Issue What is the accounting treatment, from a lessor’s perspective, for costs incurred by the lessor to evict tenants? Are these costs capitalised or expensed as incurred?
Scenario 1
A lessor makes compensation payments to evict the tenants in an investment property with the intention to refurbish/renovate the property.
Scenario 2
A lessor makes a compensation payment to evict a tenant in a multi-tenanted investment property with the intention to re-let the vacated space to a new tenant. The lessor has signed an agreement with the new tenant to occupy the space that the existing tenant is occupying. Under the agreement, the new tenant will pay a significantly higher rent than the existing tenant.
Scenario 3
The same fact pattern as Scenario 2, except that the lessor has not yet found a new tenant when it evicts the existing tenant.
Relevant literature
Under Indian GAAP the following accounting literature is relevant for concluding on this fact pattern.
Paragraph 20 & 21 of AS-10 Accounting for Fixed Assets
Paragraph 20 : The cost of a fixed asset should comprise its purchase price and any attributable cost of bringing the asset to its working condition for its intended use.
Paragraph 21 : The cost of a self-constructed fixed asset should comprise those costs that relate directly to the specific asset and those that are attributable to the construction activity in general and can be allocated to the specific asset.
Paragraph 31 & 42 of AS-19 Leases Paragraph 31 : Initial direct costs, such as commissions and legal fees, are often incurred by lessors in negotiating and arranging a lease. For finance leases, these initial direct costs are incurred to produce finance income and are either recognised immediately in the statement of profit and loss or allocated against the finance income over the lease term.
Paragraph 42 : Initial direct costs incurred specifically to earn revenues from an operating lease are either deferred and allocated to income over the lease term in proportion to the recognition of rent income, or are recognised as an expense in the statement of profit and loss in the period in which they are incurred.
Author’s view Scenario 1 View A — Expense the eviction costs as incurred
The eviction costs are costs of terminating the existing lease. Therefore, they should be expensed as incurred.
View B — Capitalise the eviction costs It is necessary for the lessor to make eviction payments to the existing tenants in order to refurbish the property. The eviction costs are directly attributable to the property and meet the definition of construction costs of the property and are costs required to bring the asset to “the condition necessary for it to be capable of operating in the manner intended by management”. Therefore, the costs should be capitalised.
Considering paragraph 20 & 21 of AS-10, the author believes that View B is more appropriate.
Scenario 2
View A — Expense the eviction cost as incurred
The eviction cost is a cost of terminating the existing lease, and does not represent a cost of the underlying investment property. Therefore, it should be expensed as incurred.
View B — Eviction costs are initial direct costs and hence can be either capitalised or expensed
Since the lessor has signed an agreement with a new tenant, it must evict the existing tenant in order to allow the new tenant to move into the property. The eviction cost is an initial direct cost incurred by the lessor to arrange the new lease.
For a lessor, paragraph 31 in the case of a finance lease and paragraph 42 in the case of an operating lease, allows either expensing or amortisation of the eviction cost. For finance leases, these eviction costs are incurred to produce finance income and are either recognised immediately in the statement of profit and loss or allocated against the finance income over the lease term. In case of operating lease, eviction costs are either deferred and allocated to income over the lease term in proportion to the recognition of rent income or expensed as incurred.
Hence, for scenario 2, the author believes that the eviction costs are initial direct costs and could be either expensed or capitalised (View B). Nonetheless, some may argue that initial direct costs include expenses such as legal fees and commission (as per paragraph 31) and not eviction costs. Hence they may favour View A, which requires compulsorily expensing as those costs are incurred.
Scenario 3
In the absence of a secured new lease contract the eviction of existing tenants and the costs incurred thereon would not constitute initial direct costs of entering into a new lease arrangement. Consequently, the author believes that such costs should not be capitalised. Nonetheless, some may still argue that under the Framework for the Preparation and Presentation of Financial Statements “An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.” Therefore, based on the asset definition in the framework, some may argue, it is possible to capitalise and amortise such eviction costs.
Considering that these issues are highly debatable the ICAI may consider providing guidance.
