The accounting for lease looks quiet simple, doesn’t it? But if you really go in to the field and experience with the real transactions, you will find a lot of different transactions involved before and after the lease agreement—which is connected with the lease closely. Lease incentives vs. tenant improvements are two among many transactions. In recent times there has been considerable confusion regarding what constitutes a lease incentive or tenant improvement. Sometimes it may not be clear whether funds provided by the landlord in connection with a lease represent lease incentives or tenant improvements. Some cases are not clear cut and may require significant judgment and consideration of several factors.
So, what is lease incentive and what is tenant improvement, how those two different transactions are recorded? Here they are “Accounting For Lease Incentives and Tenant Improvements”.
Lease incentives are payments made by a lessor to or on behalf of a lessee to entice the lessee to sign a lease. Lease incentives may include up-front cash payments to the lessee, payment of costs on behalf of the lessee (such as moving expenses), termination fees to lessee’s prior landlord, or lessor’s assumption of lessee’s lease obligation under a different lease with another landlord.
Lease incentives are sometimes called tenant inducements and should be accounted for as reductions of rental expenses by the lessee and as reductions of rental revenue by the lessor on a straight-line basis over the term of the lease.
In a lease incentive arrangement in which the lessor agrees to assume the lessee’s prior lease with a prior landlord, any estimated loss from the assumption of that lease by the lessor would need to be recognized over the term of the new lease by the lessor.
If you’re under the U.S jurisdiction, you may know what the Financial Accounting Standard Board FASB says. Particularly, the Technical Bulletin No. 88-1 (Issues Relating to Accounting for Leases) allows the lessor and the lessee to independently estimate any loss as a result of the lessor’s assumption of the lease; thus, both parties can have different measurements and record different estimated losses.
“… [t]he lessee’s estimate of the incentive could be based on a comparison of the new lease with the market rental rate available for similar lease property or the market rental rate from the same lessor without the lease assumption, and the lessor should estimate any loss based on the total remaining costs reduced by the expected benefits from the sublease or use of the assumed leased property.”
In addition, any future changes in the estimated loss, such as due to changes in the leasing assumptions, should be accounted as a change in estimates.
In accordance with Financial Accounting Standards Board (FAS) 154, “Accounting Changes and Error Corrections”, it should be recognized during the period in which the change occurred. Note, however, that the guidance does not change the immediate recognition by the lessee of items such as moving expenses, losses on subleases, and write-offs of abandoned improvements at the old premises.
Lease Incentives Case Example
To illustrate the accounting for a loss on a lessor assumption of the lessee’s lease with a third party, let me assume that the lessee signs a 10-year lease with the lessor and the lessor agreed to assume the lessee’s lease with a third party that has 3 years remaining. Also assume these other terms of the deal:
- Annual lease payment on the old lease assumed by lessor is $120,000.
- Annual lease payment by the lessee on the new lease is $250,000.
- Lessor’s estimated annual sublease revenue on the old premises is $110,000.
- Lessor’s estimated total loss from assuming lease is $60,000.
- Lessee’s estimate of the incentive is $50,000.
The proper journal entries to be recorded by the lessor and the lessee would be:
On The Lessor’s Book:
At the lease inception, you would record the following entries:
[Debit]. Lease incentive = $60,000
[Credit]. Sublease liability = $60,000
To record annual sublease payment and amortized sublease liability in years 1–3, you would make:
[Debit]. Sublease liability (60,000/3yr) = $20,000
[Debit]. Sublease expense = $100,000
[Credit]. Cash = $120,000
To record revenue on the new lease and amortized lease incentive in year 1-10, you would make the following journal entries:
[Debit]. Cash $250,000
[Credit]. Rental revenue = $244,000
[Credit]. Lease incentive (60,000/10yrs) = $6,000
On The Lessee’s Book:
At lease inception, they would make the following journal entries:
[Debit]. Loss on lease assumed by new lessor = $50,000
[Credit]. Incentive from Lessor = $50,000
(To recognize loss on sublease and the related incentive)
To record annual rental expense and amortization of incentive from lessor in years 1-10, they would make the following entries:
[Debit]. Incentives from Lessor ($50,000/10) = $5,000
[Debit]. Rental Expense = 245,000
[Credit]. Cash = $250,000
Tenant improvements are capital expenditures made by the landlord to prepare the space for lease. Such improvements are capital assets of the landlord. These improvements are components of the property and therefore should be capitalized and depreciated over their useful life consistent with the accounting for property, plant, and equipment. (Note: For IRS basis reporting entities, the improvements are depreciated over 39 years on a straight-line basis; however, if any of the investors in the entity are tax exempt entities, the depreciation would be over 40 years.)
