Should a lessee accrue expected losses in connection with leased properties that are not fully utilized?
In light of existing pandemic situation, many employers allow or require their workforce to work from home. In a number cases, working from home arrangements led to substantial amount of unutilized or underutilized leased office space. Some employer-lessees attempted to restructure their lease agreement whereby reducing the amount of office space used and/or lease payments. Other lessees, especially those that plan that their workforce will return to the office when the situation allows, continue with the existing contractual lease terms.
Reduction in the use of office space while having to make lease payments may lead to certain office leases to be considered loss making. In principal, a determination that a lease is loss making may apply to the modified lease agreement, not the original lease that was not subject to modification.
Questions arose of how a lessee should account for loss making lease agreements. One question is whether lessees should accrue for expected losses associated with underutilized office space.
US GAAP does not provide a formal definition of a loss making contract. Generally, contracts are considered loss making if overall contract cost or payments exceed contract benefits. It is reasonable to assume that for the purpose of the above test, contract costs and benefits are determined for the overall term of the contract.
Accounting literature may refer to loss making contracts as “onerous”. Historically, US GAAP guidance relevant to onerous contracts was industry specific. There is no general authoritative guidance on when to recognize losses on onerous contracts and, if a loss is to be recognized, how it should be measured. Specific guidance is offered in relation to operating lease that is subleased subject to ASC 840, Lease or so called “old” lease standard. Under ASC 840, when an entity enters into a sublease that will result in a loss, the loss should be recorded when the sublease is executed (ASC 840-20-25-15). Otherwise, neither “old” nor “new” lease standard contains authoritative guidance that requires a lessee to accrue operating losses arising from the future contractual or expected use of the property.
In most cases, lessees reporting under US GAAP account for loss making lease agreement similar to how they account for other lease agreement. The accounting follows the general guidance established for leases, i.e. ASC 840 or ASC 842.
Accounting under IFRS:
Unlike US GAAP, IFRS has a general authoritative guidance for onerous contracts provided as part of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Onerous contracts are defined as contracts in which “the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it”. (par. 10, Definitions)
IAS 37 requires entities to recognize liabilities for onerous contracts in accordance with general recognition criteria applicable to recognition of provisions and other liabilities. The recognition criteria include present obligation, “probable”, and “estimable” elements (par. 11 of IAS 37). The liability is measured at the lower of the cost to exit (i.e., any compensation or penalties arising from failure to fulfill the contract) or to fulfill the remaining obligations under a contract. Note that provisions of IAS 37 specifically apply to “any lease that becomes onerous before the commencement date of the lease” and other lease arrangements (par. 5(c) of IAS 37).
Conclusion: US GAAP guidance for loss making or onerous contract is industry specific. US GAAP guidance for leases does not contains the requirement to accrue operating losses arising from the future contractual or expected use of the property subject to lease (except for certain sublease arrangements). Therefore, in general, lessees make no such accrual. IFRS guidance requires recording the liability for in-scope onerous contracts provided general recognition criteria applicable to provisions are met.
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