Page 464 - Accounting Principles (A Business Perspective)

11. Plant asset disposals, natural resources, and intangible assets

transfer the amount in the Leasehold account to Prepaid Rent at the beginning of the fifth year by debiting Prepaid
Rent and crediting Leasehold. If this entry was made, the previous entry would have credited Prepaid Rent.
In some cases, when a lease is signed, the lump-sum payment does not cover a specific year's rent. The lessee

debits this payment to the Leasehold account and amortizes it over the life of the lease. The straight-line method is
required unless another method can be shown to be superior. Assume the USD 15,000 rent for the fifth year in the
example was, instead, a lump-sum payment on the lease in addition to the annual rent payments. An annual
adjusting entry to amortize the USD 15,000 over five years would read:
Rent Expense (-SE) 3,000
Leasehold (-A) 3,000
To amortize leasehold.
In this example, the annual rental expense is USD 18,000: USD 15,000 annual cash rent plus USD 3,000
amortization of leasehold (USD 15,000/5).
The lessee may base periodic rent on current-year sales or usage rather than being a constant amount. For
example, if a lease called for rent equal to 5 per cent of current-year sales and sales were USD 400,000 in 2010, the

rent for 2010 would be USD 20,000. The rent would either be paid or an adjusting entry would be made at the end
of the year.
A leasehold improvement is any physical alteration made by the lessee to the leased property in which
benefits are expected beyond the current accounting period. Leasehold improvements made by a lessee usually
become the property of the lessor after the lease has expired. However, since leasehold improvements are an asset
of the lessee during the lease period, the lessee debits them to a Leasehold Improvements account. The lessee then
amortizes the leasehold improvements to expense over the period benefited by the improvements. The amortization
period for leasehold improvements should be the shorter of the life of the improvements or the life of the lease. If
the lease can (and probably will) be renewed at the option of the lessee, the life of the lease should include the

option period.
As an illustration, assume that on 2010 January 2, Wolf Company leases a building for 20 years under a
nonrenewable lease at an annual rental of USD 20,000, payable on each December 31. Wolf immediately incurs a
cost of USD 80,000 for improvements to the building, such as interior walls for office separation, ceiling fans, and
recessed lighting. The improvements have an estimated life of 30 years. The company should amortize the USD
80,000 over the 20-year lease period, since that period is shorter than the life of the improvements, and Wolf
cannot use the improvements beyond the life of the lease. If only annual financial statements are prepared, the

following journal entry properly records the rental expense for the year ended 2010 December 31:
Rent Expense (or Leasehold Improvement Expense) 4,000
(-SE)
Leasehold Improvements (-A) 4,000
To record amortization of leasehold improvement.
Rent Expense (-SE) 20,000
Cash (-A) 20,000
To record annual rent.

Thus, the total cost to rent the building each year equals the USD 20,000 cash rent plus the amortization of the
leasehold improvements.

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