Theory and Practice
Lease incentives include rent-free periods, rent abatements, up-front cash payments, improvement allowances or lessor reimbursements of lessee costs. These reduce the lessee’s cost of the lease. Common examples are one or two months of free rent at the beginning of a lease, or a cash allowance to fit out a rented property.
IFRS
The IFRS approach is to deduct any lease incentives from the right-of-use asset’s initial cost (IFRS 16:24(b)). In other words, incentives do not reduce the lease liability (which is based on gross payments the lessee must make), but they reduce the recognized asset and therefore the future depreciation expense (IASB, 2016). For example, if a lessee receives a £100,000 tenant improvement allowance from the landlord, it records that as a reduction of the ROU asset (crediting that amount against the asset when measuring it at commencement). If a lease has 6 months of free rent, the lessee still recognizes depreciation and interest for those months (the lease liability isn’t forgiven during the free period – interest on the liability accrues even when cash rent is zero). The net effect is that the benefit of the free rent is spread over the lease term as a reduction of total expense: the lessee’s total depreciation plus interest for the lease will be lower than it would have been without the incentive, reflecting the lessor’s contribution (IASB, 2016). No “gain” is recognized at lease inception from an incentive; instead, the incentive is effectively recognized via lower expenses over time. This treatment is consistent with the approach under the previous IAS 17 (where lease incentives on operating leases were deferred and amortized as reductions of rent expense over the lease term).
US GAAP
Under ASC 842, the treatment is conceptually similar: no immediate income is recognized for incentives; they are spread over the lease term. If the lease is classified as a finance lease, the lessee reduces the ROU asset by the amount of incentive (just as under IFRS) (Financial Accounting Standards Board, 2016b). If it is an operating lease, US GAAP lessees typically record a separate deferred credit for the incentive and amortize it on a straight-line basis as a reduction of lease expense over the lease term (this approach is a carryover from legacy US GAAP and is effectively required by ASC 842-20-25-6) (Financial Accounting Standards Board, 2016b). The outcome is that the total lease cost recognized is net of incentives. For instance, if a tenant receives a $50,000 cash incentive on an operating lease, the lessee might debit cash $50,000, credit a “Deferred lease incentive” liability for $50,000, and then reduce rental expense by ~$10,000 per year over a 5-year lease (in practice, this is often netted within rent expense in financial statements). Practical insight: The end result under US GAAP (operating lease) – a straight-line net rent expense – is the same as under IFRS. The primary difference is presentation: IFRS builds the effect into a single asset-and-liability model (no separate “deferred incentive” liability; the ROU asset and its depreciation are lower from the start), while US GAAP may use a separate deferred liability to achieve a net reduction in expense. In both cases, the presence of a rent-free period or other incentive will not result in any immediate Income Statement gain but will reduce the lessee’s expense over the term (RSM US LLP, 2020).
UK GAAP
Historically, under FRS 102, operating lease incentives were recognized as a separate liability and amortized over the lease term (much like US GAAP). With the adoption of IFRS 16’s principles, FRS 102 will treat incentives by deducting them from the ROU asset, consistent with IFRS 16 (FRC, 2022). The outcome in terms of expense recognition remains the same (net lease expense is reduced), but going forward the U.K. standard will use the IFRS method of incorporating the effect into the ROU asset’s measurement.