So, what is the journal entry? You asked. The journal entry to record expenditures for tenant improvements of $100,000 with a 10-year useful life as an example, would be:
[Debit]. Tenant improvement = $100,000
[Credit]. Accounts Payable or Cash = $100,000
The recurring annual journal entry to record depreciation of the improvement is:
[Debit]. Depreciation ($100,000/10) = $10,000
[Credit]. Accumulated depreciation = $10,000
If at any time it was determined that the useful life of this improvement is different from what was anticipated, the annual depreciation should be adjusted going forward in accordance with the accounting for change in estimates.
One reason that the useful life of a tenant improvement changes could be that the premises where the improvements were made was subsequently leased to a tenant for an eight-year term, and it is expected that the improvements would no longer be useful at the end of that time. In this case, the depreciable life of these tenant improvements would be through the end of the lease.
Depreciation of tenant improvements should commence as soon as the improvements are substantially complete and the premises are ready for their intended use. If a lease commences while a landlord is still completing tenant improvements, revenue recognition should not start until the tenant improvements are complete, regardless of whether a tenant started paying rent or not.
In addition, there could be lease arrangements in which payments made by tenants are appropriately classified as tenant improvements and the landlord paid only a portion of the total cost of the improvements. In a situation like this, the landlord will still record the asset and the usual periodic depreciation; the portion paid by the tenant should still be recorded as asset by the landlord but with a corresponding credit to a deferred liability.
The assets should be depreciated over the shorter of the useful life or the lease term; the deferred liability should be amortized to rental revenue on a straight-line basis over the term of the related lease.
How To Determine Lease Incentives Vs Tenant Improvements
Determining whether ‘funds provided by a landlord’ is a tenant improvement or incentive should be based on the substance and contractual rights of the lessor and lessee.
Deloitte & Touche, ‘‘Lessor Accounting Issues: Follow Up to Heads Up’’ (12, No. 1, March 2005) have indicated that, factors to consider in determining whether a funding is a tenant improvement or incentive include but are not limited to these seven points:
- Whether the tenant is obligated by the terms of the lease agreement to construct or install specifically identified assets (i.e., the leasehold improvements) as a condition of the lease.
- Whether the failure by the tenant to make specified improvements is an event of default under which the landlord can require the lessee to make those improvements or otherwise enforce the landlord’s rights to those assets (or a monetary equivalent).
- Whether the tenant is permitted to alter or remove the leasehold improvements without the consent of the landlord and/or without compensating the landlord for any lost utility or diminution in fair value.
- Whether the tenant is required to provide the landlord with evidence supporting the cost of tenant improvements prior to the landlord paying the tenant for the tenant improvements.
- Whether the landlord is obligated to fund cost overruns for the construction of leasehold improvements.
- Whether the leasehold improvements are unique to the tenant or could reasonably be used by the lessor to lease to other parties.
- Whether the economic life of the leasehold improvements is such that it is anticipated that a significant residual value of the assets will accrue to the benefit of the landlord at the end of the lease term.
These factors show how complicated some leases can be in determining whether funds provided by a landlord is a lease incentive or tenant improvement.
So, now you knew how to determine whether a funding is a lease incentive or a tenant improvement. How this cost should be presented on the cash flow statement? As mentioned earlier, tenant improvements are capital assets and therefore should be presented on the investing activities section of the landlord’s cash flow statement. Lease incentives, however, are operating activities and should be presented as such.
Most often when a tenant leaves and the space is leased to a new tenant, the landlord demolishes some improvements related to the space to get it ready for the new tenant. The question is how the costs of demolition and the removed improvement should be accounted. Internal Revenue Code 168(i)(8)(B) requires that the unrecovered basis of improvements that are demolished should be written off. If a portion of the improvements from the old tenant is to be used by the new tenant, the remaining portion should continue to be depreciated.