For clients who own rental property or clients who rent, you will probably have to factor in improvements to their property in their financial statements. To help you understand this practice and follow FASB guidelines, we're sharing tips for accounting for leasehold improvements.
Understanding leasehold improvements
Leasehold improvements refer to modifications made to leased assets to accommodate the specific needs of a lessee (such as interior walls, lighting fixtures, carpeting, and similar).
Under FASB’s Accounting Standards Codification (ASC) 842, leasehold improvements paid for by the lessee are recognized as assets by the lessee if they meet criteria similar to recognizing fixed assets. These criteria require that the improvements provide future economic benefits and have a useful life extending beyond one year. When leasehold improvements are capitalized, their cost includes direct costs such as materials, labor, and design fees. In addition, they may be subject to a “capitalization limit” for cost-benefit considerations.
The cost of leasehold improvements should be recorded as an asset on the balance sheet and allocated over the asset’s useful life through amortization (versus depreciation since the lessor fundamentally owns the improvements and the lessee simply has rights during the lease term).
Amortization of leasehold improvements
In most cases, the leasehold improvements are amortized over the shorter of the useful life of those leasehold improvements or the remaining lease term. However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee should amortize a leasehold improvement to the end of its useful life.
Amortization of leasehold improvements follows the straight-line method unless another method is deemed more appropriate. Any change in the required amortization period (e.g., early lease termination, renegotiations) for the leasehold improvements should be accounted for prospectively as a change in accounting estimate in accordance with ASC 250-10-45-17.
Leasehold improvements are subject to the long-lived asset impairment guidance in ASC 360-10-40-4. If an impairment indicator exists (such as lease termination, significant changes in business strategy, or physical damage) an impairment test is required. If the carrying value of leasehold improvements exceeds their recoverable amount, an impairment loss must be recognized in the income statement.
Common Control Lease Exception
In March 2023, the FASB issued ASU 2023-01, Leases Topic (842): Common Control Arrangements, which requires a lessee in a common control lease to amortize related leasehold improvements over their useful lives to the common control group regardless of the lease term.
Fully amortizing leasehold improvements over a period shorter than the useful life of the improvements may result in financial reporting that does not faithfully represent the economics or the common control nature of those improvements. This special guidance applies for as long as the lessee controls the use of the underlying leased asset through a common control lease.
When the useful life of the leasehold improvements to the common control group exceeds the related lease term, a lessee is required to disclose the following information:
- The unamortized balance of the leasehold improvements at the balance sheet date
- The remaining useful life of the leasehold improvements to the common control group
- The remaining lease term
One issue is that the term “common control” is not defined. An assessment of whether common control exists is based on all of the facts and circumstances surrounding the relationships between the parties (both direct and indirect). If consolidated financial statements were prepared by a parent entity, generally, the entities that were consolidated are under common control.
Examples of common control transactions of leasehold improvements
ASC 805-50-15-6 provides examples of the types of transactions that qualify as common control transactions. A few examples include the following:
- A limited liability company is formed by combining entities under common control.
- Two or more not-for-profit entities that are effectively controlled by the same board members transfer their net assets to a new entity, dissolve the former entities, and appoint the same board members to the newly combined entity.
In addition, SEC staff have expressed conclusions about circumstances that common control between (or among) separate entities exists, including considering that immediate family members (married couples and their children, but not their grandchildren) hold more than 50% of the voting ownership interest of each entity (with no evidence contradicting that they will vote their shares in concert). All situations require careful consideration regarding the substance of the ownership and voting relationships.
For further consideration, FASB indicated in paragraph BC19 in the Basis for Conclusions of ASU 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities, that a broader interpretation (such as considering grandparents and grandchildren together when evaluating common control) may be supportable for private companies.
Take the next step with CPE courses
If you'd like to learn more about leasehold amortization and similar topics, Becker has a wide variety of CPE courses to build your skills while meeting your CPE requirements. Check out the following courses:
- Financial Instruments: Credit Losses (ASC 326)
- Business Combinations and Consolidations, Part 1 (ASC 805 & 810)
- Accounting for Equity Instruments
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