Lease Giveback Plus a Packaging Line That Cannot Recover Its Carrying Amount
Calumet Fabrication Inc. (calendar year end) leases a 90,000-square-foot headquarters building. At commencement on January 1, 20X1, the lease had an eight-year noncancellable term with annual payments of $520,000 due each January 1, an incremental borrowing rate of 6%, and no purchase option or transfer of title. Calumet recorded a right-of-use asset of $3,230,000 and a lease liability of $3,230,000. On January 1, 20X4, Calumet and the lessor sign an amendment that returns 36,000 square feet to the lessor, reduces the annual payment to $330,000, and sets a remaining term of five years; all other terms are unchanged. The amendment does not grant an additional right of use and is not a separate contract. Immediately before the amendment, the ROU asset was $2,019,000 and the lease liability was $2,322,000. Calumet's incremental borrowing rate on January 1, 20X4 is 7%. Separately, Calumet's packaging line asset group has a carrying amount of $2,400,000, expected undiscounted net cash flows of $2,100,000, a fair value of $1,700,000, and $60,000 of costs to sell.
1. Account for the January 1, 20X4 lease amendment. Show the amount of any gain or loss and the resulting ROU asset and lease liability.
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Step 1 - Does this qualify as a separate contract? No. The amendment only reduces the scope of the existing lease and reprices it; it conveys no additional right of use. Therefore the modification is not accounted for as a separate contract and must be treated as a partial termination plus a remeasurement of the retained portion.
Step 2 - Derecognize the terminated 40% (36,000 of 90,000 sq ft).
- ROU asset: $2,019,000 x 40% = $807,600 decrease
- Lease liability: $2,322,000 x 40% = $928,800 decrease
- Difference: $928,800 - $807,600 = $121,200 gain recognized in income at the modification date.
Step 3 - Remeasure the retained liability at the revised terms.
- Five remaining payments of $330,000, annuity due, at 7%: factor = 1 + (1 - 1.07^-4)/0.07 = 4.3872
- New liability: $330,000 x 4.3872 = $1,447,800
- Retained liability before remeasurement: $2,322,000 x 60% = $1,393,200
- Remeasurement increase: $54,600, with an equal adjustment to the ROU asset (no income effect).
Resulting balances: lease liability = $1,447,800; ROU asset = $1,211,400 + $54,600 = $1,266,000.
Judgment point. The payment fell 36.5% while the space returned fell 40%, and the discount rate rose from 6% to 7%, so the retained liability actually increases slightly even though the total obligation falls sharply. Candidates who simply multiply the payment change by the remaining term miss both the annuity-due timing and the rate reset.
2. Test the packaging line asset group for impairment and measure any loss.
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Step 1 - Trigger and recoverability test. The significant reduction in expected cash flows (and the building giveback, if the packaging line shares the same asset group or cost structure) is a triggering event. Because the asset group is held and used, apply the recoverability test: compare the carrying amount to the sum of undiscounted expected future cash flows.
- Carrying amount: $2,400,000
- Undiscounted future cash flows: $2,100,000
- Carrying amount exceeds the undiscounted cash flows, so the asset group fails the recoverability test and an impairment exists.
Step 2 - Measurement. For assets held and used, the impairment loss is the excess of carrying amount over fair value (not over undiscounted cash flows, and not over fair value less costs to sell - that measurement applies to assets held for sale).
- Fair value: $1,700,000
- Impairment loss: $2,400,000 - $1,700,000 = $700,000
Common error to avoid. The $60,000 of costs to sell is used only if the disposal-group-held-for-sale criteria are met (management commits to a plan, the asset is available for immediate sale, sale is probable within one year). Nothing in the facts indicates those criteria are met, so using $1,640,000 and recording a $760,000 loss would be wrong at this stage.
Step 3 - Post-impairment accounting. The asset group's new carrying amount of $1,700,000 becomes the basis for future depreciation over its remaining useful life. The loss is presented in continuing operations (or within the relevant functional line) and disclosed with the facts and circumstances, the amount, and the method used to determine fair value. Reversal of the loss is prohibited for assets held and used.
3. What disclosures does the lease amendment require, and could the building amendment itself be an impairment indicator for the related leasehold improvements?
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Lease disclosures. The amendment is a modification that reduces scope and changes payments, so Calumet should disclose:
- The nature and terms of the amendment, including the space returned, the new payment, and the revised term.
- The $121,200 gain on partial termination, with the line item in which it is presented. Because it is a modification gain rather than a sale-leaseback gain, it is recognized in income immediately but is not revenue.
- The maturity analysis of remaining undiscounted lease payments (five payments of $330,000) reconciled to the $1,447,800 liability, separating the current and noncurrent portions.
- The weighted-average discount rate applied to the remeasured lease (7%) and the fact that the rate was updated at the modification date.
Impairment indicator for leasehold improvements. Yes - it is a strong indicator. Returning 40% of the leased space makes it likely that tenant improvements specific to the vacated space no longer provide any future benefit. The leasehold improvements should be tested as part of the building's asset group (or as their own asset group if their cash flows are largely independent), and if the vacated portion will be abandoned, that portion should be written off over the shortened period. The auditor's judgment call is whether the improvements support the retained operations; a blanket write-off of all improvements would be as wrong as ignoring the giveback. Document the asset-grouping conclusion, because grouping the improvements with the packaging line could mask or create an impairment.