NeedsSpace Case 9-4 NeedsSpace is leasing space to rent corporate offices from WeHaveIt. According to ASC 840, NeedsSpace has entered into an operating lease with a lease term of 10 years as defined by the Glossary in ASC 840 (paragraph 5(f) of Statement 13). The lease will be terminated at the end of the 10 year term and NeedsSpace will not be given the option to renew. The lease agreement specifies that the lessee may have to perform certain tasks at the cost of the lessee when the lease term concludes.
The 1st provision being that the lessee NeedsSpace may have to repair and perform maintenance on the grounds leased. To make the leased property more suitable for business, leasehold improvements such as temporary walls and carpet was installed. This leads to the 2nd provision that may require NeedsSpace to revert the leased grounds back to its original state, at the end of the term. Entering into a lease agreement with WeHaveIt, NeedsSpace is legally and contractually responsible for making any needed general repair and maintenance on the grounds they are leasing.
In the event, that it is necessary for NeedsSpace to makes deposits to safeguard the lessor, by creating a backup maintenance fund, ASC 840-10-05-9A through 840-10-05-9C states that the funds would be considered a deposit asset and reimbursed when the actual repair and maintenance is performed. As far as the provision goes, it only indicates that the lessee has to perform maintenance not make deposits. The obligation can be assumed as a current economic obligation and not necessarily a future commitment. If the future maintenance cost can be reliably predicted, the provision may result in an accrued liability at the inception of the lease.
When the maintenance has been performed by some form of payment the liability will be expensed and removed from the lessee’s balance sheet. If the expenses cannot be predicted the lessor may forgo recognizing a maintenance liability at the inception of the lease and have the lessee expense as repairs are performed. As stated in ASC 840-10-35-6, leasehold improvements in an operating lease are capitalized and amortized over the shorter of the useful life of the asset and the lease term, taking into consideration of lease periods and renewals.
The agreement between WeHaveIt and NeedsSpace specifically said there was no option to renew the lease at the end of the term. Since the lease term and the useful life of the leasehold improvements are both 10 years, NeedsSpace’s expenses for the improvements should be capitalized and amortized over the 10 year term. The second provision states that the lessee may be required to remove all installed leasehold improvements. Per ASC 410-25-25-4 the assets in question are to be classified as an Asset Retirement Obligation (ARO) and recorded at Fair Value when it can be estimated and the cost is incurred.
The provision requires the physical removal of the improvements to restore the property to its original state and not just the payment for the lessor to do the needed task. Therefore the expenses cannot be included in the lessee’s minimum lease payments. As a result the restoration requirement can be classified as ARO by NeedsSpace. With the second provision classified as ARO, per ASC 410-20-25-5 the fair value of the liability should be recognized by increasing the carrying amount of the capitalized leasehold improvements.
When the actual expense is incurred it should be shown on the Income Statement as an operating expense as explained by ASC 410-20-45-1. NeedsSpace is also required to disclose the general description of ARO in relation to the leasehold improvements, as well as the recognition of carrying amounts, when there is a significant change in the components of the liability incurred, settled, accretion expense and lastly the revision of the estimated cash flow.
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