Question

1. Why do most leases have expensive cancellation provisions? Does the existence of this provision shift risk to the lessor or to the lessee?

2. Starting in 2019 all lease obligations must show up on the balance sheet of a corporation. This is effect does away with what type of lease in accounting speak the operating lease or the capital lease?

Answer 1

Most leases have expensive cancellation provisions, for the obvious reason to deter or discourage the lessee from terminating the lease,mid-way.It is not only expensive , but also cumbersome , to come out of the lease.Taking in view, the difficulties to both the lessee & the lessor, most lease agreements contain stringent provisions regarding cancellation ,half-way during the agreed lease-term.This is to protect both the parties involved.

The lessor (the who rents out the property) will be counting on the regular payments .He might spent money on registering the lease.Now finding another lessee for his asset, will be time consuming , also with another set of additional expenses---leave alone the mental stress before finalising a new one and the addendent unsettlement.Also to be counted ,is the loss of income(lease rent revenue) , for the intervening period, till he finds a new lessee.If he has financed the asset by borrowing, the lessor will also be answerable for his lender, who will be banking upon this regular lease rental income---depending on which , the borrower could have fixed his cost.

Similarly, for the lessee, if the lessor cancels the lease ,after inception & agreement, his routine will be affected & all his plans based on the leased property , will go hay-wire.The uncertainty willl cause financial as well as emotional stress.Due to the time value of money, new lease amount , may be more expensive .

Thus to save from all these, lease agreements impose stiff penalties for termination of the lease, which is resorted to , by both parties, mostly the lessee, under extreme exigencies.

This is more of existence of an EXIT CLAUSE, in the event of any genuine exigencies, arising , for both the parties. Mostly lessors do not agree for early termination , in commercial leases.

That said,

the existence of this provision shifts the RISK to the LESSOR only ,

as the lessee may opt to pay the penalties ,strictly, as laid down in the agreement & choose to walk out,in which case, he cannot be legally proceeded against.

As said above,the lessor has to start all over again, till he finds a new lessee.

Because he is the owner of the property & he wants to earn income from that, or else, as referred earlier, he might have borrowed , to buy this asset and may have to pay interest on the loan , from these lease rentals received.

2. Starting in 2019 all lease obligations must show up on the balance sheet of a corporation. This is effect does away with what type of lease in accounting speak the operating lease or the capital lease?

The new standard does away with operating leases---that are off-balance sheet ,now--ie. Only lease rent expenses appear in the Income Statement & the shareholders may not know anything more than that.

There is going to be no more operating leases --Lessees are required to recognise their right-of-use assets(for all the years of their use) , as also the unamortised periodic lease liability --on the balance sheet --- so, from now on, the lease rent expense will become depreciation & interest expense --as is the case with capital leases.