2. Example of leasehold improvement amortization

According to US GAAP, leasehold improvements should be amortized over the shorter of:

• term of the lease, or
• useful life of leasehold improvements.

The term of the lease can include renewal options if renewal is reasonably certain (e.g., there are bargain renewal options or there are penalties for non-renewal which make renewal likely to take place).

A common mistake by some accountants consists in amortizing leasehold improvements over their useful life irrespective of the lease term. This can be due to the automated nature of such amortization in an accounting system where useful lives are assigned to assets based on their category (e.g., leasehold improvements may be assigned a useful life similar to that of a building). In cases when lease terms are shorter than useful lives assigned to leasehold improvements, amortization expense will be understated and leasehold improvements (net of related accumulated amortization) will be overstated.

Let’s return to our example. Assume that the human resources company estimates the useful life of the leasehold improvements to be seven (7) years. Recall that the lease agreement is for five (5) years. If we assume that there are no renewal options in this agreement, then the shorter of the useful life of the improvements and the lease term is five years. Thus, the improvements should be amortized over five years, not seven years.

The human resources company will make the following journal entry (based on an annual calculation: $50,000 ÷ 5 years = $10,000) every year during the lease term:

If the human resources company assigned the incorrect amortization period of seven years, the annual amortization expense would equal $7,142 (rounded: $50,000 ÷ 7 years). This results in an understatement of amortization expense by $2,858.

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