A termination penalty is charged by a lessor to a lessee who breaks the lease
When you enter into a lease agreement, each party has several rights and responsibilities. For example, the lessee has the right to use the underlying asset for the entire lease term as long as they make their agreed-upon payments on time.
At the same time, the lessee has a responsibility to the lessor to continue making those payments through the end of the contractual agreement.
A termination penalty applies when the lessee terminates the lease earlier than the end date stated in the contract. The lease agreement usually states how much the lessor can charge the lessee as a termination penalty.
Example:
Imagine your city rented office space and has a two-year lease. Halfway through the lease, they are offered space on another street that would result in budgetary savings. However, this means the city must terminate the lease early.
If the city terminates its lease, it will have failed to meet its contractual obligation to abide by the lease until the end date. As a result, the lessor has the right to charge a termination penalty; which could be a stated fee or, alternatively, a prorated fee based on the time remaining on the lease.
Either the lessee or lessor could terminate a lease early. When a lessee terminates a lease, they relinquish the right to use the leased asset and may be subject to a termination penalty. While the lessor can also terminate the lease, there’s usually no financial penalty involved. Either way, both parties must recalculate their respective leased assets and liabilities.
Lease terminations can either be full or partial. In the case of partial termination, the lessee only has decreased use of the leased asset instead of relinquishing use altogether. However, a partial termination could still result in a termination penalty.
What’s important here?
There’s usually no financial penalty when a lessor terminates a lease early. However, an early termination penalty may apply if the lessee terminates the lease before the lease term. For GASB 87, any of these amounts incurred will need to be disclosed in your footnotes.
