Lease Incentive Accounting Under ASC 842

The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) 842 reshaped lease accounting. Replacing the former ASC 840 guidance, this update mandated that most leases be recognized on the balance sheet, increasing transparency into a company’s financial obligations. A specific area of focus within this standard is the treatment of lease incentives. This article explains how to account for lease incentives under ASC 842 for both lessees and lessors.

Defining Lease Incentives Under ASC 842

Under ASC 842, a lease incentive is a payment made by the lessor to the lessee or a reimbursement of the lessee’s costs. This can also include the lessor assuming the lessee’s obligations under a separate, pre-existing lease. These incentives are a component of the overall consideration in the contract and directly impact the financial accounting for the lease.

Common examples of lease incentives include direct cash payments from the lessor to the lessee. Another is the lessor making payments to a third party on the lessee’s behalf, such as covering moving expenses. A lessor might also agree to pay the remaining rent on a tenant’s old lease to facilitate an earlier move.

A period of free or reduced rent, often called a rent holiday, is not a lease incentive under ASC 842. While it reduces the total cash paid by the lessee, it is not a direct payment from the lessor. Instead, these rent concessions are factored into the calculation of total lease payments and spread evenly over the lease term.

A distinction exists for funds provided for property improvements. If a lessor provides an allowance for improvements the lessee will own, the payment is a lease incentive. If the lessor pays for improvements it will own, it is not an incentive but an investment in the lessor’s own asset. The accounting treatment is dictated by who owns the improvement.

Lessee Accounting for Lease Incentives

For a lessee, a lease incentive directly impacts the initial measurement of the Right-of-Use (ROU) asset but does not alter the lease liability. The incentive reduces the value of the ROU asset recorded on the balance sheet.

Initial Measurement

At the start of a lease, the lessee calculates the lease liability, which is the present value of future lease payments. The ROU asset is then calculated as the lease liability, minus any lease incentives received, plus any initial direct costs. For example, if a lease liability is $500,000, the lessor provides a $25,000 incentive, and the lessee incurs $10,000 in initial direct costs, the ROU asset is $485,000. The initial journal entry would be a debit to ROU Asset for $485,000 and a credit to Lease Liability for $500,000.

Subsequent Measurement

The lease incentive also affects how lease expense is recognized. For an operating lease, the goal is to recognize a single, straight-line lease expense each period. This expense is calculated by taking the total lease payments, subtracting the lease incentive, and dividing that net cost by the lease term. For example, if total payments are $550,000 and the incentive is $25,000, the net cost is $525,000. For a 10-year lease, the monthly lease expense would be $4,375, which is recorded each month as a debit to Lease Expense, with corresponding credits reducing the Lease Liability and ROU asset.

Lessor Accounting for Lease Incentives

From the lessor’s perspective, accounting for lease incentives depends on the lease classification: operating, sales-type, or direct financing. This classification determines how the incentive is recorded and how it impacts lease income recognition. The treatment for operating leases is the most common scenario.

Operating Leases

For an operating lease, the lessor continues to recognize the underlying asset on its balance sheet. When a lessor provides a lease incentive, it is capitalized as a deferred cost, or an asset, rather than being immediately expensed. This asset is then amortized as a reduction of lease income on a straight-line basis over the lease term. For instance, a $12,000 incentive on a three-year lease would reduce lease income by $4,000 each year.

Sales-Type and Direct Financing Leases

For a sales-type lease, the lessor derecognizes the underlying asset and recognizes a net investment in the lease and any selling profit. A lease incentive reduces both the net investment in the lease and the selling profit recognized at commencement. This is because the incentive is a reduction of the consideration received from the lessee.

In a direct financing lease, the incentive also reduces the lessor’s net investment in the lease. This reduction lowers the rate of return on the lease. The subsequent interest income recognized by the lessor over the lease term will therefore be lower.

Leasehold Improvements Funded by a Lessor

Payments from a lessor to fund property improvements, often called a tenant improvement allowance (TIA), can be confusing. The accounting for these payments depends on who owns the resulting improvement. This ownership test dictates whether the payment is a lease incentive or an investment in the lessor’s own asset.

The Ownership Test

The ownership test determines which party controls the improvement by assessing who directs its use and obtains its economic benefits. Factors include how specialized the improvements are for the lessee’s use. For example, improvements aligning a space with a lessee’s specific brand are likely owned by the lessee, as they have little value to another tenant.

Scenario 1: Lessor Owns the Improvement

If the lessor owns the improvement, the funds provided are not a lease incentive. This occurs when improvements are integral to the building, such as an HVAC upgrade. The lessor is making a capital expenditure on its own property, plant, and equipment (PP&E), and the cost is capitalized on the lessor’s books.

Scenario 2: Lessee Owns the Improvement

If the lessee owns the improvements, funds from the lessor are a lease incentive. This is common when a lessee customizes a space with specialized fixtures or branding. The lessee reduces its ROU asset by the amount of the incentive received. The lessee also capitalizes the full cost of the improvements as its own leasehold improvement asset, which is then amortized. For example, if a lessee spends $100,000 on improvements and receives a $40,000 allowance, it records a $100,000 leasehold improvement asset and reduces its ROU asset by $40,000.