What is a Tenant Improvement Allowance?

The lessor of a property may grant an allowance to a lessee that is to be used to improve the leased property. This allowance may be granted in order to convince a valuable tenant to sign a lease, or perhaps because the landlord’s only other choice is to drop the monthly rent payment - which would lower the value of the property. Examples of the improvements that may be made with a tenant improvement allowance include the construction of walls, the addition of carpeting, and the installation of electrical wiring and plumbing.

How to Account for an Tenant Improvement Allowance

The proper accounting for a tenant improvement allowance depends upon whether the lessee will own the resulting leasehold improvements, and whether it is a direct reimbursement arrangement. The options are noted in the following bullet points:

Lessee owns the improvements. If the lessee owns the improvements, then the lessee initially records the allowance as an incentive (which is a deferred credit), and amortizes it over the lesser of either the term of the lease or the useful life of the improvements, with no residual value. Typically, the term of the lease is the amortization period used. This is essentially a negative rent payment.
Lessor owns the improvements. The lessor records the expenditure as a fixed asset and depreciates it over the useful life of the asset. If the tenant moves out and terminates the related lease prior to the end of the depreciation period, the lessor can continue depreciating under the original depreciation calculation. If the building is subsequently destroyed or damaged, the lessor writes off the remaining undepreciated balance of the expenditure, which appears in the income statement as a loss.
Flow-through arrangement. If the lessor is directly reimbursing the lessee for the cost of leasehold improvements, this is a flow-through arrangement where the lessee does not record any fixed asset associated with the payments. Instead, the lessee is initially paying for the improvements, and those payments are offset shortly thereafter by payments received from the lessor.

The Securities and Exchange Commission (SEC) has also noted that when a lessee receives cash under what is judged to be a lease incentive arrangement, the cash inflow should be stated within the operating activities section of the lessee's statement of cash flows as a lease incentive. Also, any payments made for leasehold improvements should be stated within the investing activities section of the statement of cash flows.