Lease Accounting: Tenant Improvement Allowance
Tenant enhancement allowance is a win-win for a commercial real estate area. Landlords are constantly pleased to have their residential or commercial properties improved, and tenants are constantly looking for a much better handle shared build-out costs. This causes situations in which an occupant makes remodellings, repair work, or other improvements to a rented area in exchange for a break on lease payments or other compensation. It's a very common arrangement between a lessor (the property owner) and the lessee (the renter). But for lease accounting professionals, it's not constantly clear how these transactions need to be recorded and represented.
A that pays money to an occupant as compensation for leasehold improvements has provided the lessee with a renter enhancement allowance (TIA) for stated future enhancements. TIAs are a type of lease rewards. The new lease accounting requirements ASC 842 and IFRS 16 bring many modifications to accounting practices for tenant improvement allowances and lease rewards.
Tenant Improvement & Lease Negotiation
Tenant improvement allowance does not require to be paid back, so it is used to work out during the lease-signing process. Other variable factors that influence a tenant's lease agreement are base rent, complimentary lease, and longer-term lease offers. Residential or commercial property owners use TI allowance to incentivize quality occupants throughout the settlement process with a complete space that fits their distinct organization requirements. If your commercial property group executes a lease with TI allowance, then it has upstream effects to your lease accounting procedures.
To assist you understand the principles and the modifications involved with the new lease accounting requirements, here's a guide to whatever you require to know about tenant improvement allowance accounting.
A Bit About Lease Incentives
Before digging into the information of TIAs, you ought to initially consider what constitutes a lease reward. The common practice of exchanging leased residential or commercial property enhancements for some monetary factor to consider certainly certifies as a lease incentive.
But that's simply one prospective reward, and it assists to understand the larger photo of lease rewards. It also helps you comprehend why ASC 842 has the guidance it provides for lease incentives and TIAs-and how that assistance has actually altered since ASC 840.
ASC 842 defines a lease reward as one of two things:
- Reimbursement or payments made to or on behalf of a lessee.
- Losses sustained by a lessor as an outcome of presuming a lessee's pre-existing lease arrangement with a 3rd party.
IFRS 16 defines a lease reward as payments or repayment made by a lessor to a lessee related to a lease. Aside from the varying definitions, ASC 842 and IFRS 16 treat lease rewards and TIAs basically the very same. To keep things easy, the rest of this post refers to ASC 842 only, however the exact same principles apply to IFRS 16.
The brand-new lease accounting requirements need all leases to be recorded on a company's balance sheet as lease liabilities and right of use (ROU) assets. The main reason lease incentives in general-and renter enhancement allowances specifically-are so essential to the new standard is since the formula for computing an ROU property consists of lease incentives.
That formula is:
ROU possession =
Initial lease liability
PLUS Prepaid lease payments
PLUS Initial direct costs
MINUS Any lease incentives got
With that in mind, it's simple to see why you require to properly represent lease rewards, including TIAs. As a crucial part of the ROU possession, lease incentives have an effect on all journal entries associated with a lease. And considering that the ROU possession didn't exist in ASC 840 and other earlier requirements, this represents a considerable modification in practice for lease accounting professionals.
Should tenant improvement allowance be capitalized?
Tenant enhancements are long-term properties that add worth to industrial residential or commercial properties. If they extend the helpful life of a residential or commercial property and/or improve the residential or commercial property's value, occupant improvements should be capitalized.
How ASC 840 Accounted for Tenant Improvement Allowances
Under ASC 840, when a lessee received a TIA, they followed the guidance for lease rewards. Under the old standard, the guidance was merely to acknowledge the TIA as a decrease to rent expense on a straight-line basis over the term of the lease.
This made journal entries a reasonably basic job: record the payment as a debit to money, with a balancing out credit to a lease incentive liability. This liability would be amortized as a decrease to lease expenditures over the regard to the lease. In cases where a TIA was received right away, the lessee would debit receivables.
While ASC 842 still classifies TIAs as lease incentives, this is where resemblances in the accounting procedure end.
How ASC 842 Accounts for Tenant Improvement Allowances
The major change in ASC 842 concerning TIAs is that they are no longer reported as lease reward liability and amortized over the life of the lease. Lease rewards are typically taped in the initial measurement of the ROU possession and the matching lease liability.
Naturally, that assumes that any renter enhancement allowances are known upfront and kept in mind in the lease contract. To be sure, this is a typical practice. It's not unusual to see TIAs mentioned in lease contracts, either as a lump sum or set as a rate per square foot. But ASC 842 contains assistance to account for the timing of lease rewards, including TIAs.
The language utilized is "paid" rewards (paid to the lessee prior to or at commencement of the lease) and "payable" incentives (payable at some time after commencement). Paid and payable lease incentives are represented in various ways under ASC 842. Here's a take a look at how both paid and payable TIAs are handled and how they both impact the ROU possession and lease liabilities.
TIAs Paid At or Before Lease Commencement
For TIAs paid to the lessee prior to or at the time of lease beginning, ASC 842 guidance states these lease rewards are accounted for as a direct adjustment to the opening balance of the ROU property.
The ROU asset is always at first equal to the lease liability, which itself is determined as today value of future payments. That figure is then changed by the other aspects in the ROU possession formula, including reductions to rent liability in the kind of a lease incentive, such as a TIA, which suggests the impact of a paid lease incentive or TIA is that it decreases the ROU asset.
