Leasehold improvements and their amortization
February 6, 2013
Leasehold improvements represent additions to a lease property. Accounting for such improvements normally does not present a significant issue except for their amortization. This article covers a common issue which relates to the amortization of leasehold improvements.
Leasehold improvements are additions, alternations, or remodeling on a leased property. Such improvements normally revert to the lessor at the end of the lease term.
Leasehold improvements are normally presented as part of property, plant and equipment (i.e., fixed assets) in the non-current assets section on the balance sheet.
Letís look at an example of leasehold improvements. Suppose a company (Lessor) has built a new office building. The building doesnít have much interior decoration (e.g., carpet is missing, walls need painting, doors have not been installed) because Lessor wants to provide as much freedom to a potential renter (Lessee) in such decoration as possible. †A human resources company expressed an interest in renting the building for its offices and signs a lease agreement for five years. As part of the lease agreement, Lessee can decorate the office building interior (at Lesseeís expense).
Before the human resources company moves into the new building, the company hires a construction company to install carpets, paint the walls, install doors, and so on. The human resource company pays the construction company $50,000 for such work. The $50,000 represents leasehold improvements.
After five years if the human resource company (Lessee) moves out, all such improvements will stay with the building and thus will revert to Lessor. So, in effect, Lessee does not own such improvements: it uses them temporarily. This treatment is close to treatment of intangible assets (e.g., five-year software license) which is why leasehold improvements are said to be amortized instead of depreciated. Leasehold improvement amortization is normally done on a straight-line basis, and this brings us to the common issue related to amortization of leasehold improvements: the period over which leasehold improvements should be amortized.