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The new lease accounting standard,
842, addresses a number of hot topics y’all should be aware of as a lessee. One of these topics is how to treat lease incentives. This article volition walk through the proper accounting treatment.
An executed lease understanding always involves two parties, the lessor and the lessee. Typically, the execution of that understanding involves some negotiation between the parties. One of the well-nigh mutual ways lessors motivate lessees to wrap-up negotiations and sign on the dotted line is past offering the lessee a “lease incentive.”
What is a lease incentive?
A charter incentive is a payment made from a lessor straight to a lessee, or on behalf of a lessee. Every bit such, a lease incentive tin can come in many different forms and look similar a lot of different things. Lease incentives exercise not include payments from the lessor to the lessee for any good or service that the lessee is providing to the lessor.
Mutual examples of lease incentives are:
- A lump sum cash payment from the lessor to the lessee at the appointment of lease execution
- A payment from the lessor to the lessee during the lease term to reimburse for leasehold improvements
- The lessor taking over a lessee’s pre-existing lease to entice the lessee to enter into a new charter with the lessor
Regardless of what it may look like in practice, if yous are dealing with a payment from the lessor to, or on behalf of, the lessee, y’all are most likely dealing with a lease incentive.
It’southward a lease incentive: How do we treat it?
Let’s take a closer await at one of the more common incentive scenarios:
Typically, a lessee will want to update a space to fit their business needs earlier moving in. Leasing a completely empty floor, for example, would probably not be suitable for a growing business if they want to hitting the ground running on solar day one. To that end, the lessee will ordinarily spend some coin on leasehold improvements to update the space and ensure it is a suitable space for their business.
The lessor will sometimes reimburse the lessee for those leasehold improvements. This is where we must pause and consider the proper accounting treatment for this reimbursement (payment from the lessor to the lessee) nether ASC 842.
Proper bookkeeping treatment is actually determined past whether the leasehold improvements represent a lessee nugget or a lessor asset. In short, who owns the leasehold improvements? At that place are no brilliant lines here to make that determination, but if for instance, the lessee is making improvements to the space with their own branding and they ain those improvements, then the reimbursement from the lessor would be treated every bit a charter incentive under ASC 842.
If, notwithstanding, the improvements represent a lessor nugget, and then the reimbursement for that expenditure would
be considered a lease incentive under ASC 842 and would involve different accounting treatment.
There are several factors to consider when making the lessor vs. lessee endemic asset determination. Typically, when the lease requires the lessee to make specified improvements, those are considered a lessor asset. On the other hand, if the improvements are
- non required by the lessor,
- specific to the lessee, and/or
- can’t be used past a subsequent tenant,
so the improvements are most likely considered a lessee asset.
It’s important to note at that place is not a single determining gene here – all factors should be considered.
Leasehold improvements: Lessor nugget
If the leasehold comeback represents a lessor asset, and then the reimbursement is not a true lease incentive. Assume, for example, that the lessor contractually requires the lessee to spend $5,000 building the outdoor patio of the leased space. This work is done while the lessor is finalizing the building for the lessee (i.e. the asset is not gear up for use by the lessee and so the charter term has not commenced). The lessee would business relationship for such an expenditure equally prepaid hire, and whatever reimbursement from the lessor would so decrease that prepaid hire.
Any unreimbursed portion of the expenditure is and then included in lease payments as detailed beneath:
To record lessee payment for lessor leasehold improvements prior to lease commencement
The remaining $2,000 of the expenditure is treated as lease payments upon get-go
Leasehold improvements: Lessee asset
If the leasehold comeback represents a lessee asset, then the reimbursement is treated as a truthful lease incentive. Lease incentives are e’er included in the consideration in the contract according to ASC 842-x-xxx-5 and 842-10-15-35, as summarized below:
Since lease incentives are included in the calculation of consideration, they will need to be allocated between the components of the contract when there are multiple lease and non-lease components (unless the practical expedient to not separate charter and non-lease components is elected).
It is of import to call up that charter incentives always decrease consideration in the contract (summarized in a higher place). The subtract to lease payments will affect a lessee’s opening lease liability, right-of-use (ROU) asset, and lease classification. With that said, let’south take a closer await at how incentives affect a lessee’s opening charter liability and ROU asset.
Lease incentive impact to opening lease liability and ROU asset
Up until this indicate, we’ve explored how to determine whether a leasehold improvement qualifies as a truthful lease incentive. Once yous’ve fabricated the decision that the leasehold improvement represents a lessee asset and the reimbursement from the lessor qualifies as a true lease incentive, you tin can focus on how charter incentives affect your opening lease liability and ROU nugget.
Let’south take some other look at the contract consideration graphic in the previous section. You’ll notice that lease incentives are described equally ‘paid or payable’ to the lessee. You lot’ll also notice this linguistic communication in ASC 842-10-30-5. In this blog, we’ll discuss both types of incentives covered by ASC 842:
- Incentives paid at or before lease get-go
- Incentives payable at lease commencement
Every bit the accounting for each type of incentive is different, we will demonstrate the accounting for both. Showtime, nosotros’ll walk through an example of an incentive paid at or earlier lease commencement. 2d, we’ll have a look at an incentive that is payable at lease commencement, but not actually received until after the lease has started. Finally, we’ll consider what to exercise with incentives that are neither paid or payable as of lease kickoff.
Charter incentive example: Paid at or before lease commencement
Lessee: Company XYZ
ane/i/2021 – 12/31/2030 (10-yr term)
$150,000 annual payment on December 31st
$fifty,000 received from lessor at lease outset (1/one/2021)
ASC 842-20-30-1 states, “At the commencement engagement, a lessee shall measure…the charter liability as the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement…”
Using our LeaseQuery present value (PV) calculator beneath, 10 $150,000 almanac payments discounted at 3% results in a
PVof $ane,279,530. This amount is our lease liability at commencement.
