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For example, how does the lessee account for a scenario when they make
improvements to the leased asset and are subsequently reimbursed by the
lessor?
Before going further, it's essential to understand the interplay between lease
incentives and leasehold improvement.
One of the most common examples of a lease incentive is when the lessor
reimburses some or all costs the lessee has incurred for a leasehold/tenant
improvement.
When deciding on how to account for the above scenario, the lessee must
determine whether the leasehold improvement is the asset of the lessee or
lessor. See below for the decision indicators when deciding whether it’s a
lessee or lessor asset:
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Lessee Asset
Accounting
The lessee should account for the leasehold/tenant improvement inline with
the applicable property, plant and equipment standard IAS 16 or Topic 360
Dr PPE
Cr Cash
The useful life will require judgment and will depend on:
Other factors include whether the improvement increases the fair value of the
underlying asset from the lessor's standpoint and the economic life of the
improvement relative to the lease term.
When the lessor reimburses the lessee for an asset (i.e. a lease incentive) after
lease commencement, the lessee and lessor must determine whether the lease
incentive is considered fixed or variable.
Fixed incentive
Assume the incentive is subject to a cap, and it is reasonably certain the lessee
will use some or all of the amount available for reimbursement by the lessor. In
that case, the portion of the incentive that is reasonably certain to be used
should be treated as an in-substance fixed lease payment (i.e., reduction to
lease payments).
Variable incentive
Accounting
For a fixed incentive, the lessor payment is a lease incentive that should be
recorded as a reduction to fixed lease payments. Following IFRS 16, paragraph
27 and ASC 842-10-15-35, it will reduce the lease liability and right-of-use
asset value.
Lessor Asset
When a lessee pays for an improvement that is a lessor asset, the expenditure
is prepaid rent rather than a lease incentive; the reimbursement is a reduction
to prepaid rent. If a lessee were not fully reimbursed, the difference between
the costs incurred and the reimbursements received would be included in
lease payments.
Accounting
Dr Prepiad Rent
Cr Cash
Dr Cash
Cr ROU Asset
When the lessee is reimbursed for the leasehold improvement (incentives received
before commencement)
Dr ROU Asset
Cr Prepaid Rent
The lessee will calculate the additional cost of the leasehold improvement (the
amount they will not get fully reimbursed for). This will be added to the fixed
payments, which form the present value of the lease liability.
Practical example
Now if you’re unfamiliar with basic concepts of how to present value and
calculate the lease liability it’s recommended you read this article first.
Some fundamental inputs into the methodology of the calculation will be:
XNPV present value formula: we use the XNPV formula in excel, this takes
into consideration the date of payments and therefore gives a more
accurate present value amount
If you would like the excel file of the calculation please reach out to
contact@cradleaccounting.com
Part A
Frequency: Annual
Incentive: $70,000 paid to the lessee for the lessor leasehold improvements
Solution:
Initial measurement:
The present value of $150,000 paid in arrears, over 10 years with a discount
rate of 3% using an XNPV formula is: 1,279,536.85
2020/1/1
2020/1/1
2020/1/1
2020/1/1 to 2020/1/31
2020/1/1 to 2020/1/31
Part B
On January 1 2025 the lessor and lessee modifies the agreement in which:
All expenditure must be incurred by 1 July 2026 and will be offset against
the future lease payment on 31 December 2026
Lessee deems this a lessor asset and will account for the leasehold
improvement as a incentive resulting in a future reduction
Solution:
Step 2: Record the lease liability movement based on the updated cash flow
payments using the updated discount rate
Update the amortization based on the update ROU Asset value and future
lease expenditure
2025-1-1
Remeasurement of the Lease liability and ROU Asset as a result of lease incentive
modification
2025-1-1 to 2025-1-31
2025-1-1 to 2025-1-31
If you would like to understand how the calculations work please reach out to
contact@cradleaccounting.com and we will provide an excel spreadsheet with
all applicable workings and formulas.
Here at Cradle, our mission is simple; it's at the foundation of everything that we do. We want to make accountants' lives easier by leveraging technology to free up their time
to focus on running the business.
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