Financial Accounting Case Study
Subject : Financial Accounting Ⅱ Lease agreement between NeedsLease and HasSpace
NeedsLease is renting a space for its corporate office from HasSpace by entering into a lease agreement. The agreed lease term is for 10 years and there is no option to renew nor is the ability to negotiate renewal of the term. According to ASC 840 (5F of statement 13), the lease is classified as operating lease. The agreement includes two provisions that may require NeedsLease to perform certain activities at its cost. The first provision requires that the lessee, NeedsLease, may have to perform general repairs and maintenance on the leased premises. The second provision requires that NeedsLease may have to remove all the leasehold improvements and revert the …show more content…
premise back to original condition.
How should NeedsLease account for expenditures and depreciation?
As stated in ASC 840-10-35-6, leasehold improvements in an operating lease are amortized over the shorter of the useful life of the asset or the required term of the lease periods, taking into consideration of lease periods and renewals. The required term of the lease would be considered to be 10 years since the agreement between HasSpace and NeedsSpace specifically said there was no option to renew the lease at the end of the term. Since the lease term of 10 years is shorter, NeedsSpace’s expenses for the leasehold improvements should be amortized over the 10 years of the lease term. On the date of the agreement | | | Dr. Leasehold improvements | | | | Cr. Cash | | | | | | | | | Year 2 | | | | | Dr. Lease Rental Expense | | | | Cr. Cash | | | | Dr. Leasehold Improvements Amortization Expense | | Cr. Leasehold Improvements | | | | | | | Year 3 | | | | | Dr. Lease Rental Expense | | | | Cr. Cash | | | | Dr. Leasehold Improvements Amortization Expense | | Cr. Leasehold Improvements | | (The same for year 4 to 10) | | |
How should the NeedsLease account for the general repairs and maintenance?
In accordance with ASC 840-10-05-9A, NeedsSpace (the lessee) is legally or contractually responsible for repair and maintenance of the leased asset throughout the lease term. It also states that certain lease agreements include provisions that require the lessee to make deposits to the lessor to financially protect the lessor in the event the lessee does not properly maintain the leased asset. However, the provision on the case on hand does not require the lessee to make deposits but simply to perform repair and maintenance on the leased premises. According to ASC 840-10-25-5, minimum lease payments that the lessee is obligated excludes executory costs such as insurance, maintenance, and taxes in connection to the leased premises. Hence, the general repairs and maintenance costs shall be expensed as incurred. Expensed as incurred: | | Dr. General repairs and maintenance | | Cr.
Cash | | |
How should NeedsLease account for the reinstation to the property’s original condition?
According to ASC 840-10-35-6, leasehold improvements in operating lease are capitalized and amortized over the shorter of (1) the useful life of the assets and (2) lease term, considering required lease periods and renewals. In the lease agreement above, no renewal option is provided; and the lease term of 10 years happens to be the same to the economic useful lives of the leasehold improvements. Therefore, the lessee’s expenditure for leasehold improvements should be capitalized and amortized over 10 years.
Arguably, the fastest way to expense the costs related to this restoration requirement would be to treat the provision as a probable loss contingency situation with reasonably estimable loss amount. However, the lessee has neither the option to renew the lease nor the ability to negotiate for renewal. It means the loss from the removal of the leasehold improvements will certainly occur when the lease term expires in 10 years. In this vein, the restoration provision in the lease agreement may not be considered as a “contingency” situation. Although the amount of the obligation is less than certain, the amount is just an estimate, not a loss contingency with uncertainty regarding the realization of the loss itself per ASC 450-10-05-6. Accordingly, contingency treatment is ruled out in this …show more content…
case.
The lessee may consider that, due to the leasehold improvements removal provision in the lease agreement, a contractual obligation is created to restore the leased premise’s original condition when its lease term expires.
Per ASC 410-25-25-4, this asset retirement obligation (ARO) should be recorded as a liability at its fair value when it is incurred and reasonably estimable. ASC 410-20-15-3(e) also prescribes that if conditional obligations of a lessee exist to perform a retirement activity in connection with leased property, the lessee shall account for the obligation as ARO unless it meet the definition of “either minimum lease payments or contingent rentals in paragraphs 840-10-25-4 through 25-7.” Since the provision requires the performance of - not the payment for – restoration to the original condition, it may not be included in the minimum lease payments. Consequently, the restoration requirement provision in the agreement may be accounted as ARO by the
lessee.
