How to account for leasehold improvements
Leasehold improvements are defined as the enhancements paid for by a tenant to leased space. Examples of leasehold improvements are:
- Interior walls and ceilings
- Electrical and plumbing additions
- Built-in cabinetry
- Carpeting and tiles
Leasehold improvements generally revert to the ownership of the landlord upon termination of the lease, unless the tenant can remove them without damaging the leased property.
An example of leasehold improvements is offices constructed in unfinished office space.
When you pay for leasehold improvements, capitalize them if they exceed the corporate capitalization limit. If not, charge them to expense in the period incurred. If you capitalize these expenditures, then amortize them over the shorter of their useful life or the remaining term of the lease. The remaining term of the lease for amortization purposes can be extended into additional lease renewal periods if the renewal is reasonably assured (such as when there is a bargain renewal option).
If you subsequently purchase the building, the lease is presumably dissolved, so you can then amortize over the estimated remaining useful life of the building, which is likely to be a much longer period than the term of the original lease, resulting in a significantly smaller monthly charge.
Technically, you are amortizing leasehold improvements rather than depreciating them. The reason is that the landlord owns the improvements, so you are only exercising an intangible right to use the improvements during the term of the lease – and intangible assets are amortized, not depreciated.
For example, ABC Company has a five-year lease on an office building, as well as an option to renew the lease for an additional five years at the then-prevailing market rate. ABC pays $150,000 to build offices in the building immediately after it leases the space. The useful life of these offices is 20 years. Since there is no bargain purchase option to renew the lease, it is not reasonably assured that ABC will renew the lease. Consequently, it should amortize the $150,000 over the five years of the existing lease, which is the shorter of the useful life of the improvements or the lease term. ABC will recognize $30,000 of amortization in each of the five years of the lease with the following entry:
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