A leasehold improvement is created when a lessee pays for enhancements to building space, such as carpeting and interior walls. The depreciation of these improvements only occurs if the amount expended is more than the lessee's capitalization limit. If the amount expended is less than the capitalization limit, the amount is charged to expense as incurred. Otherwise, the lessee can record the expenditure in the leasehold improvements asset account.
All leasehold improvement assets must be depreciated, so that the balance in the account is eventually reduced to zero. Salvage value is not included in the depreciation calculation, since the lessor will take over any remaining assets, not the lessee. There are several rules associated with this depreciation, which are:
Useful life basis. If the leasehold improvement is expected to have a useful life less than the remaining term of the associated lease, depreciate the asset over the remaining useful life. Thus, if carpeting is installed that is expected to be replaced in five years, and the remaining lease term is for seven years, the depreciation period should be for only five years.
Lease term basis. If the leasehold improvement is expected to have a useful life that is equal to or greater than the term of the lease, depreciate the asset over the term of the lease. Thus, if walls are built that are expected to have a useful life of 20 years, and the remaining lease term is for 10 years, the depreciation period should be for 10 years.
Extended lease term basis. In some cases, the lessee may have a high expectation of renewing a lease, such as when a bargain lease rate is being offered by the lessor. In this case, where extension of the lease is reasonably assured, the lessee can extend the depreciation period to cover the additional term of the lease, capped at the useful life of the asset.
Technically, leasehold improvements are amortized, rather than being depreciated. This is because the actual ownership of the improvements is by the lessor, not the lessee. The lessee only has an intangible right to use the asset during the lease term. Intangible rights are amortized, not depreciated. However, there is no real effect on the income statement of using one term over the other, especially if the amortization and depreciation expenses are combined for presentation purposes.