Updated July 15, 2023
What is Leasehold Improvement?
The term “leasehold improvement” refers to the changes made to the rental properties to customize them to match the needs of the existing or prospective tenants.
In other words, the lessor or the lessee makes these modifications to make the rented space appealing and more useful. Sometimes, the lessee incurs the expenses for leasehold improvements upfront and reimburses them later by the lessor. A leasehold improvement is also popular as build-outs or tenant improvements.
What is Included in Leasehold Improvement?
Leasehold improvements are either carried out by the lessor to increase the marketability of the rented property or by the lessee for particular business requirements. Leasehold improvements primarily include alterations to a leased property, such as installing partitions, painting walls or other interior space, fitting customized light fixtures, changing ceiling/ flooring, etc.
How Does it Work?
If the lessor undertakes the leasehold improvements, it can also call capital improvements. In this case, the amount and extent of the improvement depend on how much the lessor plans to spend on the property’s marketability. On the other hand, if the lessee undertakes the improvement, then the expenses for the improvements are borne by the tenant, and they are more focused on the tenant’s own business requirements. The company then capitalizes the expenditure and amortizes it over the useful life of the improvements or the remaining tenure of the lease or extended lease term, whichever is lesser.
For example, let us take the case of David, who has a 5-year lease for a retail shop. David spent $50,000 to customize the layout of the space according to his business suitability, which falls under the leasehold improvement category. However, the useful life of the improvements is 10 years. So, the $50,000 expenditure should be capitalized, and then it should be amortized over the 5 years of the lease term, which is lesser than the useful life of the improvements. Consequently, David should recognize $10,000 as amortization every year for the next 5 years of the lease term.
Accounting for Leasehold Improvement
In accounting, the leasehold improvements are considered the lessee’s asset if the lessee pays for the expenses and is capitalized accordingly. Otherwise, the lessor’s asset will capitalize on the lessor’s balance sheet. Now, the payment for the leasehold improvement should be recorded as follows:
Now, suppose the improvements are usable for more than one reporting period. In that case, the improvements are recognized as fixed assets and then amortized over the lesser of the useful life of the improvements or the remaining tenure of the lease or the extended lease term as follows:
Now, suppose the lessee paid for the improvements and recorded them accordingly. In that case, the lessee should write off the same from the balance sheet after the termination of the lease because all leasehold improvements become the lessor’s property. Basically, after the expiration of the lease, the lessee has no control or enjoys no benefits from these improvements, so it should be written off. The lessee should also reverse the accumulated depreciation.
Is Leasehold Improvement a Fixed Asset
Leasehold improvements are considered fixed assets and thus are recognized as part of property, plant, and equipment (PP&E) under the non-current assets section of the balance sheet. In the US GAAP, lease improvements are accounted for as other fixed assets as per ASC 360 (Accounting Standards Codification).
Depreciation of Leasehold Improvement
Leasehold improvements are not depreciated but amortized because the improvements belong to the lessor (landlord) and not the lessee (tenant). Hence, the lessee only possesses the right to use the asset during the tenure of the lease, which amounts to an intangible asset. Since intangible rights are amortized, thus leasehold improvements are also amortized and not depreciated. Therefore, all leasehold improvements are amortized to reduce the balance to zero. Now, certain rules are to be followed during amortization accounting:
- Useful Life Basis: If the useful life of the leasehold improvements is expected to be less than the remaining lease tenure, then the associated should be amortized over the useful life. For instance, if a newly installed light fixture expects to be replaced in 3 years, while the remaining tenure of the lease is 5 years, the asset should be amortized over the 3 years.
- Lease Term Basis: If the useful life of the leasehold improvements expects to be equal to or greater than the lease tenure, then the associated should amortize over the lease tenure. For instance, if the useful life of the office partition expects to be 10 years and the remaining lease tenure is 5 years, the asset should be amortized over the 5 years.
- Extended Lease Term Bas is: If the lessor offers a bargain lease rate, the lessee assumes the lease will renew. In such a scenario, the lease period extension is reasonably certain. Thus the asset can depreciate over an extended period, which capes the asset’s useful life.
- Leasehold improvements are the modifications made to the rental properties to make them appealing to prospective tenants or more useful for the existing tenants.
- Leasehold improvements include changes, such as installing partitions, painting walls or other interior space, fitting customized light fixtures, changing ceiling/ flooring, etc.
- The lessee only possesses the right to use the asset, which is an intangible asset. Hence, assets associated with leasehold improvements amortize and do not depreciate.
- The assets associated with leasehold improvements are amortized over the lesser useful life of the improvements, the lease’s remaining tenure, or the lease term’s extension.
This is a guide to Leasehold Improvement. Here we also discuss the introduction and how does leasehold improvement work? Along with key takeaways. You may also have a look at the following articles to learn more –