Leasehold Improvements - IFRS Accounting Treatment

Introduction

Businesses often need to customise leased property to meet their operational needs. These modifications, known as leasehold improvements, represent significant investments that require careful accounting treatment. Under IFRS, leasehold improvements are typically treated as property, plant, and equipment (PPE) under IAS 16 Property, Plant and Equipment, rather than IFRS 16 Leases.

This article provides guidance on how to properly account for leasehold improvements, including recognition, measurement, depreciation, common practical challenges and journal entries.

What are leasehold improvements?

Leasehold improvements are alterations, additions, or betterments made by a lessee (tenant) to leased property that enhance the functionality, appearance, or value of the space. These improvements are typically funded and controlled by the lessee and cannot be removed at lease termination.

Common examples include:

• Structural modifications (partitions, walls, doors)
• Electrical and lighting systems
• Flooring, carpeting, and wall coverings
• HVAC system modifications
• Specialised equipment installations (built-in fixtures)
• Security systems and telecommunications infrastructure

Key distinction: Leasehold improvements differ from repairs and maintenance, which preserve existing condition, and from removable equipment, which the lessee can take when the lease ends.

Recognition and Measurement

Recognition criteria

Leasehold improvements should be recognised as PPE when they meet IAS 16's recognition criteria:

• Probability test: It is probable that future economic benefits will flow to the entity
• Reliability test: The cost can be measured reliably
• Control test: The lessee controls the asset and receives the benefits

Initial measurement

Leasehold improvements are initially measured at cost, which includes:

• Purchase price of materials and equipment
• Direct labor costs
• Professional fees (architects, engineers, project managers)
• Permits and regulatory approvals
• Directly attributable overhead costs
• Borrowing costs (if qualifying asset under IAS 23)

Excluded costs:

• General administrative costs
• Training costs for staff
• Costs of operating the asset
• Costs incurred before construction begins (unless directly attributable)

Useful Life & Depreciation

The leasehold improvements, if capitalised, should be depreciated over the shorter of:

1. The useful life of the improvement, or
2. The remaining lease term, unless there is a renewal option that is reasonably certain to be exercised. This assumes that on termination of the lease, the lessee is no longer able to use, and obtain economic benefits from, the leasehold improvement.

It is also important to consider the implications of IAS 36 Impairment of Assets, should there be any indicators of impairment in the leasehold improvement.

Example: If you install fixtures in a leased office with a 5-year non-renewable lease, and the improvements would last 10 years, it should be depreciated over 5 years.

Derecognition

Capitalised leasehold improvements should be derecognised upon disposal or when no future benefits are expected. This would generally also occur when the lease is terminated early. Any gain or loss on derecognition is recognised in profit or loss.

Further consideration under IFRS 16

• If the improvements are inseparable from the leased asset and are funded by the lessor, they may affect the lease payments and the accounting under IFRS 16 (e.g., lease incentives).
• However, when funded and controlled by the lessee, they remain a separate PPE item.

Example 1: Recording Leasehold Improvements

Scenario:

• Your company leases an office for 5 years (no renewal).
• You spend £100,000 to install interior walls, lighting, and flooring.
• Improvements have a useful life of 10 years, but lease is only 5 years.

Initial Journal Entry (Capitalise Improvements)

Dr  Leasehold Improvements (PPE)     £100,000  
    Cr  Bank / Accounts Payable             £100,000  

Capitalise the cost of improvements as PPE.

Annual Depreciation Entry (Over 5 years)

Annual depreciation = £100,000 ÷ 5 = £20,000

Dr  Depreciation Expense              £20,000  
    Cr  Accumulated Depreciation – Leasehold Improvements     £20,000  

Depreciate over the lease term, not the 10-year useful life, since the lease is not renewable.

Example 2: Early Termination of Lease

Scenario:

• After 3 years, the lease is terminated.
• Remaining NBV of improvements = £100,000 – (£20,000 × 3) = £40,000
• The improvements cannot be recovered.

Impairment or Disposal Entry

Dr  Loss on Disposal / Impairment of Leasehold Improvements   £40,000  
    Cr  Leasehold Improvements / Accumulated Depreciation     £40,000  

Derecognise remaining carrying amount since no future economic benefit remains.

Example 3: Lessor Provides Lease Incentive for Improvements

Scenario:

• Lessor reimburses £30,000 for the improvements.
• Total improvement cost is still £100,000.

Initial Capitalisation:

Dr  Leasehold Improvements (PPE)     £100,000  
    Cr  Bank / Payables                        £70,000  
    Cr  Deferred Lease Incentive (Liability)   £30,000  

Amortise Lease Incentive over Lease Term (5 years):

Dr  Deferred Lease Incentive (Liability)   £6,000  
    Cr  Lease Expense / Other Income        £6,000  

Spread incentive over the lease term to reduce lease expense or show as other income. For more information, see below our article on lease incentives:

Conclusion

Key Takeaways

Proper accounting for leasehold improvements requires careful consideration of:

• Recognition criteria and comprehensive cost measurement
• Depreciation over the shorter of useful life or lease term
• Assessment of renewal options and their probability
• Regular impairment testing, especially when lease terms change
• Distinction between improvements, repairs, and lease incentives

For any clarification, guidance, or feedback on our article, please reach out to us on insight@leash.co.za.