Leasehold Improvements

Leasehold improvements are alterations or additions that a tenant makes to property it rents, such as building interior walls, installing lighting, adding shelving, upgrading electrical systems or fitting out a shop front. Because the work improves space the tenant does not own, and usually becomes the landlord's property when the lease ends, it is accounted for separately from owned buildings. The tenant, known as the lessee, records the cost as a long-term asset and spreads it over the period it will benefit from the work.

Leasehold improvements are common in retail, restaurants and offices, where a business signs a lease on a bare shell and pays to fit it out. They appear on the balance sheet within property, plant and equipment and are expensed through amortization or depreciation, depending on the wording a company uses. They are distinct from land improvements, such as parking lots, made to land an entity owns.

Costs that add lasting value to the leased space are capitalized rather than expensed immediately. These include construction, materials, permits and architect fees directly linked to the work. Routine repairs, cleaning and redecorating that merely keep the space in its existing condition are expensed as incurred. Movable furniture and equipment that the tenant can take away are recorded as fixed assets in their own right, not as leasehold improvements.

Under US GAAP (ASC 842) and IFRS (IAS 16), leasehold improvements are amortized over the shorter of their useful life and the remaining lease term. If the lease includes a renewal option that the tenant is reasonably certain to exercise, the renewal period can be included. If ownership transfers to the tenant at the end of the lease, the full useful life is used.

A restaurant signs an eight-year lease and spends $240,000 on a kitchen fit-out, flooring and dining room fixtures. The improvements are expected to last 12 years, but because the restaurant has no reasonably certain renewal option, the amortization period is the eight-year lease term. Using the straight-line method:

Here $\text{Cost of improvements}$ is the capitalized amount and the denominator is the period of benefit in years. The charge is $240,000 divided by 8, or $30,000 a year. Each year the restaurant debits amortization or depreciation expense $30,000 and credits accumulated depreciation (or accumulated amortization) $30,000. After three years the improvements have a book value of $150,000. If the restaurant closes and walks away at that point, the remaining $150,000 is written off as a loss, much like any other disposal of fixed assets.

For federal income tax purposes, most interior improvements to nonresidential buildings fall into the category of qualified improvement property, which has a 15-year recovery period and is eligible for bonus depreciation. Tax depreciation therefore often runs much faster than book amortization, creating timing differences that are tracked through deferred income taxes. Improvements that enlarge a building, or that relate to elevators, escalators or the internal structural framework, do not qualify and are depreciated over the longer 39-year period. Detailed rules are published by the Internal Revenue Service.

• Amortizing over the asset's physical life instead of the shorter lease term, which overstates the asset and understates expense.
• Failing to account for a landlord's tenant improvement allowance. Under ASC 842, an allowance paid to the tenant generally reduces the right-of-use asset as a lease incentive, while the tenant still capitalizes the full cost of improvements it owns.
• Expensing large fit-outs immediately, which understates assets and distorts capital expenditure figures.
• Forgetting to write off unamortized balances when a lease is ended early.