leasehold improvement

Dear all,

During the company audit in March 2013, I observe that the fixed assets register is not booked in accordance with the company fixed asset policy.

They are applying useful lives according to the local legislation, e.g.

  • leasehold improvement are amortized by 20 years instead of the shorter of the remaining economic live of the asset or the remaining lease term,
  • tooling above 10.000 USD is amortized by 6 instead of 3 years,
  • a few assets below 5.000 USD got capitalized,
  • computer software, computer hardware, machinery and equipment as well as furniture and fixtures are amortized according the useful lives published by local legislation instead of the company useful lives.

An adjustment of the fixed asset register according company fixed asset policy would result in a major impairment, especially for the leasehold improvements, which are capitalized between 2002 and 2010 with 20 years useful live.

The leasing contract for the factory building had been signed in March 2002 for a duration of 2 years incl. 5 options for 2 years prolongation.

The landlord reserved a right to terminate the contract with a notification period of 3 month.

A few appendixes had been added to the contract as the company enlarged the shop floor since then. This is also the reason why sub-assets had been added from time to time to each of the capitalized leasehold improvements.

The above mentioned contract had been cancelled by the end of 2012 and replaced by a new contract as the owner of the facility changed the legal form of the company and to get rid of all different appendixes. The negotiation regarding a new contracts started 10.09.2010 and is documented with respective emails (in attachment).

Considering below mentioned paragraph to the company fixed asset policy would we be able to apply the prolongations for our amortization period?

Leasehold improvements has to amortized by the shorter of the remaining economic live of the asset or the remaining lease term March 2014.

Can we apply the 2012 signed contract for leasehold improvements, which are in connection with the new contract even although we already installed them in 2010 based on the negotiation.

“Lease extensions may be considered in the lease term only if the extension is fully within our control (i.e. the lessor cannot object) and it is highly probable that the lease will be extended (i.e. it makes commercial and economic sense to extend the lease).”

Can you please share your opinion or advise.


In reviewing the conclusion presented, I agree that setting depreciation / capitalization policy per SK accounting legislation was an error in applying US GAAP.

I disagree, however, that an impairment charge is an appropriate correction of that error.

As to the specific issue of the leasehold improvement.  Per my understanding of the facts, the original lease term, although explicitly set at of 2 years, was in fact extendable.

ASC 840-10-35-6 states (emphasis added): Leasehold improvements in operating leases that are placed in service significantly after and not contemplated at or near the beginning of the lease term shall be amortized over the shorter of the following terms:

    a.  The useful life of the assets

    b.  A term that includes required lease periods and renewals that are deemed to be reasonably assured (as used in the context of the definition of lease term) at the date the leasehold improvements are purchased.
This implies that the originally capitalized improvement should have been amortized over a term that was longer than two-years.  

This judgement is supported by subsequent facts, because the lease was, in fact, extended.

Similarly, treating the original 2002 lease and the subsequent renegotiation, which was initiated in 2010 and finalized 2012, as two discrete and separate economic events would a misreading of the facts and an overly formalistic interpretation of US GAAP guidance.

This does not imply that I agree with the original 20-year amortization period used for the first improvement.  As it was set per local legislation and not supported by the facts, it is not justifiable from a US GAAP perspective.

In other words, given the facts, the original improvement should have been amortized over approximately 10 years, after which a subsequent improvement was necessary to maintain the leasehold’s overall functionality.

This does not, however, suggest that impairing the aggregate improvement (both the amounts initially and subsequently capitalized) is appropriate.

Instead, it suggests that:

1. the error committed made in 2002 should be corrected.  

The amortization period should be changing from 20 years (the period per SK legislation) to the actual useful life (which appears to be 10 years) and the effected period restated.

2. the original and revised contracts, given that both relate to exactly the same physical leasehold, should be treated as a single agreement plus modification.  

In other words, given the Slovak Republic is not a common law country nor are the contracts entered into there consistent with the US Uniform Commercial Code, a certain leeway in interpreting the letter of these contracts is, when applying US GAAP guidance, appropriate.

3. determine both the useful life of the second improvement and estimate the term for which the lease will actually be held (assuming additional extensions).  

4. Amortize the second improvement over the sorter of the two.

In my opinion, trying to cover up the original error (and avoid making the necessary restatements) by taking one-time impairment charge risks turning one error into two errors, and should be avoided.

Finally, as the problem if inappropriate amortization / depreciation periods as well as the expensing of assets based on legislated quantification is endemic in central Europe, I would strongly suggest reviewing all the entity’s capital expenditures / depreciation policies to make sure they were not in fact subordinated to local requirements.

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