Municipalities must consider at lease commencement how likely it is that they’ll exercise any termination options when determining the initial lease term and calculating the initial lease liability and lease receivable balances.
When a lease is fully terminated, lessees give up the right to use the underlying asset. Therefore, they derecognize the right-of-use asset and accompanying lease liability. Differences between each result in a gain or loss reported on the income statement. The lessee should also account for any lease termination penalty in the gain or loss calculation if the penalty is not already included in the calculation of lease payments.
Similarly, lessors must derecognize the lease receivable and deferred inflow of resources. Differences between these two balances will result in a gain or loss reported on the income statement in the termination period.
Leases can also be partially terminated. In this case, the lease liability for the lessee is reduced by the lessee’s partial utility reduction.
Lastly, leases can terminate if the lessee purchases the underlying asset from the lessor. The lessee then reclassifies the underlying asset on its books from an intangible right-of-use asset to a fixed asset.
Example:
The owner of an office building leases six floors to a municipality for five years. However, in case it needs to downsize or move out, the municipality negotiates a lease termination option.
In year three, the municipality vacates the top floor to decrease its lease payments. At that time, the municipality must reduce the lease liability on its books.
Municipalities must consider at lease commencement how likely it is that they’ll exercise any termination options when determining the initial lease term and calculating the initial lease liability and lease receivable balances.
If the termination option requires prior notice, or if the lessee and lessor agree to terminate the lease at some point, the parties may need to recalculate the lease asset and liability before the actual termination date (the date the decision is made).