As you navigate the complexities of ASC 842 compliance, you may be wondering how and when to properly account for leasehold improvements.
What are leasehold improvements?
From an accounting standpoint, leasehold improvements are any modifications, enhancements or additions made by a tenant to their leased space (or the “leasehold interest”) that add business value.
What counts as leasehold improvements?
Leasehold improvements are modifications tenants often make to their leased spaces such as:
- Customize the layout and design of their leased space
- Improve ergonomics and make the space more employee- or customer-friendly
- Brand the leased space with a company’s look and feel
Examples of leasehold improvements
Leasehold improvements can be any update or change to a leased property’s interior finishes beyond what the landlord provides as standard. Some examples may include:
- Upgrades to drywall, electrical, flooring, carpentry and similar features, as well as
- Permanently affixed displays, shelving, partitions, lighting, signage and other enhancements that help customize the space.
Leasehold improvements may be made at any time during the term of a lease — or before moving into a space.
For instance, in a new shopping mall, a landlord typically provides a “vanilla box” that a retailer will want to customize with improvements — adding dressing rooms, sales counters and other features that will make the leasehold interest more valuable as a business location.
What is not considered a leasehold improvement?
Enhancements that are not considered a leasehold improvement include modifications to exterior or shared spaces, as well as interior features such as data cabling, furniture, non-permanent fixtures or equipment that can be removed when the tenant moves out.
Are leasehold improvements an asset or an expense?
Leasehold improvements are typically capitalized as assets rather than recorded as immediate expenses. Because these modifications extend the functionality or value of a leased property, they provide benefits over multiple years rather than a single accounting period. For this reason, they are added to the balance sheet and depreciated systematically.
Under ASC 842, leasehold improvements are treated as property, plant, and equipment (PP&E). The improvements are depreciated over the shorter of the lease term or the asset’s useful life, ensuring that costs are matched to the period during which the tenant benefits from them. This treatment differs from operating expenses, which are fully recognized in the year incurred.
Are leasehold improvements fixed assets?
Leasehold improvements are classified as fixed assets within PP&E. In most cases, they are depreciated using the straight-line method, though organizations may apply other depreciation methods consistent with their accounting policies. Importantly, depreciation must cease at the end of the lease term, even if the physical life of the improvement extends beyond that date.
What happens to leasehold improvements when a lease expires?
When a lease ends, most leasehold improvements remain with the landlord’s property. Because these improvements are typically permanent fixtures, they cannot be removed without damaging the space. This means the landlord generally retains ownership, and the tenant cannot claim additional value once the lease concludes.
Tenant rights to remove improvements
In some cases, tenants may negotiate the right to remove certain improvements at the end of the lease. These exceptions usually apply to improvements that are specific to the tenant’s operations and can be removed without materially altering or damaging the property. The details depend on the lease agreement.
How do leasehold improvements impact ASC 842?
Leasehold improvements are reported as property, plant and equipment (PP&E) assets on the balance sheet. ASC 842 does not change the way they are handled, unless a tenant uses a tenant improvement allowance to make their improvements.
When a tenant makes leasehold improvements using a tenant improvement allowance, ASC 842 requires a different treatment than the previous accounting under ASC 840. Under ASC 842, a tenant improvement allowance is treated as a lease incentive that reduces the ROU asset. If the tenant improvement allowance is not yet received, the lease liability is also reduced in future minimum lease payments.
Here are the basics you need to know about leasehold improvements relating to ASC 842 compliance:
What is a tenant improvement allowance?
A tenant improvement allowance (also called a TI allowance or TIA) may be offered to a tenant by a landlord, which the tenant may choose to use to pay for leasehold improvements. It is one of several types of lease incentives that a landlord may offer to attract tenants and is often part of lease negotiations.
The TI allowance amount will be included in the lease, along with how it will be paid. For example, it may be offered as a rent discount, paid directly to contractors or provided as a reimbursement to the tenant after the work is complete. The lease may also stipulate what leasehold improvements the allowance may cover.
Reporting a TI allowance for leasehold improvements
Under ASC 840, a TI allowance (or other lease incentive) was generally reported as a separate liability. The liability would have been reduced on a straight-line basis and reduced rent expense.
Now, under ASC 842, if a TI allowance is paid to a tenant up front, it reduces the tenant’s ROU asset, but adds a leasehold improvement asset in the amount that was paid. In other words, the tenant now has a lower lease cost and a separate monthly expense related to the leasehold improvement.
Formula for calculating tenant improvement allowance
The TIA is typically calculated on a per-square-foot basis, which provides a simple way to determine the total funding available for improvements. This formula gives tenants clarity on budgeting for construction or customization while ensuring the allowance scales appropriately with the size of the lease.
Tenant Improvement Allowance = Allowance per Square Foot × Leased Square Footage
Recording tenant improvement allowances under asc 842
Tenant improvement allowances (TIAs) are treated as lease incentives under ASC 842. This means they directly affect how both the right-of-use (ROU) asset and leasehold improvement assets are reported. Instead of recording the allowance as income, tenants must adjust their balance sheet to reflect both the reduction of the ROU asset and the addition of a corresponding leasehold improvement.
Accounting treatment for TIAs
- Step 1: Record the allowance as a reduction of the ROU asset.
- Step 2: Record an equal amount as a leasehold improvement (PP&E).
- Step 3: Depreciate the leasehold improvement over the shorter of the lease term or useful life.
- Step 4: Continue recognizing lease expenses based on the adjusted ROU asset.
Balance sheet impact
A tenant improvement allowance decreases the reported value of the ROU asset, while increasing the value of PP&E. This ensures that lease costs are properly reflected, while improvements are recognized as capitalized assets subject to depreciation.
Example of TIA recording
Suppose a tenant calculates an ROU asset of $1,000,000, and the landlord provides a $100,000 tenant improvement allowance:
- ROU Asset: $1,000,000 – $100,000 = $900,000
- Leasehold Improvement (PP&E): $100,000
The result is:
Total Assets = $900,000 ROU + $100,000 PP&E
This approach keeps the balance sheet balanced while ensuring that the improvement is depreciated appropriately.
Tracking and managing lease details
Although leasehold improvements themselves are not affected by ASC 842, there are implications in the context of lease incentives and TI allowances as part of new lease negotiations.
Understanding leasehold improvements, lease incentives and the latest accounting treatments is critical to compliance with ASC 842. At the very least, tenants should keep track of all leasehold improvement costs, since they are assets that can be amortized or depreciated.
Leasehold improvements and lease incentives are just some of the critical details that need to be tracked for effective lease accounting and management. A technology solution like Visual Lease makes it easy for you to track these and other crucial aspects of your lease portfolio.
To learn more, contact us at (888) 876-6500 — or to see Visual Lease in action, request a demo