Lease Accounting: Tenant Improvement Allowance
Last Updated on May 25, 2023 by Morgan Beard
Tenant improvement allowance is a win-win for a commercial real estate space. Landlords are always happy to have their properties improved, and tenants are always looking for a better deal with shared build-out costs. This leads to scenarios in which a tenant makes renovations, repairs, or other improvements to a leased space in exchange for a break on rent payments or other compensation. It’s a very common agreement between a lessor (the landlord) and the lessee (the tenant). But for lease accountants, it’s not always clear how these transactions should be recorded and accounted for.
A landlord that pays money to a tenant as reimbursement for leasehold improvements has provided the lessee with a tenant improvement allowance (TIA) for said future improvements. TIAs are a form of lease incentives. The new lease accounting standards ASC 842 and IFRS 16 bring many changes to accounting practices for tenant improvement allowances and lease incentives.
Tenant Improvement & Lease Negotiation
Tenant improvement allowance does not need to be repaid, so it is used to negotiate during the lease-signing process. Other variable factors that influence a tenant’s lease agreement are base rent, free rent, and longer-term lease deals. Property owners offer TI allowance to incentivize quality tenants during the negotiation process with a complete space that suits their unique business needs. If your commercial real estate team executes a lease with TI allowance, then it has upstream impacts to your lease accounting processes.
To help you understand the concepts and the changes involved with the new lease accounting standards, here’s a guide to everything you need to know about tenant improvement allowance accounting.
A Bit About Lease Incentives
Before digging into the details of TIAs, you should first consider what constitutes a lease incentive. The common practice of exchanging leased property improvements for some financial consideration certainly qualifies as a lease incentive.
But that’s just one potential incentive, and it helps to understand the bigger picture of lease incentives. It also helps you understand why ASC 842 has the guidance it does for lease incentives and TIAs—and how that guidance has changed since ASC 840.
ASC 842 defines a lease incentive as one of two things:
- Reimbursement or payments made to or on behalf of a lessee.
- Losses incurred by a lessor as a result of assuming a lessee’s pre-existing lease agreement with a third party.
IFRS 16 defines a lease incentive as payments or reimbursement made by a lessor to a lessee associated with a lease. Other than the differing definitions, ASC 842 and IFRS 16 treat lease incentives and TIAs essentially the same. To keep things simple, the rest of this post refers to ASC 842 only, but the same concepts apply to IFRS 16.
The new lease accounting standards require all leases to be recorded on an organization’s balance sheet as lease liabilities and right of use (ROU) assets. The main reason lease incentives in general—and tenant improvement allowances specifically—are so important to the new standard is because the formula for calculating an ROU asset includes lease incentives.
That formula is:
ROU asset =
Initial lease liability
PLUS Prepaid lease payments
PLUS Initial direct costs
MINUS Any lease incentives received
With that in mind, it’s easy to see why you need to accurately account for lease incentives, including TIAs. As a critical part of the ROU asset, lease incentives have an impact on all journal entries related to a lease. And since the ROU asset didn’t exist in ASC 840 and other earlier standards, this represents a significant change in practice for lease accountants.
Should tenant improvement allowance be capitalized?
Tenant improvements are long-term assets that add value to commercial properties. If they extend the useful life of a property and/or enhance the property’s value, tenant 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 incentives. Under the old standard, the guidance was simply to recognize the TIA as a reduction to rent expense on a straight-line basis over the term of the lease.
This made journal entries a relatively simple task: record the payment as a debit to cash, with an offsetting credit to a lease incentive liability. This liability would be amortized as a reduction to rent expenses over the term of the lease. In cases where a TIA was received immediately, the lessee would debit accounts receivable.
While ASC 842 still classifies TIAs as lease incentives, this is where similarities in the accounting process end.
How ASC 842 Accounts for Tenant Improvement Allowances
The major change in ASC 842 regarding TIAs is that they are no longer reported as lease incentive liability and amortized over the life of the lease. Lease incentives are often recorded in the initial measurement of the ROU asset and the corresponding lease liability.
Of course, that assumes that any tenant improvement allowances are known upfront and noted in the lease contract. To be sure, this is a common practice. It’s not unusual to see TIAs stated in lease agreements, either as a lump sum or set as a rate per square foot. But ASC 842 contains guidance to account for the timing of lease incentives, including TIAs.
The language used is “paid” incentives (paid to the lessee prior to or at commencement of the lease) and “payable” incentives (payable at some point after commencement). Paid and payable lease incentives are accounted for in different ways under ASC 842. Here’s a look at how both paid and payable TIAs are handled and how they both affect the ROU asset and lease liabilities.
TIAs Paid At or Before Lease Commencement
For TIAs paid to the lessee prior to or at the time of lease commencement, ASC 842 guidance says these lease incentives are accounted for as a direct adjustment to the opening balance of the ROU asset.
