In 2006, the Financial Accounting Standards Board (FASB) took another look at leasehold improvements. The revisions based on the Board’s findings resulted in FASB Emerging Issues Task Force (EITF) Issue 05-6, titled “Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination.” This issue clarifies the standard for lease accounting -- Statement of Financial Accounting Standards (SFAS) 98 “Accounting for Leases.”
Leasehold Improvements Definition
Leasehold improvements are improvements added to property that is leased. These include items like renovations and remodeling. Although leasehold improvements are alterations to existing items, they are capitalized like any other asset. In 2004, Congress mandated that businesses had to amortize leasehold improvements using the straight-line amortization method, typically over a 15-year period. These leasehold improvements are amortized over either the improvement’s usable life or the remaining life of the lease. The shorter period is used.
Statement of Financial Accounting Standards (SFAS) 98 “Accounting for Leases” is the standard for the accounting and maintaining of leasing agreements, including leasehold improvements. SFAS 98 superseded SFAS 13, which was issued in 1976. SFAS 13 was also called “Accounting for Leases.” SFAS 98 helped to define what a “lease term” is. Because leasehold improvements are amortized over the shorter of the improvement’s useful life or the remaining time of the lease term, the clarification of the “lease term” is important in order to determine a correct amortization period.
FASB EITF Issue 05-6
FASB EITF Issue 05-6 is the most recent change affecting the accounting for leasehold improvements. This document looks specifically at the effect of the amortization of leasehold improvements over the correct amortization period. FASB EITF issue 05-6 asks whether the leasehold improvements were added “significantly after and not contemplated at or near the beginning of the initial lease term.” Leasehold improvements that are added a long time after the leasing agreement was established must be amortized over the shorter of the usable life of the improvement or the remaining life of the lease term. One clarification that Issue 05-6 made is an emphasis on the inclusion of possible lease renewals in the life of the lease. Judgment calls have to be made on whether a renewal of the lease can be reasonably sure or not. Once this is established, the shorter of the two periods can be determined, and the correct amortization period will be used.
Amortizing leasehold improvements creates an expense on a company’s income statement. The amortization also creates a reduction in taxable income for income tax purposes. For example, assume Company A amortizes $1,000,000 in leasehold improvements over ten years, when it should be amortizing them over 20 years. This creates a difference of $50,000 in expense per year ($1 million divided by 10 vs. 20 years). This can make a significant impact on a company’s bottom line. An error could result in re-filing taxes and a financial restatement. Therefore, the clarification provided by Issue 05-6 on the determination of the amortization period of leasehold improvements is important.