Tenant Improvement Allowance Accounting for Lessees under ASC 840

by | Oct 4, 2020 | 0 comments

What is a tenant improvement allowance?

A tenant improvement allowance (TIA) is generally defined as money paid by a landlord to the tenant/lessee to reimburse that tenant for the construction of leasehold improvements, such as modifications to commercial real estate. TIAs may also be paid directly to vendors on behalf of the lessee. TIAs are generally explicitly stated in the lease agreement as either a per square foot amount or a lump sum.

A lease incentive generally refers to any payments made to the tenant or on the tenant’s behalf by the landlord. This includes reimbursements for moving expenses, payments for tenants to break existing leases and payments for TIAs.

Because tenant improvement allowances typically don’t need to be repaid to the landlord, they are a common type of lease incentive and must be accounted for in accordance with lease guidance. The guidance under US GAAP includes the current FASB standard, ASC 840, as well as the new standard, ASC 842. In this blog, we will walk through the accounting under ASC 840. For a full explanation of tenant improvements and lease incentives under ASC 842, click here.

Lease Accounting Guide

ASC 840-20-25-7 defines lease incentives in the following way:

“Lease incentives include both of the following:

  • Payments made to or on behalf of the lessee
  • Losses incurred by the lessor as a result of assuming a lessee’s pre existing lease with a third party.”

While many landlords may provide reimbursement for hard construction expenses only, lease incentives can also cover soft costs (costs of obtaining permits, legal fees, etc.) if negotiated within the lease agreement.

How to account for tenant improvement allowances under ASC 840

Under ASC 840, when a lessee receives a Tenant Improvement Allowance, they are receiving a lease incentive. ASC 840-20-25-6 states that lease incentives shall be recognized as reductions to rental expense by the lessee (reductions to rental revenue by the lessor) on a straight-line basis over the term of the lease.

Therefore, the journal entry for a lessee at lease inception is to record the payment as a debit to cash, and to record an offsetting credit to a lease incentive obligation liability, which is amortized (as a reduction to rent expense) over the life of the lease. Sometimes, the tenant improvement allowance may not be received immediately, and in that case the lessee would debit A/R (accounts receivable).

We have seen some companies debit cash and credit leasehold improvements. This is a common mistake, as incentives received should not be netted against leasehold improvements. The accounting for leasehold improvements is accounted for separately from the funds received as a lease incentive.

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Accounting for TIAs under ASC 840 example

To illustrate the required journal entries and calculations for a TIA let’s assume the following facts:

Lease Term: 10 years

Base Rent: $1,000 annual payment (in arrears) in years 1-5, and $2,000 annual payment (in arrears) in years 6-10

Lease Classification: Operating Lease

Incentive: $1,000 tenant improvement allowance for leasehold improvements, received from lessor at lease commencement

Cost of leasehold improvements: $20,000 (Note: The leasehold improvements are accounted for separately from the lease, through the lessee’s routine fixed asset accounting process).

The lessee would make the following journal entry upon commencement of the lease and receipt of the $1,000 incentive:

1,000 incentive tenant improvement journal entry

The lessee records the leasehold improvements at the time the improvements are made for the amount the lessee pays through their normal fixed asset accounting process:

20,000 leasehold improvements

To calculate the amount of straight-line rent expense to be recognized per period, take the total amount of lease payments and divide it by the total number of periods in the lease term. For this example, the payments are $1,000 in years 1-5 and $2,000 in years 6-10. When calculated, the total lease payments is $15,000 (5 x $1,000 + 5 x $2,000). The lease term is 10 years, so we take the total value of the payments of $15,000 divided by 10 years to get a straight-line expense of $1,500 to be recognized annually.

The amortization schedule for the base rent of the initial lease would look as follows:

base rent amortization schedule

The lessee makes the following journal entry to record the first year’s rent expense, rent payment, and deferred rent, following the amortization table above:

1,500 rent expense

However, this straight-line rent expense calculation does not take the TIA into consideration so we have a second step to make sure we arrive at the correct accounting treatment for the lease incentive. Lease incentives, in this case, the TI allowance, that are paid or payable at lease commencement decrease the consideration in the contract. Therefore, the lessee needs to subtract the $1,000 tenant improvement allowance received from the landlord from the total required cash payments of $15,000, resulting in $14,000 of total consideration and an annual straight-line expense of $1,400 ($14,000 / 10 years).