For entities making the transition to ASC 842, any unamortized balance of a TIA is debited so that it eliminates the lease incentive liability from the balance sheet. It is then reclassified to the ROU asset's opening balance by way of a credit.
After an ASC 842 transition is complete, TIAs got at the time of lease beginning are recognized as a debit to cash and a change to the preliminary value of the ROU asset. This is achieved with a credit to the lease liability account and a debit to the ROU property, equal to the preliminary liability balance minus the amount of the TIA.
TIAs Payable After Lease Commencement
Sometimes, a tenant enhancement allowance is received as a decrease of lease payments in the durations when the improvements to the leased residential or commercial property happen. The ASC 842 assistance for lease incentives, consisting of TIAs, paid after the lease commencement date is factored into the lease liability in addition to the ROU asset measurement.
Recall that the lease liability under the new standards is computed as the present value of future payments. That includes payments got for an occupant improvement allowance. The timing of capital is a vital element in present value computations, and that's shown in how TIA payments are recorded.
Payments for improvements must be tape-recorded in the duration when they are expected to be received during the lease term and then netted with the lease payments for that same period. The lease liability is decreased due to the fact that of the anticipated cash payments, and this also has the impact of reducing the ROU property balance.
TIAs That Are Neither Paid Nor Payable
Beyond paid and payable lease incentives, a third kind of lease incentive is those that fit neither category.
Lease incentives that are neither paid nor payable are contingent on, or only receivable after, some future occasion takes location. While ASC 842 acknowledges that this is a type of lease incentive that could exist, it doesn't offer any particular guidance on how to appropriately account for incentives that fall under this category. Therefore, numerous techniques have been used to account for TIAs of this type.
One common method is to determine if lease terms include a maximum quantity of compensation and assess whether the lessee is likely to sustain those costs. If so, that optimum quantity of repayment can be treated as a payable lease reward, with the corresponding decrease to the ROU property and lease liability.
A second technique is to wait until all reimbursable costs have actually been sustained and after that lower the ROU possession and lease liability by that amount.
As companies and their lease accounting professionals spend more time under ASC 842 and more audit cycles have actually occurred, more conclusive assistance on this third type of lease reward will likely emerge. It's likewise possible that FASB may modify ASC 842's guidelines to cover this third kind of lease reward at some time in the future.
Leasehold Improvements: Lessor Asset or Lessee Asset?
One of the more vital elements of an effective ASC 842 transition is properly determining and categorizing leases. The brand-new requirement requires all leases to be taped on the balance sheet and under one of 2 classifications - operating leases or finance leases (previously referred to as capital leases under ASC 840). ASC 842 also requires that ingrained leases be detected in other agreements that might not be outwardly recognized as a lease arrangement.
When it pertains to renter enhancement allowances and lease rewards more usually, it's also critical to identify if a leasehold enhancement qualifies as a lessor possession or a lessee asset.
The term "leasehold enhancement" is a sort of catch-all term utilized to describe a renter performing improvements on a rented area and receiving some sort of settlement in return. However, it's not always clear if the reduced rent payments or other reimbursement is a kind of lease reward and a property for the lessee.
ASC 842 deal high-level assistance concerning this. According to the standard, if a lessee is making improvements to a rented area with their own branding and will then own the enhancements, it qualifies as a lessee property. However, if the improvements are in fact a lessor property, any repayment or payment for the enhancement would require to be represented differently.
Some of the elements to consider in the lessor property vs. lessee property decision revolve around requirements set out in the lease contract. When a lease needs a lessee to make specified improvements, it will be a lessor asset. On the other hand, if the enhancements are not required, are particular to the lessee, and can't be utilized by subsequent tenants, they are a lessee possession.
Lessor Asset Accounting Under ASC 842
If a leasehold improvement is identified to be a lessor possession, the lessee ought to not represent it as a lease incentive.
For circumstances, if a lessor contractually requires a lessee to sustain the costs of fixing the leased space's front door and entrance before lease beginning, this is not a lease incentive. The lessee would represent the repair work expenditures as prepaid lease. Any reimbursements, consisting of reductions in month-to-month rent payments, would be accounted for as a decline to that prepaid rent.
Unreimbursed portions of the improvement expenditure are then included in lease payments upon commencement of the lease.
If a leasehold improvement is identified to be a lessee property, then it certifies as an occupant enhancement allowance under ASC 842. All of the assistance on accounting for lease rewards applies, with appropriate measurement of the ROU asset and lease liabilities.
Occupier Makes Tenant Improvement Allowance Accounting Easier
The changes made to occupant improvement allowance accounting from ASC 840 to ASC 842 are anything but straightforward. Whereas lease incentives were an easy matter of credits and debits under the old requirement, lease accounting professionals need to now be familiar with the ROU possession, today worth of future payments, and lease liabilities in order to upgrade your balance sheet and earnings statement.
All of these changes include transparency to renting arrangements and costs, eventually giving your company's financial statements more accuracy. Mastering all the requirements of ASC 842 is considerably easier with a modern lease accounting software application. Here at Occupier, we offer the most comprehensive service, built on an user-friendly and ingenious tech stack.