Leasehold Improvement can be described as the changes that are made to the leased or rental property in order to ensure that it is best suited for the purposes of the tenant.
During the course of the lease agreement, there might be a number of changes that the tenant requires in order to bring the property to its proper usage.
When making changes in the structure, or the building, it is important to consider the fact that leasehold improvements are mostly undertaken by the property owner, and therefore, they need to be properly accounted for in order to get best possible results.
However, there is no hard and fast rule that leasehold improvements need to be solely undertaken by the property owner only. In certain cases, the tenant can also provide for these expenses, after bringing it in the notice of the property owner.
As a matter of fact, it is also highly important to ensure the fact that these leasehold improvements are often significant in terms of the financial value, and therefore, they need to be properly accounted for in order to make it best suited to both the parties.
Some examples of leasehold improvements include paintings, replacement of fixtures and fittings, and other miscellaneous expenses that might be relevant in this regard.
Accounting for Leasehold Improvement
Leasehold Improvements can be considered to be either an asset or an expense. In the case where leasehold improvements are considered to be a fixed asset, there is a need to ensure that the expense meets the capitalization criteria.
During the course of the tenancy period, there is a lease agreement that is drawn which specifies which alterations or changes can be made within the structure of the property and if those expenses can be capitalized.
Normally, there is a capitalization limit that is set on the expenses that are incurred by the tenant, and these expenses, if have a useful life of more than one year, are normally considered to be capital expenditures.
Therefore, if the investment in leasehold improvement is considered to be a fixed asset by the tenant, then it is amortized over the useful life of the improvement.
However, it must be noted that upon the termination of the lease contract, all the leasehold improvements are considered to be the property of the property owner, unless stated otherwise.
In the case where leasehold expenses are incurred by the tenant, and they are capitalized, the following journal entries are shown in the financial statements:
|Dr. Expense – Leasehold Improvement Expense||$ 10,000|
|Cr. Cash||$ 10,000|
Similarly, in the cases where the tenant records leasehold improvements as a capital expense, the following journal entry is made:
|Dr. Leasehold Improvement (Non-Current Assets)||$ 10,000|
|Cr. Cash||$ 10,000|
Are Leasehold Improvements Fixed Assets?
A leasehold improvement is only classified as fixed assets if they are duly capitalized, as per the capitalization threshold that is general acceptance. In most cases, the general guidelines for leasehold improvements are as follows:
- The benefits of the leasehold improvements are classified to last for more than one year. In other words, the economic benefits resulting from the leasehold improvements are likely to span across a period of more than 1 year (they are considered to be long term), as opposed to short term.
- Leasehold improvements that are substantial, and significant in nature are often capitalized. This is also because of the fact that expensing them in a single year might often take an uncalled for strain on the balance sheet, because of which they capitalized, and then duly amortized over the course of time.
- Leasehold improvement expenses, which are one-time, and non-recurring are often capitalized. Regular leasehold improvements are not capitalized and are treated as expenses in most cases.
The general depreciation rule across all leasehold improvements can be categorized into three broad categories, which are as follows:
- Useful Life Basis: In the case where the leasehold improvements are incurred, they are assumed to have a useful life of around 5 years or 10 years. Depending on the useful life of the asset, they are amortized and expensed every subsequent year.
- Lease Term Basis: In the case where the tenant has borne for capitalized expenses, it can be seen that the expense is depreciated over the useful life of the lease agreement. If a lease lasts for a period of 10 years, then the capitalized expense will be depreciated or expensed over a period of 10 years.