NeedsLease is renting a space for its corporate office from HasSpace by entering into a lease agreement. The agreed lease term is for 10 years and there is no option to renew nor is the ability to negotiate renewal of the term. According to ASC 840 (5F of statement 13), the lease is classified as operating lease. The agreement includes two provisions that may require NeedsLease to perform certain activities at its cost. The first provision requires that the lessee, NeedsLease, may have to perform general repairs and maintenance on the leased premises. The second provision requires that NeedsLease may have to remove all the leasehold improvements and revert the …show more content…
premise back to original condition.
How should NeedsLease account for expenditures and depreciation?
As stated in ASC 840-10-35-6, leasehold improvements in an operating lease are amortized over the shorter of the useful life of the asset or the required term of the lease periods, taking into consideration of lease periods and renewals. The required term of the lease would be considered to be 10 years since the agreement between HasSpace and NeedsSpace specifically said there was no option to renew the lease at the end of the term. Since the lease term of 10 years is shorter, NeedsSpace’s expenses for the leasehold improvements should be amortized over the 10 years of the lease term. On the date of the agreement | | | Dr. Leasehold improvements | | | | Cr. Cash | | | | | | | | | Year 2 | | | | | Dr. Lease Rental Expense | | | | Cr. Cash | | | | Dr. Leasehold Improvements Amortization Expense | | Cr. Leasehold Improvements | | | | | | | Year 3 | | | | | Dr. Lease Rental Expense | | | | Cr. Cash | | | | Dr. Leasehold Improvements Amortization Expense | | Cr. Leasehold Improvements | | (The same for year 4 to 10) | | |
How should the NeedsLease account for the general repairs and maintenance?
In accordance with ASC 840-10-05-9A, NeedsSpace (the lessee) is legally or contractually responsible for repair and maintenance of the leased asset throughout the lease term. It also states that certain lease agreements include provisions that require the lessee to make deposits to the lessor to financially protect the lessor in the event the lessee does not properly maintain the leased asset. However, the provision on the case on hand does not require the lessee to make deposits but simply to perform repair and maintenance on the leased premises. According to ASC 840-10-25-5, minimum lease payments that the lessee is obligated excludes executory costs such as insurance, maintenance, and taxes in connection to the leased premises. Hence, the general repairs and maintenance costs shall be expensed as incurred. Expensed as incurred: | | Dr. General repairs and maintenance | | Cr.
Cash | | |
How should NeedsLease account for the reinstation to the property’s original condition?
According to ASC 840-10-35-6, leasehold improvements in operating lease are capitalized and amortized over the shorter of (1) the useful life of the assets and (2) lease term, considering required lease periods and renewals. In the lease agreement above, no renewal option is provided; and the lease term of 10 years happens to be the same to the economic useful lives of the leasehold improvements. Therefore, the lessee’s expenditure for leasehold improvements should be capitalized and amortized over 10 years.
Arguably, the fastest way to expense the costs related to this restoration requirement would be to treat the provision as a probable loss contingency situation with reasonably estimable loss amount. However, the lessee has neither the option to renew the lease nor the ability to negotiate for renewal. It means the loss from the removal of the leasehold improvements will certainly occur when the lease term expires in 10 years. In this vein, the restoration provision in the lease agreement may not be considered as a “contingency” situation. Although the amount of the obligation is less than certain, the amount is just an estimate, not a loss contingency with uncertainty regarding the realization of the loss itself per ASC 450-10-05-6. Accordingly, contingency treatment is ruled out in this …show more content…
case.
The lessee may consider that, due to the leasehold improvements removal provision in the lease agreement, a contractual obligation is created to restore the leased premise’s original condition when its lease term expires.
Per ASC 410-25-25-4, this asset retirement obligation (ARO) should be recorded as a liability at its fair value when it is incurred and reasonably estimable. ASC 410-20-15-3(e) also prescribes that if conditional obligations of a lessee exist to perform a retirement activity in connection with leased property, the lessee shall account for the obligation as ARO unless it meet the definition of “either minimum lease payments or contingent rentals in paragraphs 840-10-25-4 through 25-7.” Since the provision requires the performance of - not the payment for – restoration to the original condition, it may not be included in the minimum lease payments. Consequently, the restoration requirement provision in the agreement may be accounted as ARO by the
lessee.