When two parties enter into a lease contract, they negotiate different terms. One of the common ways lessors use is to offer incentives or allowances to the lessees.
A lease incentive reduces the lease liability for the lessee. It should be recognized under ASC 842 if it meets certain criteria.
Accounting for the lease incentive is fairly simple. Both parties can use the same judgment basis to recognize the lease incentive in their respective account books.
What is a Lease Incentive?
A lease incentive is a payment made by the lessor directly to the lessee or on behalf of the lessee. These payments are linked with underlying asset expenses usually.
A lessor may make such incentive payments to make the lease terms more appealing to the lessee. These payments can be made on or after the commencement date of the lease contract between the two parties.
Some common examples of lease incentive payments include:
- Cash payment from the lessor at the commencement date to the lessee.
- Reimbursement of expenses incurred by the lessee for the underlying asset improvements.
- Prepaid expenses by the lessor on behalf of the lessee that relate to the lease contract.
A lease incentive can take several forms. However, in either case, the lease incentive will reduce the lease liability expense for the lessee or the lessor. Both parties will recognize the lease incentive in their respective account books accordingly.
Accounting for Lease Incentives under ASC 842
The lease incentive is recognized and recorded in the account books under ASC 842. The lease incentive should be recorded using the straight-line expense method for an operating lease.
In some cases, the lease contract may include the terms relating to the asset improvements or other related expenses. Otherwise, it should be assessed whether the expense relates to the asset of the lessee or the lessor.
Payments made by the lessor should be considered as expenses for the asset of the lessee if:
- The lessee receives any allowance or incentive amount in excess of the asset improvement expenses.
- The lessee can use the received fund discretely for the underlying asset.
Similarly, payments made by the lessee should be considered for the asset of the lessor if:
- Lessee has an obligation to install the asset in a certain condition.
- The Lessee cannot alter asset improvements without the prior consent of the lessor.
- Lessor will receive significant residual value of the asset at the end of the lease contract.
Lease incentive expenses should only be recognized if they belong to the lessee asset meeting one of the conditions stated above.
Leasehold Expenses – Lessor Asset
If any expenses related to the underlying asset are determined to be the lessor asset meeting the conditions stated above, it will not be recorded as a lease incentive under ASC 842.
The lessee will only record such reimbursement from the lessor as a prepaid rent/lease expense. For example, the contract stated a condition to the lessee for certain asset improvement that resulted in a $ 3,000 cost.
The lessee will receive the reimbursement from the lessor. The lessee will record $3,000 as a prepaid lease payment.
Leasehold Expenses – Lessee Asset
If the leasehold expenses incurred are determined to be the lessee asset, then they will be recognized as lease incentives.
The lease incentive is recognized under ASC 842 – 10-30-5 and 842-10-15-35.
Total Lease Contract Payment = lease payments + fixed payments + variable payments – lease incentive payments.
A lease incentive will reduce the lease payment for the lessee. The lease incentive amount should be amortized using the straight-line allocation method.
The ASC 842 does not provide clear directions for any lease improvements or expenses not paid or payable.
Both parties can use professional judgment to recognize such expenses when they incur. However, there should be a reasonable judgment for the timing and amount of the payable expense.
Let us understand the concept with the help of a simple working example.
Suppose a company ABC is a leasing company of manufacturing equipment. Another company XYZ is interested in leasing manufacturing equipment.
Both companies enter into a lease agreement with the following details.
- Lease term is 5 years
- Annual Lease payment: $ 50,000
- Lease Incentive Amount: $ 30,000 received at commencement of lease.
- Interest Rate: 5%
Under the ASC 842 – 20-30-1, the lease payments not paid yet should be recorded at present values.
The first step is to calculate the PV and NPV of lease payments for five years using a 5% interest rate.
|1||$ 50,000||$ 47,600|
|2||$ 50,000||$ 45,350|
|3||$ 50,000||$ 43,200|
|4||$ 50,000||$ 41,150|
|5||$ 50,000||$ 39,200|
The next step is to calculate the Right of Use (ROU) value of the leased asset.
According to ASC 842 – 20-30-5, the ROU consists of:
- Initial lease payment measurement
- Any amount paid to the lessor less any lease incentives
- Indirect costs incurred by the lessee on the leased asset
The company XYZ received a lease incentive of $ 30,000 from ABC (lessor). Hence, it will be deducted from the NPV of lease amount ($ 216,500 – 30,000 = $ 186,500).
The journal entry for recording the lease incentive will be:
|ROU Asset||$ 186,500|
|Lease Liability||$ 216,500|
The company XYZ will record the yearly lease payments and the lease incentive on a straight-line basis with the following journal entries.
|Lease Expense||$ 50,000|
|ROU Asset||$ 6,000|
|Lease Expense||$ 6,000|
Amortized Lease Incentive over 5 years = 30,000/5 = $ 6,000.
It means the company XYZ will be actually making a lease payment of $ 44,000 to the lessor ABC yearly.
Finally, the last step is to record the journal entry for the total lease liability account that is offset by the ROU amount account.
The journal entry for year 1 will be:
|Lease Liability (PV of lease payment at Year 1)||$ 47,600|
|ROU Asset||$ 47,600|