Accounting for Property Leases

What is the proper accounting for property leases? We have entered into a 12-year, two-month lease on office space in Washington, D.C. and have some fairly complex questions. Here are the facts:

• The lease was signed on May 15, 2007.
• The lease quite clearly states that the base rent commencement date is September 1, which is when the property was physically occupied.
• Between May and September, the space was being built out to meet our needs and was not able to be occupied.
• The first two months are rent-free, after which payments are made monthly over the remaining 144 months.
• Built into the lease is a 2.5 percent annual cost-of-living increase in rent payments. These kick in on September 1 every year.
• The landlord gave us an allowance for and reimbursed us for some of the leasehold Improvements.

We understand that the free rent has to be amortized over the life of the lease, as it is a "move-in" incentive. However, do we have to amortize the total lease commitment (146 months, including cost-of-living increases) evenly over the 146 months? Or do we amortize on a cash-paid basis, adjusted for the free rent period, thereby letting the COL increases kick in on their anniversary?

For reporting purposes, what is considered to be the start (or inception) date of the lease – the base rent and occupancy date of September 1, or the date the lease was signed (May 15)? Does this alter the rent amortization schedule? Bear in mind that we were unable to occupy the space until September 1.

How do we amortize the leasehold improvements? Do we simply depreciate the net cost (after landlord allowance) as depreciation expense? Or do we depreciate the gross cost as depreciation expense and show the landlord build-out allowance as a reduction of rent expense?

Finally, over what period of time does this apply - i.e., what is considered the start date of the lease?

Any feedback on these issues would be greatly appreciated.

Malcolm High (mhigh@worldatwork.org)

Response:

Here’s what I can tell you about your question:  

• The total lease commitment should be expensed ratably, starting on the day build-out begins. Rent expense is required to be taken ratably, starting with beneficial occupancy, which is considered to be the day the build-out begins. This would mean that the period of expense is something greater than the 146-month term, but I can’t tell exactly, as the start date is not given (only the signing date, which may be close).

• The gross leasehold improvements should be amortized through depreciation expense over the life of the lease.

• The landlord allowance should be set up as a deferred liability and then recognized as an offset to rent expense over the life of the lease.

Anonymous