Accounting for Lease Incentives: GAAP Basics for Real Estate
August 13, 2021
By Evan Mann
As the U.S. economy continues to recover from the COVID-19-induced recession, landlords of commercial properties are offering material incentives to both new and existing tenants to entice them to enter into long-term lease agreements or extend their existing lease agreements. These incentives may come in varying forms including, but not limited to, cash payments made to lessees (or to third parties on behalf of lessees) upon signing of a lease agreement or full or partial reimbursements of certain costs incurred by the lessee, such as moving expenses or costs to construct or renovate the underlying leased asset. (Note: It’s often common practice for landlords, in exchange for higher base rents, to provide these incentives to tenants.) While the economics of these incentives may be clear cut, the accounting for them under generally accepted accounting principles (“GAAP”) may not be.
For lessors to understand the accounting treatment of a lease agreement, GAAP requires a determination be made to classify the lease agreement between operating, sales-type, or direct financing leases. This determination requires financial statement preparers to use judgement to assess the specific facts and circumstances of each lease agreement, which may include both quantitative and qualitative factors. Refer to guidance for the specific criteria for making this assessment. Although GAAP provides for three types of lease classifications for lessors, the primary purpose of this article is to shed light on the accounting treatment by lessors of lease incentives contained in operating leases.
Lease agreements entered into by lessors are commonly classified as operating leases. Such arrangements may come in the form of, for example, a ten-year lease agreement for one floor of a commercial office building or a store within a shopping center, plus the lessor to reimburse the lessee for renovation costs of the underlying asset. Although classified as an operating lease, management should perform additional assessments to determine the accounting treatment of lease incentives based upon the nature of the incentive which include, but are not limited to, the following:
- If the lessor is required to make a cash payment to the lessee, or a payment to a third party on behalf of the lessee, the lessor will defer such cost and recognize it on a straight-line basis over the term of the lease agreement as a reduction to revenue.
- If the lease agreement provides for a partial or full reimbursement of the lessee’s cost to develop or renovate the underlying leased asset, management must first determine whether the lessor or the lessee owns the asset by considering the unique elements of the improvements. Considerations should include: i) At the end of the lease, what happens to the improvements of the underlying asset? Are they destructed and removed or left for the landlord? ii) Are the improvements made to the underlying asset customized or generic? iii) Is the lessor or the lessee overseeing the construction/renovation of the underlying asset? The answers to these questions will determine who owns the related asset, and how the lease incentives should be accounted for by the lessor.
- If management concludes that the lessee owns the asset, the lessor should defer such cost and recognize it on a straight-line basis over the term of the related lease agreement as a reduction to revenue.
- If management concludes that the lessor owns the asset, the lessor should defer such cost as a tenant improvement and recognize it on a straight-line basis as depreciation over the lesser of the useful life of the asset or the term of the related lease agreement.
However, there may be some instances where at lease commencement, the lease incentive may not yet be incurred by the lessor, or the amount of lease incentive may be unknown. These scenarios can occur when, for example, the lease agreement provides for a partial or full reimbursement of the lessee’s cost to develop or renovate the underlying leased asset, and upon lease commencement, the amount of reimbursement to be requested by the lessee is unknown. GAAP does not explicitly shed light on when to recognize these incentives, and how much to recognize. If the lease agreement provides for a maximum dollar amount of the lease incentive to the lessee, upon lease commencement, the lessor should use judgement to estimate, based on the specific facts and circumstances of the lease agreement, whether the lessee will incur total expenditures eligible for reimbursement by the lessor of an amount equal to or greater than the maximum lease incentive. While making this assessment, management may consider, for example, the overall construction budget of the lessee. If the lessee is projecting to incur expenditures which exceed the amount of the incentive, the economics of these facts and circumstances indicate that the lessor should defer the entire incentive upon lease commencement and recognize it on a straight-line basis over the term of the lease agreement as a reduction to revenue.
Sales-Type and Direct Financing Leases
Lessors may find themselves in less common circumstances where lease agreements are classified as sales-type or direct finance leases. One criteria of a lease agreement, which may trigger recognition of a lease as a sales-type lease or a direct financing lease for a lessor, is whether the present value of the sum of the lease payments plus any residual value guaranteed by the lessee (which is not already reflected in the lease payments) equals or exceeds substantially all of the fair value of the underlying leased asset. Lease payments, included in this calculation, are reduced by any lease incentives paid by the lessor to the lessee, thus reducing total lease payments on an undiscounted basis prior to determining the present value.
Once criteria are met to account for a lease agreement as a sales-type or direct financing lease, a lessor is required to recognize a net investment in the lease. Components of this measurement are lease payments, which are reduced by any lease incentives paid by the lessor to the lessee.
This article serves to highlight the most common implications to a lessor of certain negotiated terms between lessors and lessees within financial reporting under GAAP and does not discuss the accounting treatment for all possible scenarios. There are many nuances and provisions to the standards referenced herein to which financial statement preparers should refer to for further information and detail, including applicable transition guidance from ASC 840 to ASC 842. ASC 842 will take effect for periods beginning after December 15, 2021 for private companies, and is already effective for public companies.