How to Handle Lease Incentive Liability Under ASC 842

Making Sense of Lease Incentive Liabilities Under ASC 842

Managing business leases is tough enough without tackling how to account for lease incentive liabilities, especially with the new ASB 842 rules. Whether it’s receiving a rent discount, a cash reimbursement, or a non-cash reimbursement, i.e., the landlord covering or paying for a part of your build-out, those incentives should be accurately accounted for.

Under the new ASC 842 rules, accounting for leases has changed. Generally, the real impact of ASC 842 is more responsibility on companies to account for lease activity consistently and transparently on the balance sheet.

To put it clearly and simply, lease incentives are benefits you receive from a landlord upon entering into a lease agreement, but under ASC 842, they must not be ignored or treated as if they are free money. Instead, these incentives must be included in the calculations for lease liability and right-of-use assets, which will be significant to your financial statements.

The good news is, once you break the steps down, it is not as hard as you think! In this guide, we will help you identify what you need to know in order to accurately reflect your lease incentive liabilities and comply with ASC 842 rules.

Understanding Lease Incentives: What They Are and Why They Matter

Before we get into the accounting of lease incentives, it is important to understand what lease incentives are. To simplify, lease incentives are services (benefits) provided by a landlord to a tenant to facilitate the signing of a lease.

They can take many forms – rent-free months, cash reimbursements, or the landlord paying for all or some of the costs of improvements to the leased area. These incentives may seem like a nice bonus at the beginning of a lease, but they carry financial and reporting considerations that organizations must consider in their accounting and related disclosures.

ASC 842 indicates that lease incentives are not merely something to cheer; they are within the lease and must be appropriately reflected in your books as their own line item. If not recorded correctly, lease incentives could be misstatements in both assets and liabilities.

ASC 842 was designed to enhance clarity on all reporting on leases; therefore, lease incentives are also to be reflected transparently and establish consistency in accounting for lease incentives.

Understanding what constitutes a lease incentive is the first step to appropriately accounting for lease incentives, which also ensures compliance.

How ASC 842 Changes the Way Lease Incentives Are Treated

ASC 842 has introduced tremendous change to how leases will be recorded on financial statements. Under the old rules of ASC 840, operating leases typically stayed off-balance sheet and were mostly unnoticed. Under the new rules, virtually all leases will show a right-of-use (ROU) asset and a lease liability.

Furthermore, the treatment of lease incentives must now be considered in both of these two components of the lease accounting process, instead of being informally related or ignored.

If you have a lease incentive – for example, the landlord gives you 50,000 for improvements to the property – ASC 842 will require you to reduce that amount from total lease payments when calculating the initial ROU asset amount.

The lease liability will be calculated based on gross lease payments, before applying any lease incentives. When considering these two materials, this creates a mismatch that will need to be tracked correctly going forward.

Underestimating lease incentives creates conditions in which the tracking of asset value will be incorrect, expense recognition and timing misstated, and ultimately, non-compliance during the audit. It will take considerable effort to make it correct from the beginning.

Step-by-Step: Accounting for Lease Incentive Liabilities

Once you determine you received a lease incentive, it is time to incorporate it into your accounting for your lease under ASC 842. The first step is to determine the total lease payments over the term of the lease. Then simply subtract the value of the lease incentive from the total lease payments to recognize the proper amount of right-of-use (ROU) asset.

There is no reduction to the lease liability. The lease liability will continue to be calculated on the full lease payments because this is the amount due from the lessee.

Let’s say you have lease payments of $500,000, and the landlord gave you a $50,000 incentive. You will recognize a lease liability of $500,000 (appropriately discounted), but the ROU asset would be based on $450,000.

This does two things: it gets the accounting in accordance with ASC 842, and it properly recognizes that you got a benefit from the landlord’s contribution. You will also need to take the value of the incentive and allocate it over the lease term, which will impact the straight-line expense recognition in your income statement as well.

The goal is to keep everything in balance, both after and before the incentives are entered.

Common Mistakes to Avoid When Recording Lease Incentives

Even with the best of intentions, error is a blind spot for businesses accounting for lease incentives under ASC 842. One area of concern is netting the incentives against the lease liability, resulting in erroneous financial statements.

Another area of error is omitting the ROU asset adjustment for the incentive, especially when the incentives contain non-cash presumptive incentives (e.g., construction costs or rent-free periods).

Another pitfall would be maintaining insufficient documentation of the incentive at the time of the lease signing. If the incentive is later determined, or not specifically disclosed in the legal documents, incorrect calculations will follow both during implementation and retrospectively.

Companies can mitigate these risks through a thorough review of lease contracts, clear tracking of all incentives received, and consistent processes when recording and calculating the lease liability and asset. Good internal communication between the accounting team and the lease’s legal and contractual teams will also benefit compliance with all lease requirements.

Wrap It Up Right: Stay Compliant and Confident with Your Lease Incentive Accounting

Properly accounting for lease incentive liabilities under ASC 842 is not just about compliance, but ensuring your financial statements are true, transparent, and audit-ready.

The process, from knowing what qualifies as a lease incentive to implementing the new accounting policies in a methodical way, shows that a small detail can have significant consequences on your balance sheet.

The recommendation is to keep a paper trail, keep a lookout for common errors, and ensure both your lease liabilities and right-of-use assets are complete.

If this feels daunting, you don’t have to go it alone. Black Owl Systems provides lease accounting solutions that automate compliance processes and minimize risk. Whether you have a single lease or hundreds, we have the tools and expertise to help you appropriately apply ASC 842 with confidence.

Visit our website today and learn how we can help make your lease accounting processes easier, smarter, and compliant with standards.