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ACCOUNTING FOR LEASEHOLD METHODS | Spread-Out Method vs. Outright Method

Sep 8, 2025

Overview

This lecture covers the accounting treatment for leasehold improvements, including definitions, the roles of the lessor and lessee, methods for recognizing income (outright and spread out), detailed example calculations, the handling of security deposits, and the impact of changes in fair value at the end of the lease.

Leasehold Improvements: Definition and Parties

  • Leasehold improvement: Any enhancement or construction made by the lessee on leased property, as agreed upon in the lease contract, which becomes the property of the lessor when the lease expires or is terminated.
  • The lessee is responsible for making or constructing the improvement.
  • The lessor becomes the owner of the improvement at the end of the lease, and must recognize the value of the improvement as income.

Methods of Recognizing Income from Leasehold Improvements

  • There are two main methods for accounting for leasehold improvements:
    • Outright Method: The lessor recognizes the entire fair value (usually equal to the cost incurred by the lessee) of the improvement as income when the improvement is completed.
    • Spread Out Method: The lessor recognizes income gradually by amortizing the estimated book value of the improvement over the remaining term of the lease. The income is reported annually (or monthly) until the lease ends.

Worked Example: Outright vs. Spread Out

  • Scenario: Miguel (lessor) leases land to Luigi (lessee) for 10 years starting January 1, 2018. Luigi pays a security deposit of 150,000 pesos and an annual lease fee of 50,000 pesos. Luigi constructs a building on the property, completed August 1, 2018, at a cost of 2,000,000 pesos. The building’s useful life is 15 years (180 months).

Outright Method

  • The lessor recognizes the full cost of the improvement (2,000,000 pesos) as income in the year the building is completed, regardless of when during the lease it is finished.
  • The lessor also reports the annual rent fee (50,000 pesos).
  • For 2018, the lessor’s total income is 2,050,000 pesos (2,000,000 from the improvement + 50,000 rent).

Spread Out Method

  • The lessor calculates the estimated book value of the improvement at the end of the lease:
    • Lease term: 10 years = 120 months.
    • Improvement completed after 7 months (January–July), so lessee uses the improvement for 113 months (120 - 7).
    • Useful life of improvement: 15 years = 180 months.
    • Accumulated depreciation during the lease: 2,000,000 × (113/180) = 1,255,556 pesos.
    • Estimated book value at lease end: 2,000,000 - 1,255,556 = 744,444 pesos.
  • This estimated book value (744,444 pesos) is spread over the remaining 113 months of the lease.
    • Monthly income recognized: 744,444 á 113 ≈ 6,588 pesos.
  • For 2018, the lessor recognizes:
    • Rent income: 50,000 pesos.
    • Improvement income: 6,588 × 5 months (August–December) = 32,940 pesos.
    • Total income for 2018: 82,940 pesos.
  • For subsequent years, the lessor recognizes 50,000 pesos rent plus 6,588 × 12 = 79,056 pesos from the improvement each year.

Security Deposits Handling

  • Security deposits paid by the lessee are refundable at the end of the lease and are not considered income for the lessor.
  • The lessor records the deposit as a liability, not as income.
  • If the lessee defaults (e.g., fails to pay rent), the deposit may be appropriated by the lessor as payment for the defaulted amount. Only then does the lessor recognize the deposit as income.

Changes in Fair Value of Improvements

  • At the end of the lease, if the fair value of the improvement is higher than the book value, the lessor recognizes additional income.
  • If the fair value is lower than the book value, the lessor recognizes a loss.

Income Recognition Methods for Lessor and Lessee

  • The lessor, as a service-oriented party, typically recognizes income on a cash basis.
  • The lessee records payments as expenses, using either the cash or accrual basis, depending on their accounting method.

Key Terms & Definitions

  • Leasehold Improvement: Modification or construction on leased property by the lessee, which becomes the lessor’s property at lease end.
  • Outright Method: The lessor recognizes the full value of the improvement as income when construction is completed.
  • Spread Out Method: The lessor recognizes income gradually by amortizing the estimated book value of the improvement over the lease term.
  • Security Deposit: Refundable amount paid by the lessee to the lessor as assurance of contract compliance; not income unless appropriated due to default.

Action Items / Next Steps

  • Review the detailed example calculations for both the outright and spread out methods.
  • Practice analyzing scenarios involving security deposits and their treatment in lease agreements.
  • Understand how changes in the fair value of improvements at lease end affect the lessor’s income recognition.

Full transcript