A retailer builds out custom leasehold improvements at a cost of $200,000 in a store it leases under a non-cancelable 6-year lease with a single 4-year renewal option. The improvements have a physical useful life of 15 years, but the retailer is not reasonably certain it will exercise the renewal option. Under US GAAP, over what period should the retailer amortize the $200,000 of leasehold improvements?
- Over 6 years, the remaining lease term, because that is shorter than both the improvements' 15-year physical useful life and the term including a renewal option the retailer is not reasonably certain to exercise
- Over 15 years, the improvements' full physical useful life, because leasehold improvements are always amortized over their physical useful life regardless of the length of the underlying lease
- Over 10 years, the non-cancelable lease term plus the renewal option period, because all renewal options are automatically included in the amortization period regardless of whether exercise is reasonably certain
- Over the shorter of 6 years or 15 years, but rounded up to the nearest 5-year increment, as required under US GAAP for leasehold improvement amortization schedules
Why A? And why not the others?
Correct answer: A. Over 6 years, the remaining lease term, because that is shorter than both the improvements' 15-year physical useful life and the term including a renewal option the retailer is not reasonably certain to exercise
Leasehold improvements are amortized over the shorter of the improvement's useful life or the lease term, where the lease term includes renewal periods only when the lessee is reasonably certain to exercise the related renewal option. Here the improvements' physical useful life is 15 years, but the retailer is not reasonably certain it will exercise the 4-year renewal option, so the relevant lease term for amortization purposes is the 6-year non-cancelable period rather than the full 10 years including the option. Because 6 years is shorter than the 15-year physical life, the improvements are amortized over 6 years. The option requiring amortization over the full 15-year physical life ignores that leasehold improvements are constrained by the lease term whenever that term is shorter, since the improvements have no assured use to the retailer beyond the period it controls the leased space. The option automatically including the renewal option's 4 years regardless of certainty of exercise ignores the reasonably-certain-to-exercise condition, which exists precisely to prevent extending the amortization period based on an option the lessee may never take up. The option applying a rounding convention to the nearest 5-year increment fabricates a mechanical rule that does not exist anywhere in US GAAP; the shorter-of comparison uses the actual useful life and actual lease term, not a rounded approximation.
Source: FASB ASC 842-20-35-12 (amortization of leasehold improvements over the shorter of their useful life or the lease term, including renewal periods reasonably certain to be exercised)