The TIA amortization schedule for the initial lease would look like this:

tenant improvement allowance amortization schedule

The entry to reduce the lease expense each year by $100, and to amortize the tenant improvement allowance, at the end of year 1 is shown separately below:

lease incentive liability

In practice, the above two entries can be combined into one annual, or periodic entry:

periodic entry of amortization schedule

Note that as a result of the TIA, rent expense each year is $1,400 instead of $1,500.

A common question about TIAs is how the entries would be different if the tenant does not receive the cash directly, that is, the tenant submits invoices to the landlord and the landlord pays the contractor directly instead of reimbursing the tenant. In that case, rather than debiting cash in the first entry, you would debit leasehold improvements:

lessor debit of leasehold improvements

In the second entry, the lessee debits leasehold improvements for only the cost of the leasehold improvements that was paid for directly by the lessee in its normal fixed asset process:

record leasehold improvements paid by tenant

This scenario still results in the recognition of $20,000 of leasehold improvements, comprised of the $19,000 of cash outlaid by the lessee and the $1,000 paid on behalf of the lessee.

Note that the $1,000 paid directly to the contractor by the landlord would be reported as a non-cash transaction in the lessee’s supplemental cash flow disclosures.

Accounting for tenant improvement allowances when a lease renews

As discussed above, a tenant improvement allowance is recorded as a liability which is amortized (as a reduction to rent expense) over the life of the lease. It is generally accepted practice, that if the lease is extended through a renewal option, the unamortized balance of the initial tenant improvement allowance should be amortized over the remaining term of the modified lease.

A common error is to continue amortizing the TIA over the initial lease term without adjusting the amortization period to reflect the updated lease term. This is incorrect and results in the understatement of expense in the earlier years of the lease and the overstatement of expense in the latter years of the lease. In order to understand the correct accounting, we have included an example below.

Accounting for TIAs in renewals under ASC 840 example

Let’s assume we have the same facts as above, but now at the beginning of Year 7, the company decides to renew the lease for an additional 4 years. The payments are now $3,000 in years 7-10 and $4,000 in years 11-14.

The journal entries to record the incentive, the leasehold improvements, the amortization of the incentive and the lease payment for the first 6 years under the initial lease are the same as above.

Now let’s take a look at the journal entries for the renewal. Recall that at the end of Year 6, the company decides to renew the lease for an additional 4 years, and the payments are now $3,000 in years 7-10 and $4,000 in years 11-14. Based on this, the new lease term is 8 years (years 7 through 14). To record the rent payment in Year 7, calculate the new straight-line expense by taking the new total value of the payments from Years 7 through 14, less the $2,000 balance of deferred rent at the end of Year 6, calculated as $26,000, or $28,000 minus $2,000. Divide this value by the remaining 8 year lease term to come up with a period straight-line rent expense of $3,250.

The base rent amortization schedule for the renewed lease is below:

base rent amortization schedule renewed lease

The entry to record the rent payment and expense at the end of Year 7, reflecting the renewal, is as follows:

year 7 rent payment and expense

To calculate the amortization of the tenant improvement allowance after the renewal, take the unamortized balance at the end of Year 6 of $400 and divide it by the 8-year lease term (Years 7 through 14) to come up with the new amortization amount of $50 each year.

Below is the TIA amortization schedule for the renewed lease:

tenant improvement allowance schedule for renewed lease

The journal entry to record the amortization of the TIA each period after the renewal is as follows:

tenant improvement allowance amortization after renewal

Notice that the net rent expense for the initial lease was $1,400 for years 1 – 6, while the net rent expense for the renewed lease is $3,200 ($3,250 minus $50). If we hadn’t correctly adjusted our amortization of the TIA upon the change in lease term, we would have been understating our expense in years 7-10 and overstating our expense in years 11-14.

When using LeaseQuery, calculations for lease incentives are handled automatically by the system. Simply enter the new rent payments per the renewal, and LeaseQuery calculates your new base rent expense adjusted for any previous deferred or prepaid rent and adjusts the amortization of the TIA as required by ASC 840.

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Tenant improvement allowances are a type of lease incentive, which are recognized by the lessee as a reduction to rental expense (or a reduction to rental revenue by the lessor) on a straight-line basis over the term of the lease. Now that we have walked through an example of accounting for a TIA under ASC 840 and the real-life example of a renegotiated lease term, hopefully these illustrations make the interpretations easier for you.

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