Journal Entries for Leasehold Improvements

Quick Answer: Leasehold improvements are modifications made to a leased property by the tenant. Under both ASC 842 and IFRS 16, leasehold improvements are capitalized as a fixed asset and depreciated over the shorter of the asset's useful life or the remaining lease term. The standard journal entry debits Leasehold Improvements (an asset account) and credits Cash or Accounts Payable.

What Are Leasehold Improvements?

Leasehold improvements are structural changes, renovations, or additions a tenant makes to a rented commercial space to make it suitable for their operations. Common examples include installing walls, electrical upgrades, new flooring, improved HVAC systems, custom cabinetry, or building out office space. Unlike routine repairs and maintenance — which are expensed immediately — leasehold improvements are capitalized because they provide economic benefit over multiple accounting periods.

The defining accounting characteristic of a leasehold improvement is that it becomes part of the leased property but the tenant pays for it. At the end of the lease, these improvements typically remain with the landlord, though lease agreements may specify otherwise. This "reversion to landlord" feature drives the unique depreciation treatment that distinguishes leasehold improvements from other fixed assets.

Key Accounting Standards: ASC 842 and IFRS 16

Both U.S. GAAP (under ASC 842) and IFRS (under IFRS 16) provide guidance on lease accounting, including the treatment of leasehold improvements. The core principle is consistent across both frameworks: leasehold improvements are recognized as a non-current asset and depreciated systematically over their useful life or the lease term, whichever is shorter.

Under ASC 842, lessees recognize leasehold improvements as part of the right-of-use asset if the improvements are funded through the lease's overall economics. If the tenant makes separate capital expenditures for improvements, those are classified separately as leasehold improvements. IFRS 16 follows a similar logic but uses slightly different terminology, referring to the lessee's expenditure on improvements to the underlying asset.

Initial Recognition: Capitalizing Leasehold Improvements

When a tenant incurs costs to improve leased property, those costs are capitalized rather than expensed — provided the improvements meet the capitalization threshold and extend beyond routine maintenance. The initial journal entry records the asset at its cost, which includes all expenditures necessary to make the improvement ready for use: materials, labor, permits, design fees, and any directly attributable overhead.

If the tenant pays for the improvements in multiple installments, a portion may be credited to Accounts Payable until payment is made. The capitalized amount becomes the basis for subsequent depreciation calculations.

Depreciation of Leasehold Improvements

Leasehold improvements are depreciated over the shorter of the asset's estimated useful life and the remaining lease term. This rule exists because the tenant generally loses the benefit of the improvement when the lease ends — if the improvement has a 15-year economic life but the lease runs for only 8 more years (including renewal options that are reasonably certain to be exercised), the depreciation period is 8 years.

What about renewal options? Under ASC 842, a renewal option should be included in the lease term if it is "reasonably certain" to be exercised. This matters because a longer lease term extends the depreciation period for leasehold improvements tied to that lease. Carefully evaluate the economic incentives — if the tenant has made substantial leasehold improvements, renewal is often reasonably certain, and the depreciation period should reflect that.

Lease Incentives and Tenant Improvement Allowances

Many commercial leases include a tenant improvement allowance — the landlord agrees to reimburse the tenant for a portion of the improvement costs. The accounting treatment depends on who controls the construction work:

• If the tenant controls the work: The tenant capitalizes the full cost of improvements and records the landlord allowance as a reduction to the right-of-use asset. The allowance is treated as a lease incentive under ASC 842.
• If the landlord controls the work: The landlord owns the improvements and the tenant does not capitalize them. Instead, the cost may be reflected in the lease payments.

Disposal and Write-Off of Leasehold Improvements

When a tenant vacates a leased space before the leasehold improvements are fully depreciated, the remaining book value must be written off. This occurs because the tenant no longer has access to or benefit from the improvements. The journal entry removes both the gross asset and accumulated depreciation, with any difference recognized as a loss on disposal.

Tax Treatment of Leasehold Improvements

For U.S. federal income tax purposes, qualified leasehold improvements are eligible for bonus depreciation under current tax law, allowing businesses to deduct a significant portion of improvement costs in the year placed in service rather than capitalizing and depreciating. This creates a temporary difference between book and tax reporting that may require deferred tax accounting. The Section 179 deduction may also apply to qualified improvement property. Taxpayers should consult their tax advisor because the rules change periodically with tax legislation.

Disclosure Requirements

Under ASC 842, lessees must disclose the nature of their leases, including significant terms and conditions. Leasehold improvements are presented as a separate line item or within property, plant, and equipment on the balance sheet. The notes to financial statements should describe the depreciation method, useful lives, and any impairment considerations for leasehold improvements. IFRS 16 has similar disclosure requirements, emphasizing the need for transparency around significant judgments made in determining depreciation periods and renewal option assumptions.

For additional guidance on fixed asset accounting, see our comprehensive guide on journal entries for depreciation. For context on how improvements interact with prepaid lease costs, review journal entries for prepaid rent.