For example, suppose a landlord owns a commercial building that he wants to lease out as office space. In order to attract the right tenants, the landlord installs floor and wall coverings, ceilings, partitions, air conditioning, fire protection, and security. The landlord pays for these improvements.
For example, suppose a landlord owns a commercial space and the owners of a hair salon and spa want to rent it. The owners of the hair salon plan to install carpeting, lighting and walls and doors for private rooms. The tenant, or the owners of the hair salon, pay for the improvements. Sometimes, the landlord gives the tenant an allowance, called a tenant improvement allowance, to pay for the leasehold improvements. This allowance is usually a certain dollar amount per square foot of space. If the cost of the leasehold improvements exceeds the tenant improvement allowance, the tenant pays for those improvements out of pocket. Sometimes the tenant alone pays for the improvements. No matter the payment arrangement, in most cases the improvements become the property of the landlord at the end of the lease.
Capital expenses are recorded as an asset on a balance sheet, and then charged to expense over time on the income statements using depreciation or amortization. [1] X Research source If the landlord makes tenant improvements, the capital expenditure is recorded as an asset on the landlord’s balance sheet. Then the expense is recorded on the landlord’s income statements using depreciation over the useful life of the asset. If the tenant pays for leasehold improvements, the capital expenditure is recorded as an asset on the tenant’s balance sheet. Then the expense is recorded on income statements as amortization over either the life of the lease or the useful life of the asset, whichever is shorter. [2] X Research source The tenant expenses the leasehold improvements with amortization instead of depreciation because the ownership of the improvements reverts to the landlord at the end of the lease. Therefore, the improvements are treated as intangible assets, for which amortization is used instead of depreciation. [3] X Research source
Tangible assets are physical assets, such as land, buildings or equipment. These are recorded with depreciation. Depreciation is calculated using the useful life of the asset and the salvage value, or the amount for which the asset can be sold at the end of its useful life. [5] X Research source Intangible assets are non-physical assets, such as licenses, copyrights, patents or trademark. These expenses are recorded with amortization. [6] X Research source
For example, suppose the hair salon and spa who is leasing commercial space from the landlord spends $35,000 on the necessary improvements. It is the hair salon who will record those assets and expenses on their balance sheet and income statements.
The hair salon will record $7,000 of amortization each year for a period of five years on their own accounting documentation ($35,000 / 5 years = $7,000 per year).
For example, suppose the hair salon could commit to renewing the lease for an additional five years after the expiration because the landlord is offering a discount on rent if they renew. In this case, the period of the lease would be 10 years, and the useful life of the equipment is still seven years. Now, the shorter period is the useful life of the improvements. So the hair salon will amortize these expenses over the course of seven years. The annual amortization expense will be $5,000 ($35,000 / 7 years = $5,000 per year).
The matching principle in accounting says that expenses are reported by a company in the same period as the related revenues. According to the matching principle, it would be incorrect for the hair salon to record the entire cost of the leasehold improvements, $35,000, in the first year because revenue related to those improvements will be generated over the next several years. [10] X Research source With amortization, part of the cost of the leasehold improvements gets moved from the tenant’s balance sheet to the tenant’s income statement so it can be matched with the revenue obtained from the use of these items. [11] X Research source
For example, suppose the lease for the hair salon stated that the monthly rent would be $2,000 for a term of 60 months and that the landlord agreed to contribute $10,000 to the leasehold improvements in the form of free rent for five months. In this example, the hair salon is paying $2,000 per month for 55 months, or $110,000 total ($2,000 x 55 = $110,000). The term of the lease is 60 months, so the monthly rent that must be recorded as an expense for the tenant and as revenue for the landlord must be $1,833. 33 ($110,000 / 60 = $1,833. 33).
The landlord records the gross value of the incentive as an asset on the balance sheet. Then the asset is expensed over the term of the lease as a reduction of rental income. The tenant records the gross value of the incentive as a liability on the balance sheet. Then the liability is recorded as a reduction of rental expense over the term of the lease. Suppose in the above example, the landlord gave the tenant $10,000 to use for leasehold improvements. The landlord would record $10,000 as an asset on the balance sheet. If the lease were for 60 months, then the monthly reduction to rental income to be recorded on the income statement would be $166. 67 ($10,000 / 60 = $166. 67). In the same example, the tenant would record a $10,000 liability under fixed assets on their own balance sheet. This would be offset by a $166. 67 reduction in rental expense each month over the term of the lease.
The total amount of the expenditures are recorded as an asset on the landlord’s balance sheet. Then, each month, the depreciation expense is recorded on the landlord’s income statements.
Subtract the salvage amount from the total expenditure. This is the amount that will be depreciated each month on the landlord’s accounts. For example, suppose the landlord paid $35,000 for capital improvements. The useful life is 7 years (or 84 months). The salvage value is $1,400. So the depreciable amount is $33,600 ($35,000 - $1,400 = $33,600).
For example, if the depreciable amount is $33,600 and the useful life is 84 months, then calculate the depreciation with the equation $33,600 / 84 = $400. This is the amount of depreciation to be recorded each month.
