Introduction
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. 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.
See also, our full IFRS 16 guide.
Overview
Leasehold 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:
- The useful life of the improvement, or
- 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.
Reassessing the Lease Term: Catch-up and Forward Methods
The depreciation period for a leasehold improvement is tied to the lease term, and the lease term is an estimate rather than a fixed fact. When a renewal option that was not previously expected to be exercised becomes reasonably certain — or the reverse — the depreciation period changes.
A change in the expected lease term is a change in accounting estimate under IAS 8. It is applied prospectively: prior periods are not restated, and the remaining carrying amount is spread over the revised remaining period. Importantly, the change does not need to be announced formally. Where new information shows the previous estimate no longer holds, the estimate is revised.
One event, two adjustments
A lease term reassessment hits both standards at once. The IAS 16 leasehold improvement gets a new depreciation period, and the IFRS 16 lease liability is remeasured with a revised discount rate, with the difference taken to the right-of-use asset. It is easy to process one and overlook the other.
Applying the revised period
Two approaches appear in practice, and they give different answers.
Under the forward method, the change is applied evenly over the remaining life from the beginning of the year in which the new information arises. The carrying amount at the start of that year, less any residual value, is spread over the remaining periods as reassessed.
Under the catch-up method, accumulated depreciation is first adjusted to the balance it would have carried had the revised estimate always applied, with the correction recognised in the current period. Depreciation for the year is then charged on the revised basis. A catch-up can be negative: where the lease term is extended, the correction reduces accumulated depreciation and therefore reduces the total charge for the year.
The depreciation charge under the catch-up method has two components — the correction and the current-year charge — and disclosing them separately makes the movement in the asset note far easier to follow.
Example: extending the lease term
An entity fits out leased premises at a cost of 240,000 under a six-year lease with no renewal initially expected. The fitout is depreciated over six years, at 40,000 a year.
At the start of year four, the entity commits to a renewal that extends the lease by three years, and exercise becomes reasonably certain. The carrying amount at that date is 240,000 − (40,000 × 3) = 120,000, and the remaining term is now six years rather than three.
| Item | Amount |
|---|---|
| Cost of the fitout | 240,000 |
| Accumulated depreciation, end of year three | (120,000) |
| Carrying amount at reassessment | 120,000 |
| Revised remaining lease term | 6 years |
| Revised annual depreciation | 20,000 |
The annual charge halves from 40,000 to 20,000. The first three years stand as reported; only the periods from the date of reassessment onwards carry the revised charge.
Where the reassessment shortens rather than extends the term, the effect runs the other way and can be severe. A fitout with five years of carrying amount remaining, on a lease now expected to end in two, must absorb the full remaining balance over those two years.
Impairment of Leasehold Improvements
Leasehold improvements are within the scope of IAS 36. They rarely generate cash inflows that are independent of other assets, so they are usually tested as part of the cash-generating unit that uses the leased property rather than on their own.
Indicators that warrant a test include:
- a decision to vacate, sublet or consolidate the space before the lease ends;
- a fitout built for a purpose the business no longer pursues;
- underperformance of the operation housed in the leased premises; and
- physical damage, or a change in how the space is permitted to be used.
Where the space will be vacated before the end of the lease, the improvement and the right-of-use asset are typically impaired together, since both depend on continued occupation of the same premises. A sublease that recovers part of the cost reduces, but rarely eliminates, the write-down.
Presentation and Disclosure
Leasehold improvements sit within property, plant and equipment and are usually shown as a separate class in the IAS 16 note, with their own cost, accumulated depreciation and reconciliation of movements.
They should not be merged with right-of-use assets. The two are measured under different standards, and IFRS 16 requires right-of-use assets either to be presented separately or to be identifiable through disclosure of the line items that contain them. Combining a lessee's own fitout with the right to use the landlord's building obscures both.
Where the depreciation period has been revised, IAS 8 requires disclosure of the nature and amount of the change in estimate. For a significant fitout on a reassessed lease this can be a material movement in the current and future depreciation charge, and it is worth stating the revised period explicitly alongside the amount.
For the related lease disclosures, see our guide to IFRS 16 disclosures.
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:
Lease Incentives
Tracking leasehold improvements in Excel?
Leash automates lease schedules, journal entries, and IFRS 16 compliance, so you're not rebuilding this in Excel every month-end.
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.