How to Account for Lease Incentives under ASC 842

November 11, 2021

Lessors often provide benefits to their lessees in the form of making payments to, or on behalf of, the lessee. Such payments could be moving costs, legal or professional fees, or an upfront cash payment. Lessors will occasionally also assume the lessee’s preexisting lease with another party.

Such payments or assumption of the lessee’s obligations are considered lease incentives and are recorded as a reduction in the lease right-of-use (ROU) asset, with a corresponding reduction in lease expense over the lease term. For example, if the present value of future lease payments is $1M, and the lessor provides an upfront payment of $100,000 to the lessee, then the lessee would record the following balances at the lease inception:

Dr. Cash               $100,000

Dr. ROU asset    $900,000 (set equal to the lease liability less the incentive received from the lessor

Cr. Lease liability    $1,000,000

Here, the annual lease expense, assuming a 10-year term for an operating lease, would be $90,000.

If the lease incentive is not paid at the start of the lease term, but is expected to be received at a later date, the lease liability is initially reduced by the present value of the future incentive to be received.  The lower initial lease liability also reduces the lessee’s initial ROU asset, but by less than if the lease incentive was paid up front. As a result, the initial lease liability would be lower, and ROU asset would have a greater value, than if the lease incentive was paid at the start of the lease. The total lease expense will be the same, however, irrespective of when the lease incentive is paid to the lessee.  For the example above, and assuming the PV of the $100,000 cash incentive to be paid in the future is $80,000, then the lessee would record the following at the lease inception:

Dr. ROU asset    $920,000

Cr. Lease liability    $920,000 (i.e. $1,000,000 – $80,000)

Here, the annual lease expense would also be $90,000.

The lease incentive could also affect the lease classification, that is whether the lease is a finance, or operating, lease.  Further, if the lessor makes the premises available to the lessee earlier than the ‘move in’ date, the lease term for accounting purposes will likely start earlier, and be longer, than it otherwise would.

Leasehold improvements:

Where the lessor makes payments to construct or improve the premises the lessee is renting, the question arises as to whether the improved asset is a ‘lessee’ or ‘lessor’ asset.  If the improved or constructed asset is a ‘lessor’ asset – i.e. deemed to primarily benefit the lessor rather than the lessee – then the improvements are not accounted for by the lessee.  Unfortunately, making this determination can require significant judgment.  Nevertheless, the following are indicators that the improvements may be lessee rather than lessor assets:

  • What happens to the improvements when the lease ends? If the landlord gets to keep or benefits from them, then they likely are not a lessee asset.
  • Are the improvements specialized to the lessee’s needs? For example, if the improvements are specialized laboratory or retail space designed to benefit the lessee, then they likely are lessee assets.
  • Which party supervises and/or bears the cost of the build out? Where the lessee is actively involved in supervising the build out or is required to pay for any cost overruns, this may suggest that the lessee is the ‘accounting’ owner (i.e. the entity that accounts for and records the assets) of the improvements.
  • Who legally owns the improvements? The legal owner may indicate who the ‘accounting’ owner is.

It’s important to note that there can be only one accounting owner of the improvements – that is the lessor and lessee cannot each record a portion of each leasehold improvement.  Similarly, just like the accounting under the prior guidance (ASC 840), any amounts attributed to leasehold improvements are capitalized as a fixed asset, and therefore, under ASC 842, are not included in the lessee’s ROU asset.

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