lease termination.
The guidance can be broken into two categories:
Costs to terminate the lease before the end of its term
A liability for costs to terminate a lease before the end of its term should be recognized when the bank terminates the lease in accordance with the lease terms (for example, upon giving written notice) or has otherwise negotiated a termination. This liability should be measured at its fair value upon the termination of the lease. Calculating the fair value of the liability is essentially an exercise in discounting the cash flow at an appropriate discount rate. As a practical matter, the amount of time between the termination of the lease and any termination payment will be short and the amount of the payment will approximate fair value.
Generally, payments made to terminate a lease as described above will be deductible for tax purpose when paid.
Costs that will continue to be incurred under the lease for its remaining term without economic benefit to the lessee
This scenario might come into play if the lessor is not interested in negotiating a lease termination and insists that the lessee perform as agreed. In this case, the fair value of the liability at the “cease-use date” should be recorded. This liability will be based on the remaining lease payments, reduced by estimated sublease rentals (if allowed) that could be reasonably obtained for the property-even if the lessee does not intend to enter into a sublease. The assumed sublease payments cannot reduce the remaining lease payments below zero. The cease-use date occurs when the lessee stops using the leased property.
In promulgating this guidance, FASB believed that a decision to not sublease the property is separate from the decision to cease using the property. The liability recorded at the cease-use date assumes that the property will be subleased. If the bank decides not to sublease the property, the forgone sublease income will be booked as an expense during the period(s) such decision continues to be in effect.
For tax purposes, deductions will be incurred as lease payments are made and income realized as sublease payments are received.
If you are contemplating a possible lease termination, please contact your tax and accounting expert to assist you in applying this guidance in your specific circumstances.