Tenant improvement allowance is a win-win for a business property area. Landlords are constantly delighted to have their residential or commercial properties improved, and tenants are always trying to find a much better deal with shared build-out expenses. This leads to scenarios in which a renter makes remodellings, repair work, or other improvements to a rented space in exchange for a break on rent payments or other compensation. It's a very typical agreement between a lessor (the proprietor) and the lessee (the occupant). But for lease accounting professionals, it's not constantly clear how these transactions must be taped and represented.

A property owner that pays cash to a renter as repayment for leasehold enhancements has offered the lessee with a tenant enhancement allowance (TIA) for said future enhancements. TIAs are a kind of lease rewards. The new lease accounting requirements ASC 842 and IFRS 16 bring lots of modifications to accounting practices for renter improvement allowances and lease rewards.

Tenant Improvement & Lease Negotiation

Tenant enhancement allowance does not require to be paid back, so it is used to negotiate during the lease-signing process. Other variable elements that affect a tenant's lease arrangement are base rent, free lease, and longer-term lease offers. Residential or commercial property owners use TI allowance to incentivize quality tenants during the settlement procedure with a complete area that suits their special company needs. If your commercial realty team executes a lease with TI allowance, then it has upstream impacts to your lease accounting procedures.

To help you understand the principles and the modifications involved with the new lease accounting standards, here's a guide to whatever you require to learn about occupant enhancement allowance accounting.

A Bit About Lease Incentives

Before digging into the information of TIAs, you should first consider what makes up a lease incentive. The common practice of exchanging rented residential or commercial property improvements for some monetary factor to consider definitely certifies as a lease incentive.

But that's simply one potential reward, and it helps to comprehend the larger photo of lease incentives. It also helps you understand why ASC 842 has the guidance it provides for lease incentives and TIAs-and how that guidance has actually altered given that ASC 840.

ASC 842 specifies a lease reward as one of 2 things:

- Reimbursement or payments made to or on behalf of a lessee.

• Losses incurred by a lessor as an outcome of assuming a lessee's pre-existing lease contract with a 3rd party.
  
  IFRS 16 defines a lease incentive as payments or compensation made by a lessor to a lessee related to a lease. Other than the varying definitions, ASC 842 and IFRS 16 reward lease rewards and TIAs basically the same. To keep things easy, the rest of this post describes ASC 842 just, however the very same principles apply to IFRS 16.
  
  The brand-new lease accounting standards need all leases to be tape-recorded on a company's balance sheet as lease liabilities and right of usage (ROU) assets. The primary factor lease rewards in general-and tenant enhancement allowances specifically-are so crucial to the new requirement is since the formula for computing an ROU asset includes lease rewards.
  
  That formula is:
  
  ROU possession =
  
  Initial lease liability
  
  PLUS Prepaid lease payments
  
  PLUS Initial direct costs
  
  MINUS Any lease incentives received
  
  With that in mind, it's simple to see why you require to properly account for lease rewards, including TIAs. As a critical part of the ROU asset, lease incentives have an impact on all journal entries connected to a lease. And since the ROU possession didn't exist in ASC 840 and other earlier standards, this represents a significant change in practice for lease accountants.
  
  Should tenant improvement allowance be capitalized?
  
  Tenant improvements are long-term properties that include value to industrial residential or commercial properties. If they extend the beneficial life of a residential or commercial property and/or improve the residential or commercial property's value, occupant improvements ought to be capitalized.
  
  How ASC 840 Accounted for Tenant Improvement Allowances
  
  Under ASC 840, when a lessee received a TIA, they followed the guidance for lease incentives. Under the old requirement, the assistance was merely to acknowledge the TIA as a decrease to rent cost on a straight-line basis over the term of the lease.
  
  This made journal entries a relatively simple job: tape-record the payment as a debit to money, with a balancing out credit to a lease reward liability. This liability would be amortized as a reduction to rent expenditures over the term of the lease. In cases where a TIA was gotten immediately, the lessee would debit balance dues.
  
  While ASC 842 still classifies TIAs as lease rewards, this is where similarities in the accounting procedure end.
  
  How ASC 842 Accounts for Tenant Improvement Allowances
  
  The major modification in ASC 842 regarding TIAs is that they are no longer reported as lease reward liability and amortized over the life of the lease. Lease rewards are typically taped in the preliminary measurement of the ROU asset and the corresponding lease liability.
  
  Naturally, that assumes that any occupant enhancement allowances are known in advance and noted in the lease agreement. To be sure, this is a typical practice. It's not unusual to see TIAs specified in lease arrangements, either as a lump sum or set as a rate per square foot. But ASC 842 contains guidance to account for the timing of lease rewards, consisting of TIAs.
  
  The language utilized is "paid" rewards (paid to the lessee prior to or at beginning of the lease) and "payable" incentives (payable eventually after beginning). Paid and payable lease rewards are accounted for in various ways under ASC 842. Here's a take a look at how both paid and payable TIAs are dealt with and how they both impact the ROU asset and lease liabilities.
  
  TIAs Paid At or Before Lease Commencement
  
  For TIAs paid to the lessee prior to or at the time of lease beginning, ASC 842 assistance states these lease incentives are represented as a direct adjustment to the opening balance of the ROU property.
  
  The ROU asset is always at first equal to the lease liability, which itself is determined as the present value of future payments. That figure is then adjusted by the other elements in the ROU possession formula, including decreases to rent liability in the type of a lease incentive, such as a TIA, which indicates the effect of a paid lease reward or TIA is that it lowers the ROU asset.
  
