ABMMB, LLC (the Company) owns and operates three full service restaurants known as Morgan’s Tap Room. Its stores are all leased and the Company is in growth mode and recently hired a new controller, Stan, to manage its accounting function.
On January 1, 2012, the Company signed a lease for a new location. The lease contained a base term of 10 years and includes three fi ve year options to extend the term if desired.
The lease contains annual rent escalations and the landlord is providing a $1 million tenant improvement allowance for the
Company to use to customize the space.
The landlord turned over the building to the Company on April 1, 2012 and the store recently opened on June 1, 2012.
The morning after the grand opening party at the restaurant, Stan came into work and obtained the signed lease from the
President and began to review its provisions to determine the appropriate accounting treatment. In conjunction with this process,
Stan decided he should review the current three stores’ leases to ensure the treatment was also in accordance with GAAP.
While reviewing the current three lease agreements, Stan determined the following about each of the three existing locations: r Bethesda — Base term 10 years, three fi ve year renewals, every fi ve years the rent escalates by the lesser of 2% or CPI, no tenant improvement allowance was received r Arlington — Base term 10 years, three fi ve year renewals, every fi ve years the rent escalates by the greater of 2% or CPI, no tenant improvement allowance was received r Washington DC — Base term 10 years, three fi ve year renewals, the rent escalates annually by fi xed dollar amounts, no tenant improvement allowance was received, and the lease was amended in
2012 for rent abatements granted
Stan opened up the Company’s lease accounting schedule and balance sheet and noted that deferred rent was recorded for the Washington DC store; however, no other deferred rent was noted.
1.
Should any deferred rent be recorded for the existing stores?
2.
Should the Washington DC straight line rent schedule change for the signed amendment in 2012?
3.
What steps does Stan need to take to record the new store’s lease?
1.
Yes, deferred rent should have also been recorded on Arlington’s lease. The language
“greater of” implied that at a minimum every 5 years the rent would increase by 2%. Therefore, this should have been included in a straight line rent schedule and recorded as such.

2.
Yes. The rent abatement needs to be accounted for in the “cash paid” portion of the deferred rent schedule and the existing deferred rent balance needs to be re-amortized with the new cash payments included over the same remaining lease term.
3.
Stan needs to take the following steps: a.
Perform lease classi fi cation testing to determine if the lease is an operating or a capital lease. (The remainder of this example assumes the lease is an operating lease as this is the more common treatment seen.) b.
Discuss with management the expected term of the lease — although the base term is 10 years, the Company intends to stay in this location for 15 years before it will perform any major remodels to the store.
c.
Create a straight line rent schedule for the cash paid vs. GAAP rent expense recognized over the 15 year term of the lease. Don’t forget to include April and May as “free” rent months on the schedule.
i.
Tip — create a separate GL account called “Straight Line Rent Expense” to track the GAAP rent separate from cash paid for rent for ease of reporting ii.
Schedule should add up all of the cash paid over the 15 years/15.167 years (15 years plus 2 months for free rent period) for annual straight line rent expense to be recognized over the term of the lease iii.
The difference between cash paid and GAAP straight line rent is recorded into a “Deferred Rent” liability account on the balance sheet iv.
Set up recurring entries in the accounting GL system d.
Record tenant improvement allowance on the books.
i.
DR — Leasehold improvements ii.
CR — Deferred rent e.
Create (or add onto straight line schedule) tenant improvement allowance amortization table.
i.
Tenant improvement allowance received $1,000,000/15.167 years = annual amortization ii.
Set up recurring entries in the accounting GL system for this amortization against rent expense
(typically included in Straight line rent expense” GL account recommended above) f.
Review leasehold improvement (LHI) lives in the fi xed asset sub-ledger as follows: i.
For new store, all new additions to
LHI placed into service on June 1,
2012 with get a life of 15 years (or less if the economic life of the speci fi c asset is less, i.e. parking lot) ii.
TRAP — On June 1, 2013 , a halfwall is added around the bar area in the restaurant, the LHI life assigned to this asset for GAAP should be 14 years — because that is the remaining lease life in the corresponding deferred rent schedule, not 15 years because that is the Company’s typical LHI life.