The next step is to calculate the ROU asset. Per ASC 842-20-thirty-5, at charter kickoff, the ROU nugget consists of:
- The amount of the initial measurement of the lease liability
- any charter payments made to the lessor at or before the showtime date, minus whatever lease incentives received, and
- any initial direct costs incurred past the lessee.
Visitor XYZ received $50,000 in lease incentives at commencement. Therefore, in accordance with 842-twenty-30-five, the opening ROU asset is accordingly measured by subtracting the $50,000 in charter incentives received from the opening lease liability balance to get in at the opening ROU asset balance in the amount of $1,229,530.
Periodical entry recorded at charter commencement: 1/1/2021
Company XYZ will institute the opening balances noted above as well every bit the cash receipt of the incentive at lease outset.
These opening lease liability and ROU asset balances are seen in the below amortization schedule.
Journal entries recorded at the end of Year one: 12/31/2021
Before considering the incentive, Company XYZ volition record the almanac $150,000 cash rent payment to the lessor and the respective charter expense.
The entry to record the amortization of the lease incentive also results in a corresponding adjustment to lease expense is shown below:
These two entries consequence in a cyberspace lease expense of $145,000, equal to the lease expense shown in the acquittal tabular array higher up. As previously mentioned, lease incentives paid or payable always subtract consideration in the contract. Company XYZ will subtract the $fifty,000 of incentives received from the $1.5M of full cash payments, resulting in almanac straight-line lease expense of $145,000 (($one,500,000 – $fifty,000) / ten years = $145,000).
Finally, Visitor XYZ will reduce the charter liability, with an showtime reduction to the ROU asset, to the present value of the remaining lease payments equally of the end of year one, which is $1,167,916 per the amortization schedule above.
The entries from above are aggregated in the T-accounts beneath. You’ll notice that the ending balances highlighted in green appropriately tie to the acquittal schedule (above) as of the end of the beginning year (2021).
Charter incentive example: Payable at lease beginning
Now nosotros’ll employ the same base instance, except in this scenario the $50,000 charter incentive is payable to the lessee at lease start – receivable in ii parts – $20,000 at the end of year 1 and $30,000 at the end of year two.
1/1/2021 – 12/31/2030 (10-year term)
$150,000 almanac payment on Dec 31st
Discount Charge per unit:
$50,000 payable at lease commencement
- $20,000 to be received from lessor at 12/31/2021
- $30,000 to exist received from lessor at 12/31/2022
At lease first, the lease liability is measured as the nowadays value of the remaining charter payments. Furthermore, considering lease incentives payable at commencement decrease fixed lease payments, the two installments of the incentive payable in years one and ii will be netted confronting cash payments in their respective years for purposes of the nowadays value calculation.
Using our LeaseQuery nowadays value (PV) computer again, the nowadays value calculation for this fix of facts equals $1,231,835, which represents the opening lease liability and ROU asset residue in this example.
Journal entry recorded at lease beginning: ane/one/2021
These opening lease liability and ROU nugget balances are seen in the below amortization schedule.
Periodical entries recorded at the cease of Year 1: 12/31/2021
Similar to our kickoff example, earlier considering the incentive, Visitor XYZ will record the almanac $150,000 greenbacks rent payment to the lessor and a respective increase to lease expense.
Visitor XYZ and then records the receipt of the cash incentive at the stop of twelvemonth 1 in the amount of $twenty,000. Just as a greenbacks payment would decrease the charter liability, the cash receipt of the incentive volition increase the lease liability.
The entry to record the amortization of the lease incentive at the end of year one results in a respective adjustment to charter expense:
Finally, Company XYZ will adjust the lease liability, with a respective adjustment to the ROU nugget, to the present value of remaining lease payments every bit of the end of year one, which is $1,138,790 per the amortization schedule above. The adjustment of $113,045 is calculated every bit the yr one reduction of the lease liability ($93,045) plus the adjustment to the lease liability for the greenbacks incentive received in yr ane ($twenty,000).
The entries we take walked through in this example are aggregated in the T-accounts beneath. You’ll notice that the ending balances highlighted in green appropriately tie to the acquittal schedule (above) as of the end of the starting time year (2021).
Charter incentives: Not paid or payable
Lease incentives not paid or payable at lease commencement constitute a third category of incentives. These incentives are contingent on, or simply receivable later on a future consequence takes identify. This category of incentive is non direct addressed in ASC 842. As such, there are multiple interpretations of the accounting treatment for contingent incentives.
Ane arroyo is to estimate the timing and amount of the incentive, and to care for it as payable at beginning using those estimates. Making an guess like this assumes that the future triggering consequence(due south) is/are within the lessee’s control and is/are reasonably certain to occur. If at that place is a subsequent deviation in the timing or corporeality of the incentive received versus the original guess, one time that departure is identified, the lessee should then remeasure the charter liability and ROU asset using the nigh recent discount rate applied to the charter. This would exist the discount charge per unit applied at commencement unless the lease had since been modified, in which instance the lessee would apply the discount rate used in the most recent modification.
It’southward of import to highlight that this is a remeasurement and not a traditional modification. ASC 842-20-35-5 indicates that a lessee does not update the discount charge per unit when remeasuring the charter liability and ROU nugget when the remeasurement is driven by a alter in the lease payments resulting from the resolution of a contingency.
Summary: Charter incentive accounting: Easiest with a software solution!
Lease incentives are definitely one of the more complex and technical topics under ASC 842. Making these calculations in Excel tin can involve a lot of transmission override and room for fault. Simplify and automate this procedure by booking a demo with LeaseQuery today!
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