Update: The guidance below will be superseded upon the new lease accounting standard becoming effective for most private companies in 2020. For further information on the upcoming changes to lease accounting, see our article on preparing for the new lease standard.
Many leases include incentives offered in the form of free or reduced rent, or up-front cash payments for items like moving expenses or improvements needed to customize the rental space as an enticement for a lessee to sign a lease. These lease incentives require specific accounting treatment in order to be recorded in accordance with U.S. GAAP.
Tenant incentives, whether given in the form of a rent reduction or as an actual cash payment, are recorded as a deferred credit when received and are figured into the straight-line rent expense, which is recognized over the life of the lease. Tenant improvement allowances can either be paid for directly by the landlord or reimbursed by the landlord to the tenant. In either circumstance, a deferred credit for the amount provided must be recorded when the landlord has provided funding for the improvements. These tenant improvements are recorded as fixed assets on the tenant’s books. Amortization of the deferred credit and amortization of the tenant improvement asset are both determined on a straight-line basis over the lesser of the term of the lease or the estimated life of the improvements. The tenant improvements will be amortized to amortization expense, which is usually reported with depreciation for financial reporting. The related amortization of the deferred credit for the tenant improvement allowance will result in a corresponding reduction in rent expense over the life of the lease.
Given the variety of ways landlords can provide lease incentives, it can become tricky not only to identify all the items that need to be recorded, but also to determine whether an incentive or an allowance has been received. For anyone entering into a new lease, reading the entire lease – as simple as that sounds – is a key step in successfully identifying and recording the proper transactions. Though there may not be an initial outflow of cash in connection with a new lease, a tenant may have some accounting considerations related to the lease that must be recorded at the lease’s inception.