What are Leasehold Improvements?

Leasehold Improvements are defined as modifications made to a leased space or a leased asset to make it more suited to the specific needs of the given tenant. When a rental or a tenancy agreement is signed upon, there are several different components included. Leasehold improvements tend to be one of such factors. Naturally, the tenant would need to make amends to ensure that the new location is well suited to the tenant. This might require changes to be made to the existing space to make it better suited to the tenant’s needs.

In this regard, the changes that are supposed to be made are referred to as leasehold improvements. These leasehold improvements are included in the balance sheet of the party that is incurring these particular expenses. Therefore, it is important to have clarity regarding the utilization of these expenses and the criteria under which they can be capitalized.

Classification

The classification of leasehold improvements in the balance sheet is subject to the following terms and conditions:

Materiality: For leasehold improvement to be classified on the Balance Sheet, the costs must be material and subjective. It is also important to consider the overall materiality threshold involved in the overall state of affairs. Regardless, materiality tends to be quite subjective, yet it should be material enough to be classified and subsequently classified as a non-current asset.

Qualified Improvements: To ensure that improvements are qualified, it is important to note that several different qualified improvements can be capitalized. Factually, it can be seen that qualified improvements are only certain leasehold improvements that can be capitalized, whereas other improvements cannot be capitalized.

Examples of leasehold improvements in this regard include improvements made to occupy a building or structural changes in buildings. However, equipment or machinery directed towards leasehold improvements cannot be capitalized under leasehold improvements.

Therefore, it can be seen that only certain leasehold improvements can be included as non-current assets that are allowed to be included as non-current assets. This classification may or may not be included in the balance sheet.

The reason why companies might choose to capitalize leasehold improvements mainly lies in the realm of making it easier for landlords (or parties carrying out leasehold improvements) to expense them every year in a proportionate fashion. If leasehold improvements were to be expensed in the Income Statement in an upfront manner, this might adversely impact the profit volume of that company in the given year.

 Recognition

Leasehold Improvements in the balance sheet are only supposed to be categorized in the financial statements as non-current assets if they are eligible.

They are supposed to be recognized once the expense is undertaken and the materiality threshold is achieved. In most cases, leasehold improvements span a period of few months. In such a case, accountants can begin to classify eligible leasehold improvements in the balance sheet (if there is an overlap with a fiscal year) and then include disclosure to the financial statement notes.

Furthermore, it can be seen that leasehold improvements can only be recognized once there is a certainty that this is a material expense, which would be included as a part of the building in the long state of affairs. The process of recognition in the financial statements is supposed to include the cost incurred to bring the leasehold improvements to a working state.

In the same manner, it is also important to consider that these leasehold improvements are supposed to be amortized or depreciated over time. Therefore, in subsequent years, accountants are also supposed to include the carrying value of the leasehold improvements as the net amount between the cost of the leasehold improvements and the accumulated depreciation to date.

Measurement

The measurement of leasehold improvements in the balance sheet is supposed to be undertaken at cost. This means that all the costs incurred in the eligible category of leasehold improvement can be included at cost. In this aspect, it must be seen that all the regular repairs and maintenance expenses that are incurred to bring the leasehold improvements into a workable state should not be included as part of the capitalized costs for leasehold improvements.

This also implies that subsequent additions (or subtractions) to the leasehold improvements that incur a certain cost should not be included as capital costs in the leasehold improvement. This is also because subsequent additions to the said structure are not material (or significant) enough to be included as part of capital costs.

Example of Leasehold Improvements in the Balance Sheet

An example of leasehold improvements and how they are treated in the Balance Sheet is illustrated via the following example:

Kwick Inc. has procured a place from Jimmy Inc. to expand its operations. However, certain additions needed to be made to the existing structure to bring the premise to a suitable working condition. Jimmy Inc. undertook the responsibility to go ahead with leasehold improvements on the premises. The total cost of installation of the new room (as leasehold improvement) amounted to $120,000. This was amortized over a lease period of 15 years.

In the scenario mentioned above, it can be seen that leasehold improvements are considered eligible for 15 years. Since the landlord’s expense is undertaken, it will be mentioned as a leasehold improvement (non-current asset) in the financial statements.

The entry that records leasehold improvements in the financial statements are as follows:

ParticularDebitCredit
Leasehold Improvement$120,000 
 Cash (Or Cash equivalents)$120,000

Subsequently, it can be seen that leasehold improvements are also supposed to be amortized over a period of 15 years. This implies that the amortization charge per year would be $8000. This is an expense that would be reflected in the Income Statement of the landlord (i.e., Jimmy Inc.).

In the same manner, accumulated depreciation will also be charged to the Balance Sheet to reflect the correct carrying amount of the said asset.

For example, after 2 years, the leasehold improvements in the balance sheet would look like this:

ParticularDebitDebit
Leasehold Improvements$120,000 
Less: Accumulated Depreciation$16000 
Net Leasehold Improvements $104,000

It is also important for accountants to ensure that all necessary disclosures about leasehold improvements are also included in the financial statements. This is because, in a standalone manner, they might appear to be confusing to the users of the financial statements.

Therefore, including additional notes to the financial statements is considered important in ensuring no information asymmetry is involved.