What is Leasehold Improvement?
The term “leasehold improvement” refers to the changes that are made to the rental properties to customize them to match the particular needs of the existing or prospective tenants. In other words, these are modifications are either made by the lessor or the lessee to make the rented space appealing and more useful. Sometimes, the lessee incurs the expenses for leasehold improvements upfront and then later is reimbursed by the lessor. A leasehold improvement is also popularly known as build-outs or tenant improvements.
What is Included in Leasehold Improvement?
Leasehold improvements are either carried out by the lessor with the objective to increase the marketability of the rented property or by the lessee themselves for particular business requirements. Leasehold improvements primarily include alterations made 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, then it is known as capital improvements. The amount and extent of the improvement, in this case, depends on how much the lessor plans to spend on the marketability of the property. 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 expenditure is then capitalized and amortized 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 own business suitability, and this falls under the category of leasehold improvement. 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 to be the lessee’s asset if the lessee paid for the expenses and is capitalized accordingly. Otherwise, it will be the lessor’s asset and capitalized in the lessor’s balance sheet. Now, the payment for the leasehold improvement should be recorded as follows:
| Particulars | Debit | Credit |
| Leasehold improvement | XXX | |
| Cash | XXX |
Now, if the improvements are usable for more than one reporting period, 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:
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| Particulars | Debit | Credit |
| Amortization expense | XXX | |
| Accumulated amortization | XXX |
Now, if the lessee paid for the improvements and recorded them accordingly, then 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, and so it should be written off. In fact, the lessee should also reverse the accumulated depreciation.
Is Leasehold Improvement a Fixed Asset
Leasehold improvements are considered to be 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 rather amortized because the improvements actually 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 such that the balance is eventually reduced to zero. Now, there are certain rules that are to be followed during the amortization accounting:
- Useful Life Basis: If the useful life of the leasehold improvements is expected to be lesser than the remaining tenure of the lease, then the associated should be amortized over the useful life. For instance, if a newly installed light fixture is expected to be replaced in 3 years, while the remaining tenure of the lease is 5 years, the asset should be amortized over the 3-year period.
- Lease Term Basis: If the useful life of the leasehold improvements is expected to be equal to or greater than the lease tenure, then the associated should be amortized over the lease tenure. For instance, if the useful life of the office partition is expected to be 10 years and the remaining lease tenure is 5 years, the asset should be amortized over the 5-year period.
- Extended Lease Term Bas is: In case the lessor offers a bargain lease rate, then the lessee has an assurance that the lease will be renewed. In such a scenario, the extension of the lease period is reasonably certain, and thus the asset can be depreciated over the extended period, which is capped at the asset’s useful life.
Key Takeaways
- Leasehold improvements are the modifications that are made to the rental properties to either make them appealing for the 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, asset associated with leasehold improvements is amortized and not depreciated.
- The assets associated with leasehold improvements are amortized over the lesser of the useful life of the improvements or the remaining tenure of the lease or the extended lease term.
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