Accounting for Leasehold Improvements and Tenant Improvement Allowances Under ASC 842

Leasehold improvements are capitalized alterations a tenant makes to leased premises. They belong in fixed assets, separate from the right-of-use asset. The funding arrangement determines their accounting treatment, while the amortization period requires a judgment rather than a standard number of years.

Black Owl Systems keeps lease accounting records and supporting documents together throughout the term. This guide addresses lessee accounting under ASC 842, including the distinction from improvements owned by the lessor.

Teams reporting under IFRS 16 or ASPE 3065 can compare the frameworks below. A centralized lease management record helps retain allowance terms and renewal assessments. Black Owl’s implementation and advisory services can support that workflow.

Are leasehold improvements capitalized or expensed?

Work that extends a property’s life or increases its capacity is capitalized. Ordinary repairs and maintenance are expensed as incurred. The nature of the work determines the treatment, regardless of the amount spent.

Constructing interior walls, putting in new wiring or plumbing, and installing fixed units are capital projects. Repainting walls, replacing a damaged light fitting, and patching an existing floor are repairs.

A single project can contain both types of work. Reconfiguring a floor and repainting it, for example, combines improvements with maintenance. Allocate the expenditure between the capital and expense portions instead of applying one treatment to the entire refit.

How do you record leasehold improvements in accounting?

Recognize the capitalized expenditure in a separate fixed asset class, usually called leasehold improvements. It is recorded alongside property, plant and equipment, not as part of the right-of-use asset.

Items that can be moved do not belong in this class. Desks, chairs, free-standing equipment, and other assets the tenant would take to its next premises are recorded elsewhere. A leasehold improvement must be attached to the property.

The balance sheet treatment for owned fixed assets also applies to these improvements. The tenant owns and depreciates them even though it does not own the underlying building.

How are leasehold improvements treated in accounting?

Begin by establishing who funded the work. The physical extent of the fit-out does not determine what the tenant records; the funding arrangement does.

In the third arrangement, the landlord both builds and owns the improvements. The tenant recognizes neither a leasehold improvement nor a lease incentive. The rent may be higher to compensate the landlord for its expenditure, but the tenant records no additional item for the work itself.

When the tenant pays for the improvements

A tenant that finances its own fit-out capitalizes the entire cost as a leasehold improvement. This spending does not alter the lease measurement. The right-of-use asset and lease liability remain the amounts that would have been recorded without the fit-out.

Use this as the baseline when comparing the other funding arrangements. The difference is who contributes the money for the work.

When the landlord provides an improvement allowance

A tenant improvement allowance is money the landlord pays toward the tenant’s work. ASC 842 treats that payment as a lease incentive, which reduces the right-of-use asset.

The arrangement creates two separate accounting items. The improvement is the physical asset constructed with the funds. The incentive is the funding received, and it reduces the lease asset rather than the fixed asset.

Before posting, compare each amount with its supporting record. The fixed asset balance should reflect the gross cost of the project, while the reduction in the right-of-use asset should match the allowance received. An amount recorded net of the other signals an error.

Combining the two can lead to either double-counting or omitting the cost. Record the improvement at gross cost, then account for the allowance as a separate reduction to the right-of-use asset. The treatment of an allowance on the liability side addresses payments received after commencement.

The receipt date changes the entry rather than the eventual outcome. An allowance received by commencement reduces the right-of-use asset directly. Where the allowance is receivable after commencement, it reduces the lease payments used to calculate the liability.

The effect of a tenant improvement allowance on the right-of-use asset

This example is illustrative.

Consider a five-year lease with annual payments of $100,000 in arrears and an incremental borrowing rate of 5%. At commencement, those payments produce a lease liability of $432,948. The fit-out costs $200,000, and the tenant owns all the improvements in each funding arrangement below.

The improvement is recorded at $200,000 in all three cases. Changing the source of funding does not change the tenant’s ownership of the complete fit-out.

The lease liability is also the same in each case. The allowance reduces the asset’s cost rather than the amount owed under the lease.

Only the right-of-use asset varies, declining by the amount of the landlord’s contribution. Measurement before the incentive is applied establishes the $432,948 starting balance. Each funding case begins with that figure and deducts the applicable allowance.

The lower right-of-use asset subsequently produces less amortization. In this way, the allowance reduces expense over the lease term rather than being recognized all at once.

Determining the amortization period

ASC 842-20-35-12 requires leasehold improvements to be amortized over the shorter of their useful life or the lease term. Applying that rule involves more judgment than the wording initially suggests.

The relevant term is the accounting lease term, which includes renewal periods when the option is reasonably certain to be exercised. Reaching that conclusion requires an assessment of the circumstances.

Comparing the second and third rows shows how much the option assessment matters. The same expenditure on an unchanged fit-out is amortized over twice as long, cutting the annual charge in half. The difference comes entirely from the judgment about renewal.

The fit-out itself can support that judgment. A substantial investment gives the tenant an economic reason to renew because leaving would mean giving up the remaining benefit of the work. That incentive can support a longer lease term, which then extends the period over which the same improvement is amortized.

This relationship is favorable to the tenant when the conclusion is properly documented. The investment supports the longer term and is then amortized over it. First make and substantiate the assessment that establishes the remaining lease term. The amortization period cannot be settled before that assessment is complete.

The timing of the comparison also matters. Apply the shorter-of test when the improvement is placed in service, not when the lease commences. A fit-out completed two years into a five-year lease has only three years of the original term remaining.

This is particularly important for refurbishments and expansions undertaken during the lease. A $200,000 project with three years left requires annual amortization of $66,667, not $40,000. Using the original five-year term would understate the annual charge.

Once the period has been determined, straight-line amortization is the usual approach. The standard straight-line write-off pattern applies unless the improvement’s benefits are consumed unevenly.

Accounting for the improvements when the lease ends

An improvement will normally be fully amortized when the lease expires. With the period correctly established, its carrying amount reaches zero as the tenant departs, leaving no balance to write off.

The tenant generally surrenders the improvements to the landlord at that point, usually without compensation. A transfer of an asset that has already been fully amortized has no accounting effect.

An early departure or a change in the expected term creates a different result. Leaving before the improvement is fully amortized requires the remaining balance to be written off. Where a reassessment shortens the lease term, amortization is accelerated prospectively over the revised period.

Abandonment is another possibility. When the tenant stops using the premises and has no intention of returning, the improvement is abandoned rather than impaired. Accelerate amortization so its carrying amount is zero by the cease-use date.

The accounting for an early lease exit addresses what happens to the lease balances alongside the improvement.

Restoration and make-good obligations

A requirement to restore the premises to their original condition appears in many leases. That obligation is neither part of the leasehold improvement asset nor a lease payment.

It is accounted for as an asset retirement obligation under ASC 410. When the obligation arises, recognize a liability equal to the present value of the expected restoration expenditure. Capitalize the corresponding amount into the related asset and accrete the liability over the term.

Companies often overlook this obligation during the fit-out and discover it only three months before expiry. Record the retirement obligation created by the work when the improvement is built. The landlord’s final survey should not be the first time it reaches the accounting team.

Comparing IFRS 16 and ASPE 3065

Frameworks that capitalize leases take nearly the same approach to leasehold improvements. Most differences concern terminology rather than the accounting result.

The main difference under ASPE 3065 is how the allowance is recorded. An operating lease creates no right-of-use asset to reduce, so the allowance is deferred and recognized against rent expense instead. The Canadian private enterprise framework produces a similar expense pattern through a different treatment.