The ROU asset is always initially equal to the lease liability, which itself is calculated as the present value of future payments. That figure is then adjusted by the other factors in the ROU asset formula, including reductions to lease liability in the form of a lease incentive, such as a TIA, which means the impact of a paid lease incentive or TIA is that it lowers the ROU asset.
For entities making the transition to ASC 842, any unamortized balance of a TIA is debited so that it removes 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 received at the time of lease commencement are recognized as a debit to cash and an adjustment to the initial value of the ROU asset. This is accomplished with a credit to the lease liability account and a debit to the ROU asset, equal to the initial liability balance minus the amount of the TIA.
TIAs Payable After Lease Commencement
In some cases, a tenant improvement allowance is received as a reduction of rent payments in the periods when the improvements to the leased property occur. The ASC 842 guidance for lease incentives, including 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 calculated as the present value of future payments. That includes payments received for a tenant improvement allowance. The timing of cash flows is a critical factor in present value calculations, and that’s reflected in how TIA payments are recorded.
Payments for improvements should be recorded in the period when they are expected to be received during the lease term and then netted with the rent payments for that same period. The lease liability is lowered because of the expected cash payments, and this also has the effect of lowering the ROU asset balance.
TIAs That Are Neither Paid Nor Payable
Beyond paid and payable lease incentives, a third type 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 event takes place. While ASC 842 recognizes that this is a type of lease incentive that could exist, it doesn’t provide any specific guidance on how to properly account for incentives that fall into this category. Therefore, various approaches have been used to account for TIAs of this type.
One common approach is to determine if lease terms include a maximum amount of reimbursement and assess whether the lessee is likely to incur those costs. If so, that maximum amount of reimbursement can be treated as a payable lease incentive, with the corresponding reduction to the ROU asset and lease liability.
A second approach is to wait until all reimbursable costs have been incurred and then reduce the ROU asset and lease liability by that amount.
As companies and their lease accountants spend more time under ASC 842 and more audit cycles have occurred, more definitive guidance on this third type of lease incentive will likely emerge. It’s also possible that FASB might modify ASC 842’s guidelines to cover this third type of lease incentive at some point in the future.
Leasehold Improvements: Lessor Asset or Lessee Asset?
One of the more critical aspects of a successful ASC 842 transition is properly identifying and classifying leases. The new standard requires all leases to be recorded on the balance sheet and under one of two categories — operating leases or finance leases (formerly known as capital leases under ASC 840). ASC 842 also requires that embedded leases be detected in other contracts that may not be outwardly identified as a lease agreement.
When it comes to tenant improvement allowances and lease incentives more generally, it’s also critical to identify if a leasehold improvement qualifies as a lessor asset or a lessee asset.
The term “leasehold improvement” is a sort of catch-all term used to describe a tenant performing improvements on a leased space and receiving some sort of compensation in return. However, it’s not always clear if the reduced rent payments or other reimbursement is a type of lease incentive and an asset for the lessee.
ASC 842 offer high-level guidance regarding this. According to the standard, if a lessee is making improvements to a rented space with their own branding and will then own the improvements, it qualifies as a lessee asset. However, if the improvements are actually a lessor asset, any reimbursement or compensation for the improvement would need to be accounted for differently.
Some of the factors to consider in the lessor asset vs. lessee asset determination revolve around requirements laid out in the lease contract. When a lease requires a lessee to make specified improvements, it will be a lessor asset. On the other hand, if the improvements are not required, are specific to the lessee, and can’t be used by subsequent tenants, they are a lessee asset.
Lessor Asset Accounting Under ASC 842
If a leasehold improvement is determined to be a lessor asset, the lessee should not account for it as a lease incentive.
For instance, if a lessor contractually requires a lessee to incur the costs of repairing the leased space’s front door and entryway before lease commencement, this is not a lease incentive. The lessee would account for the repair expenditures as prepaid rent. Any reimbursements, including reductions in monthly rent payments, would be accounted for as a decrease 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 determined to be a lessee asset, then it qualifies as a tenant improvement allowance under ASC 842. All of the guidance on accounting for lease incentives applies, with appropriate measurement of the ROU asset and lease liabilities.
Occupier Makes Tenant Improvement Allowance Accounting Easier
The changes made to tenant improvement allowance accounting from ASC 840 to ASC 842 are anything but straightforward. Whereas lease incentives were a simple matter of credits and debits under the old standard, lease accountants must now get to know the ROU asset, the present value of future payments, and lease liabilities in order to update your balance sheet and income statement.
All of these changes add transparency to leasing arrangements and costs, ultimately giving your company’s financial statements more accuracy. Mastering all the requirements of ASC 842 is significantly easier with a modern lease accounting software. Here at Occupier, we offer the most comprehensive solution, built upon an intuitive and innovative tech stack.
To see how Occupier can improve your lease accounting workflow, request a demo today.
