Accounting for leasehold improvements is often confusing, and it requires that estimates be made regarding the projected life of the improvement and the period over which it should be depreciated. Leasehold improvements can represent a large expense to a company that rents space and needs to make alterations to make it usable.
If you own your place of business and make improvements to it, they are called capital improvements. If you lease the space and make improvements, they are called leasehold improvements. These include functional or structural changes to the office space to make it appropriate for your company's needs. They can include building walls, installing lighting, putting in bathrooms or anything else that increases the usefulness or the value of the space. Because these improvements provide benefits for long periods, you cannot expense them in the year they are incurred. They must be treated as a capital expense and depreciated over time.
In the U.S., "SFAS 13 -- Accounting for Leases" outlines how leasehold improvements should be treated in the financial statements. The estimated useful life of the improvement must be calculated first. The useful life is the length of time until the improvement needs to be changed or upgraded. Compare the useful life with the lease term. Generally accepted accounting principles require that the improvement be depreciated on a straight-line basis over the shorter of either the useful life or the lease term. For example, if the improvement cost $1,000 and would last for at least 10 years and the lease term is five years, you would depreciate the cost over a five-year period, taking an expense of $200 per year.
Accounting for leasehold improvements becomes more complex when the lease includes optional renewals. For example, you may have a lease on a property for three years but have a renewal option for another three. GAAP requires that, if the renewal is reasonably assured, you include the renewal period or periods in the depreciation time frame. Situations that could show such assurance include penalties for not renewing, bargain buyout options after the next renewal period, and leases that are renewable at the option of the lessor. If there is no assurance of renewal, the leasehold improvements are depreciated over the original lease term only.
When renting your office space, you may encounter many other costs of operating the space, such as maintenance, utilities, repairs and the lease payments themselves. These costs are not capital in nature and should be expensed in the period in which they are incurred.