Lease incentives and rent concessions (initial and in-life)

Lease incentives such as landlord fit-out contributions and rent-free periods are common in mall leases and directly reduce the economics of the lease, so they must be reflected in the initial lease measurement rather than being recognized as income when received: rent-free periods and incentives receivable after commencement reduce the lease payments and therefore the lease liability, while incentives received at or before commencement reduce the right-of-use (ROU) asset. Getting this wrong overstates both the ROU asset and future rent expense, and understates the true cost of occupying the space. Separately, temporary rent concessions negotiated mid-lease (common during downturns or renegotiations with mall landlords) can be a lease modification requiring remeasurement of the lease liability using a revised discount rate, which changes the ROU asset and future depreciation and interest expense. Retailers with large store portfolios face this issue continually as leases are renewed, incentivized, or renegotiated.

Is the incentive received at or before lease commencement (reducing the initial right-of-use asset), receivable after commencement under the original lease terms (deducted from the lease payments, so reducing the lease liability), or granted later as a concession during the lease term? If granted later, does it qualify as a lease modification requiring remeasurement of the liability at a revised discount rate, or does a practical expedient apply? Has the full revised lease payment stream been used consistently in the remeasurement rather than only the concession period?

1. At lease commencement, build the lease payment schedule net of any rent-free periods already agreed (a rent-free period is not separately recognized as income - it simply means no payment is due for that period, which is already reflected in the discounted cash flow stream).
2. Identify any additional lease incentives in cash or as a contribution to fit-out costs (e.g., a fixed cash payment from the landlord) and when they are received: incentives received at or before commencement reduce the initial measurement of the ROU asset (step 4) and do not enter the lease liability; incentives still receivable after commencement are deducted from the fixed lease payments, because lease payments are measured net of lease incentives receivable, and therefore reduce the lease liability.
3. Recognize the lease liability at the present value of the lease payments not yet paid at commencement (i.e., the payment stream that already reflects the rent-free period and is net of any incentives receivable after commencement).
4. Recognize the ROU asset at the amount of the lease liability, plus initial direct costs and any estimated dismantling costs, minus lease incentives received at or before commencement (incentives receivable after commencement are already reflected through the lease liability).
5. For in-life rent concessions, assess first whether the change meets the definition of a lease modification (a change in scope or consideration not part of the original terms). If yes, remeasure the lease liability using a revised discount rate at the effective date of the modification and adjust the ROU asset by a corresponding amount.
6. If a temporary concession does not change the scope of the lease and only affects consideration up to and including payments originally due within a limited period (and consideration decreases are not disproportionate versus the reduction in scope), assess whether the entity has elected any available practical expedient for COVID-19-type concessions still applicable to it; otherwise apply the general modification model.

Initial ROU asset and lease liability are measured using the present value of lease payments discounted at the rate implicit in the lease, or the lessee's incremental borrowing rate if the implicit rate is not readily determinable - typically the incremental borrowing rate for retail store leases. Lease incentives received at or before commencement reduce the ROU asset measurement amount for amount and are not discounted. Lease incentives receivable after commencement are deducted from the fixed lease payments of the period in which they are receivable, so they are discounted within the lease liability; because the ROU asset starts from the lease liability, they reduce the ROU asset through that route rather than as a separate deduction. Subsequently, the ROU asset is measured at cost less accumulated depreciation (straight-line over the lease term unless another systematic basis is more representative) and impairment; the lease liability is subsequently measured using the effective interest method, increased for interest and decreased for lease payments made. On modification, the lease liability is remeasured using a revised discount rate applied to the revised payment stream, and the difference is recorded as an adjustment to the ROU asset (not P&L), unless the ROU asset is already reduced to nil, in which case any further reduction is recognized in profit or loss.

ROU assets presented separately or disclosed if included within another line item, with the line item identified; lease liabilities presented separately from other liabilities or disclosed; depreciation charge for ROU assets by class of underlying asset; interest expense on lease liabilities; amount of lease incentives and rent-free benefits reflected in ROU asset and lease liability measurement for material new leases during the period; nature and financial effect of significant lease modifications during the period, including rent concessions; maturity analysis of lease liabilities; significant judgments in determining the incremental borrowing rate and lease term

• Recognizing landlord fit-out contributions as immediate other income rather than deducting them from the ROU asset (if received at or before commencement) or from the lease payments (if receivable after commencement)
• treating every incentive as an ROU-only adjustment and ignoring that incentives receivable after commencement reduce the lease payments and therefore the lease liability
• treating a rent-free period as generating income during the free months instead of spreading its benefit through the discounted payment stream from day one
• failing to assess whether an in-life rent concession is a lease modification and instead recognizing the reduced rent as a simple reduction in expense
• using the original (pre-modification) discount rate when remeasuring for a modification instead of a revised rate at the effective date
• not distinguishing between concessions that reduce scope (e.g., early termination of part of the space) versus pure price concessions, which affects the modification mechanics
• forgetting to reassess lease term or purchase/renewal options triggered by a concession negotiation