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Leasehold improvements: What you need to know for ASC 842

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As you navigate the complexities of ASC 842 compliance, you may be wondering how and when to account for leasehold improvements.

What are leasehold improvements?

From an accounting standpoint, leasehold improvements are any modifications, enhancements or additions made by a tenant to their leased space (or the “leasehold interest”) that add business value.

Tenants often make these improvements to their leased spaces to:

  • Customize the layout and design of their leased space
  • Improve ergonomics and make the space more employee- or customer-friendly
  • Brand the leased space with a company’s look and feel

Examples of leasehold improvements

Leasehold improvements can be any update or change to a leased property’s interior finishes beyond what the landlord provides as standard.

They may include upgrades to drywall, electrical, flooring, carpentry and similar features, as well as permanently affixed displays, shelving, partitions, lighting, signage and other enhancements that help customize the space.

Leasehold improvements may be made at any time during the term of a lease — or before moving into a space.

For instance, in a new shopping mall, a landlord typically provides a “vanilla box” that a retailer will want to customize with improvements — adding dressing rooms, sales counters and other features that will make the leasehold interest more valuable as a business location.

Furthermore, enhancements that are not considered a leasehold improvement include modifications to exterior or shared spaces, as well as interior features such as data cabling, furniture, non-permanent fixtures or equipment that can be removed when the tenant moves out.

Are Leasehold Improvements Considered Lease Incentives?

Leasehold improvements and lease incentives are distinct concepts in the realm of leasing agreements. Leasehold improvements refer to modifications or enhancements made to a leased property by the tenant to better suit their specific needs or business operations. These improvements typically remain with the property at the end of the lease term. On the other hand, lease incentives are concessions offered by landlords to attract tenants, such as rent-free periods, cash allowances, or assistance with moving costs. While both leasehold improvements and lease incentives can enhance the overall leasing experience, they serve different purposes: the former focuses on customizing the space, while the latter aims to make the lease agreement more appealing to potential tenants.

How do leasehold improvements impact ASC 842?

Leasehold improvements are reported as property, plant and equipment (PP&E) assets on the balance sheet. ASC 842 does not change the way they are handled, unless a tenant uses a tenant improvement allowance to make their improvements.

When a tenant makes leasehold improvements using a tenant improvement allowance, ASC 842 requires a different treatment than the previous accounting under ASC 840. Under ASC 842, a tenant improvement allowance is treated as a lease incentive that reduces the ROU asset. If the tenant improvement allowance is not yet received, the lease liability is also reduced in future minimum lease payments.

Here are the basics you need to know about leasehold improvements relating to ASC 842 compliance:

What is a tenant improvement allowance?

A tenant improvement allowance (also called a TI allowance or TIA) may be offered to a tenant by a landlord, which the tenant may choose to use to pay for leasehold improvements. It is one of several types of lease incentives that a landlord may offer to attract tenants and is often part of lease negotiations.

The TI allowance amount will be included in the lease, along with how it will be paid. For example, it may be offered as a rent discount, paid directly to contractors or provided as a reimbursement to the tenant after the work is complete. The lease may also stipulate what leasehold improvements the allowance may cover.

Reporting a TI allowance for leasehold improvements

Under ASC 840, a TI allowance (or other lease incentive) was generally reported as a separate liability. The liability would have been reduced on a straight-line basis and reduced rent expense.

Now, under ASC 842, if a TI allowance is paid to a tenant up front, it reduces the tenant’s ROU asset, but adds a leasehold improvement asset in the amount that was paid. In other words, the tenant now has a lower lease cost and a separate monthly expense related to the leasehold improvement.

For example, suppose an ROU asset is calculated at $1 million and the landlord offers a lease incentive of $100,000 in a TI allowance. The result would be a $100,000 reduction in the ROU asset and $100,000 in leasehold improvement (PP&E) assets:

ROU asset $1,000,000 – TI allowance $100,000 = Total assets $900,000 lease + $100,000 PP&E

Tracking and managing lease details

Although leasehold improvements themselves are not affected by ASC 842, there are implications in the context of lease incentives and TI allowances as part of new lease negotiations.

Understanding leasehold improvements, lease incentives and the latest accounting treatments is critical to compliance with ASC 842. At the very least, tenants should keep track of all leasehold improvement costs, since they are assets that can be amortized or depreciated.

Leasehold improvements and lease incentives are just some of the critical details that need to be tracked for effective lease accounting and management. A technology solution like Visual Lease makes it easy for you to track these and other crucial aspects of your lease portfolio.

To learn more, contact us at (888) 876-6500 — or to see Visual Lease in action, request a demo. 

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