  For entities making the shift to ASC 842, any unamortized balance of a TIA is debited so that it eliminates the lease incentive liability from the balance sheet. It is then reclassified to the ROU possession's opening balance by method of a credit.
  
  After an ASC 842 transition is complete, TIAs received at the time of lease start are recognized as a debit to money and a modification to the initial worth of the ROU property. This is accomplished with a credit to the lease liability account and a debit to the ROU property, equal to the preliminary liability balance minus the quantity of the TIA.
  
  TIAs Payable After Lease Commencement
  
  In many cases, a renter enhancement allowance is gotten as a decrease of lease payments in the durations when the improvements to the leased residential or commercial property take place. The ASC 842 guidance for lease rewards, consisting of TIAs, paid after the lease start date is factored into the lease liability in addition to the ROU asset measurement.
  
  Recall that the lease liability under the brand-new requirements is computed as the present worth of future payments. That consists of payments got for a tenant enhancement allowance. The timing of capital is a critical consider present value calculations, and that's shown in how TIA payments are tape-recorded.
  
  Payments for improvements need to be taped in the period when they are expected to be gotten during the lease term and after that netted with the lease payments for that exact same duration. The lease liability is reduced because of the expected cash payments, and this likewise has the result of decreasing the ROU asset balance.
  
  TIAs That Are Neither Paid Nor Payable
  
  Beyond paid and payable lease incentives, a third kind of lease reward is those that fit neither category.
  
  Lease incentives that are neither paid nor payable are contingent on, or only receivable after, some future occasion happens. While ASC 842 acknowledges that this is a kind of lease reward that could exist, it does not supply any specific assistance on how to properly account for rewards that fall into this category. Therefore, numerous techniques have actually been used to represent TIAs of this type.
  
  One common approach is to determine if lease terms include a maximum quantity of reimbursement and assess whether the lessee is most likely to sustain those expenses. If so, that maximum quantity of reimbursement can be dealt with as a payable lease reward, with the corresponding reduction to the ROU asset and lease liability.
  
  A second method is to wait up until all reimbursable expenses have been incurred and after that reduce the ROU asset and lease liability by that quantity.
  
  As business and their lease accounting professionals invest more time under ASC 842 and more audit cycles have occurred, more conclusive assistance on this 3rd kind of lease incentive will likely emerge. It's also possible that FASB might modify ASC 842's standards to cover this 3rd kind of lease incentive at some point in the future.
  
  Leasehold Improvements: Lessor Asset or Lessee Asset?
  
  Among the more critical aspects of a successful ASC 842 shift is correctly identifying and classifying leases. The new standard needs all leases to be recorded on the balance sheet and under one of 2 classifications - running leases or finance leases (formerly referred to as capital leases under ASC 840). ASC 842 likewise requires that ingrained leases be identified in other agreements that might not be outwardly recognized as a lease contract.
  
  When it pertains to occupant enhancement allowances and lease rewards more generally, it's likewise critical to determine if a leasehold enhancement certifies as a lessor asset or a lessee property.
  
  The term "leasehold improvement" is a sort of catch-all term utilized to explain a renter carrying out improvements on a rented area and getting some sort of settlement in return. However, it's not always clear if the lowered rent payments or other repayment is a type of lease incentive and a property for the lessee.
  
  ASC 842 deal high-level guidance regarding this. According to the requirement, if a lessee is making improvements to a leased space with their own branding and will then own the improvements, it certifies as a lessee property. However, if the improvements are really a lessor property, any repayment or settlement for the improvement would require to be represented in a different way.
  
  A few of the factors to think about in the lessor possession vs. lessee asset decision revolve around requirements laid out in the lease contract. When a lease requires a lessee to make defined improvements, it will be a lessor asset. On the other hand, if the enhancements are not required, are particular to the lessee, and can't be utilized by subsequent renters, they are a lessee asset.
  
  Lessor Asset Accounting Under ASC 842
  
  If a leasehold improvement is figured out to be a lessor asset, the lessee should not account for it as a lease incentive.
  
  For example, if a lessor contractually requires a lessee to the costs of fixing the leased area's front door and entryway before lease start, this is not a lease reward. The lessee would account for the repair work expenditures as pre-paid lease. Any repayments, consisting of reductions in regular monthly rent payments, would be represented as a decline to that pre-paid lease.
  
  Unreimbursed parts of the enhancement expense are then included in lease payments upon beginning of the lease.
  
  If a leasehold improvement is figured out to be a lessee asset, then it qualifies as a renter enhancement allowance under ASC 842. All of the guidance on accounting for lease incentives uses, with appropriate measurement of the ROU property and lease liabilities.
  
  Occupier Makes Tenant Improvement Allowance Accounting Easier
  
  The changes made to renter improvement allowance accounting from ASC 840 to ASC 842 are anything however simple. Whereas lease rewards were an easy matter of credits and debits under the old requirement, lease accountants should now be familiar with the ROU possession, today worth of future payments, and lease liabilities in order to update your balance sheet and earnings statement.
  
  All of these changes add transparency to renting plans and costs, ultimately offering your company's monetary declarations more accuracy. Mastering all the requirements of ASC 842 is substantially easier with a contemporary lease accounting software. Here at Occupier, we use the most thorough option, built upon an instinctive and ingenious tech stack.