When a business rents a property and makes significant changes or upgrades to improve its usability, those changes are known as leasehold improvements. These modifications can include installing new lighting, constructing partitions, adding flooring, or redesigning interiors to suit business needs. Although the company doesn’t own the property, it still incurs costs that need to be capitalized and depreciated over time. Understanding the journal entry for leasehold improvements is essential for accurate accounting and financial reporting. This topic provides a clear explanation of how to record these improvements and how they affect financial statements.
What Are Leasehold Improvements?
Leasehold improvements are physical changes made by a tenant to a leased space to customize it for business operations. These improvements become part of the property and typically remain when the lease ends, benefiting the property owner as well. As a result, leasehold improvements are recorded as assets by the lessee, even though the property is not owned.
Examples of Leasehold Improvements
- Installing HVAC systems
- Interior redesign or reconstruction
- Adding customer service counters or reception areas
- Painting, flooring, and ceiling modifications
- Electrical and plumbing upgrades specific to the business
Accounting Treatment of Leasehold Improvements
Leasehold improvements are recorded as fixed assets under property, plant, and equipment (PP&E) in the balance sheet. They are capitalized and depreciated over the shorter of their useful life or the lease term, including renewal periods if reasonably certain.
Key Accounting Points
- Improvements are not expensed immediately.
- They are depreciated or amortized gradually over time.
- If the lease ends before the improvements are fully depreciated, the remaining balance is written off.
Initial Journal Entry for Leasehold Improvements
When leasehold improvements are made, the cost is capitalized. Let’s say a business spends $25,000 on upgrading a leased retail space.
Leasehold Improvements A/c Dr. $25,000 To Cash / Accounts Payable $25,000
This entry records the acquisition of the leasehold improvements as a non-current asset.
Depreciation of Leasehold Improvements
Depreciation helps allocate the cost of the improvements over their useful life. Suppose the lease is for 5 years and the improvements are expected to last the same duration. The annual depreciation would be:
Annual Depreciation = $25,000 ÷ 5 = $5,000
Depreciation Journal Entry
Depreciation Expense A/c Dr. $5,000 To Accumulated Depreciation Leasehold Improvements $5,000
This entry is made at the end of each accounting period to reflect the expense in the income statement and reduce the asset value in the balance sheet.
Lease Term Extension Impact
If the lease term is extended before the end of the original agreement and the useful life of improvements is reassessed, the depreciation period may be adjusted. For example, if the lease is extended by 3 years (making it 8 years in total), and $10,000 remains un-depreciated, the new depreciation would be:
Revised Annual Depreciation = $10,000 ÷ 3 = $3,333.33
This change should be applied prospectively from the date of reassessment.
Impairment or Write-Off of Leasehold Improvements
If the lease is terminated early or the improvements no longer provide economic benefit, the remaining unamortized balance must be written off.
Journal Entry for Write-Off
Loss on Disposal / Impairment A/c Dr. $Remaining Balance To Leasehold Improvements A/c $Remaining Balance
This reflects the recognition of loss in the income statement and removal of the asset from the books.
What If Landlord Pays for Improvements?
In some cases, the landlord may reimburse the tenant for the cost of improvements. This creates a lease incentive, which is treated differently.
Journal Entry for Reimbursement
Cash / Receivable A/c Dr. $X To Deferred Lease Incentive A/c $X
The deferred incentive is amortized over the lease term, reducing rent expense over time.
Presentation in Financial Statements
Balance Sheet
- Leasehold improvements appear under non-current assets.
- They are shown net of accumulated depreciation.
Income Statement
- Depreciation expense is recorded annually, reducing net profit.
- Any impairment or write-off is shown as a separate loss or expense.
Tax Implications
Leasehold improvements may qualify for depreciation under local tax laws. The depreciation method and period may differ from accounting standards. In some jurisdictions, tax deductions can be accelerated, providing early tax relief. Businesses should consult with tax professionals to apply the correct tax treatment.
Practical Example
Let’s walk through a complete example:
- A company leases a warehouse for 6 years.
- It spends $60,000 on improvements.
- The improvements have no residual value and will be fully used during the lease.
Step 1: Record the improvement
Leasehold Improvements A/c Dr. $60,000 To Bank / Payables $60,000
Step 2: Record annual depreciation
Depreciation Expense A/c Dr. $10,000 To Accumulated Depreciation $10,000
This is repeated every year for 6 years.
Step 3: End of lease asset fully depreciated
Accumulated Depreciation A/c Dr. $60,000 To Leasehold Improvements A/c $60,000
This clears the asset and its depreciation from the books.
Best Practices for Managing Leasehold Improvements
- Maintain clear documentation and contracts for each improvement.
- Assess useful life and lease terms carefully to determine depreciation periods.
- Reassess the lease term regularly for changes that affect amortization.
- Review impairment indicators to ensure timely recognition of losses.
Leasehold improvements are an important part of business investment when occupying rented property. Recording them properly through journal entries ensures accurate financial reporting and compliance with accounting standards. From capitalizing costs to depreciating them over time, each step plays a role in presenting a true picture of financial performance. Whether it’s the initial capitalization, adjusting for lease extensions, or writing off unused improvements, understanding the journal entry for leasehold improvements helps businesses manage their assets responsibly and plan for long-term financial health.