When a company leases a new space, it often needs to make improvements to the property to suit its business needs. For example, a retail store might need to build shelves and counters, while an office tenant might need to install cubicles and partitions. These types of improvements are known as leasehold improvements and can represent a significant investment for a company.
From an accounting standpoint, leasehold improvements must be capitalized on the balance sheet, meaning the cost of the improvements is spread out over time in line with the company’s use of space. More specifically, the lessee improvements should be amortized over the shorter of either the useful life of the assets or the remaining lease term. However, if there is a transfer of ownership or purchase option that is reasonably certain to be exercised, the lessee should use the useful life of the asset. As a result, companies should carefully consider the accounting for new leasehold improvements when entering into new leases.
Determining the ownership of assets for leasehold improvements is vital for any company leasing space because it directly impacts leasehold accounting. These assets may include things like new walls or lighting. In some cases, the lessor may own these assets; in other cases, the lessee may own the assets outright. When building out your accounting it is essential to clarify who owns these assets.
It’s important to determine whether the improvements are lessee or lessor assets because the conclusion may affect:
- Which accounting standard to use
- Which entity recognizes the asset
- Whether there is a lease incentive or a reimbursement of costs
- The lease commencement date
- If there will be a sale and leaseback evaluation
It is critical to note that the accounting owner of leasehold improvements may determine the lease commencement date. For instance, if a lessor grants the lessee access to the leased space so the lessee can construct lessee improvements, the lease commencement date is the date the lessor made the asset available for use by the lessee.
Who Owns Which Asset?
The answer comes down to a mutual understanding. For instance, if a tenant (lessee), or a landlord (lessor) on behalf of the tenant, makes improvements to a space to align with its branding and determines that it owns those improvements, then the amount paid by the lessor would be recorded as a lease incentive by the lessee. Therefore, the leasehold improvements would be recorded in the tenant’s financial records.
However, if the improvements are to build-out space, that will be the assets subject to a lease, such as plumbing or lighting. Then, if it is determined that the landlord owns those improvements, any amounts paid by the landlord would be considered part of the overall asset subject to the lease and any amounts paid by the tenant would be recorded as lease payments.
It’s important to note that when recording leasehold improvements, it is not appropriate to split a single asset between the lessee and lessor’s financial records, regardless of how much each party may have paid. Instead, each party must determine who owns the improvement to account for it properly.
For example, let’s say a landlord offers to build out a space for $50,000, but the tenant wants to upgrade to a better quality carpet than the landlord typically installs. Therefore, the tenant agrees to pay $30,000 for those upgrades. The total improvements will cost $80,000, with the landlord paying $50,000 and the tenant paying $30,000. If the tenant is determined to be the owner of the improvements, then the entire $80,000 would be recorded in the tenant’s financial records as leasehold improvements, and both the tenant and landlord would account for the $50,000 that the landlord paid as a lease incentive. Conversely, if the landlord is determined to be the owner of the improvements, then the entire $80,000 would be recorded in the landlord’s financial records as leasehold improvements, and both the landlord and tenant would account for the $30,000 that the tenant paid as a lease payment.
With so many factors to consider, leasehold improvements are a complex and often misunderstood aspect of accounting. Failure to accurately record and depreciate improvements can cause financial reporting ramifications. With careful consideration and analysis, however, you can ensure that you comply with the relevant accounting guidance.It is advisable to work with a qualified accounting provider to ensure accuracy and compliance for your leasehold accounting.
Our team of professionals, and counterparts at CBIZ and CBIZ MHM, stand ready to assist you with any of your lease accounting needs.