[Music] hello everyone this is second part of our discussion um the concept of income and in this video we will discuss more of the accounting for leasehold improvements so what is a list hold improvement so elise hold improvement is any improvement made by the lessee on the list property in pursuant to the agreement between the lessor and the lessee for which will become the property of the lessor upon the expiration or termination of the contract of the lease so for example if the lessor and the less he agreed that the lessee will construct a building over the leased property and then that building will become the property of the lessor then that building is considered is a leasehold improvement so again uh the party making the improvement or constructing the improvement is the lessee well the property being constructed or yes it's the left source property so the leasehold improvement shall become the property of the lessor and therefore there is a corresponding income that the lessor shall report in his income tax return the value of such improvement will become an income of the lessor using either the following method so in this accounting for literal improvements there are two methods being used so the first method in accounting for leasehold improvement is the outright method under the outright method improvement is recognized as income when the improvement is completed so for example if the lessor and the lessee agreed that the lessee will construct a building on the list property and such building shall become the property of the lessor upon the termination of the lease contract then the lessor shall recognize such improvement as his income when the construction is completed okay you might be asking why should the lessor recognize the improvement as his income where in fact the lessee was the one to construct the building so the reason is that since the the lease agreement provides that the lease improvement or the building being constructed by the lessee will become the property of the lessor then the lessor shall recognize such improvement as his income because in a way after the end of the lease contract the improvement shall become his property okay so you might be asking how much or to what extent should the lessor report the improvement as his income well the answer is simple if it uh the lesser is using outright method then the entire fair value of the property i mean of the improvement shall be considered as income in that case the fair value is equal to the cost of the property of the improvement as constructed by the lessee okay so the second method is the spread out method in this method the estimated book value of the improvement at the end of the lease period is amortized or spread out over the term of the lease and the income computed is reported every year until the lease is over so i like spread out method the lessor in i mean under outright method the lessor will recognize the entire cost or fair value of the property the leasehold improvement as his income however in contrast in spread out method the lessor will spread the book value of the improvement over the life of the contract of the lease okay so let's have an example for the two for these two methods so assume that miguel the owner of one hector land entered into a lease agreement with luigi so miguel is the lessor while luigi is the lessee for a period of 10 years beginning january 1 2018. the terms of the lease provide that the lessee who is luigi shall pay the lessor an amount of 150 000 pesos as two-year deposit and 50 000 pesos for the annual lease fee second the less initial erect or constructive building the ownership of such building shall transfer to the lessor upon the expiration of the term the lease or upon termination the advanced payment that 105 000 is a security deposit which shall be paid back to luigi let's see upon expiration but in case of default of payment such amount shall be appropriated meaning in case luigi delhi failed to pay the annual lease fee then the hundred thousand shall be considered or appropriated as payment the construction of the building began january 1 2018 which is also the same as the commencement of the lease and was completed on august 1 2018. with a total cost of 2 million the cost of construction equates to the fair value of the improvement the improvements used for life is 15 years so let's analyze this problem so miguel the lessor entered into an agreement at least agreement with luigi the lessee for a period of 10 years the lease contract is effective for 10 years and then luigi the lessee will pay a secret deposit of 150 000 pesos for a deposit and then 50 000 pesos as the first years or the annual lease fee aside from that the agreement provides that the lessee luigi will construct a building the construction of the building began january 1 2018 which is the same as the commencement or the start of the lease and the construction was completed on august 1 2018 with a total cost of 2 million now under the outright method the question is how much would be the income of the lessor under the outright method so our solution would be the income of the lessor shall report the annual rent fee of 50 000 pesos which is the uh 50 000 the annual rent and then the cost of the improvement which is 2 million so regardless when it was completed the entire amount 2 million is considered as income of the lessor why because again the lesser expects that this improvement shall be shall become his property at the end of the lease contract therefore for the year 2018 the lessor will report an income of 2 million pesos and 5 000 pesos so 2 million and 5000 pesos okay so we recognized outright the leasehold improvement as an income okay now let us use the same problem but using the spread out method so miguel the owner of one hector land entered into a lease agreement with luigi for a period of 10 years beginning january 1 2018. the terms of the lease provide that the lessee shall pay the lessor an amount of 100 000 pesos as a two year deposit few thousand pesos is the annual lease fee the lessee shall erect a building and the ownership of which shall transfer to the lessor upon the expiration of the term of the lease or upon termination advanced payment is a security deposit which shall be paid back to luigi upon expiration but in case of default of payment such amount shall be appropriated the construction of the building began january 1 2018 and was completed on august 1 to 18. with a total cost of 2 million pesos the cost of construction equates to the fair value of the improvement and the improvements used for life is 15 years so basically we have the same problem from the previous one but in this case we'll be using the spread out method so what will be our solution so first we need to compute the estimated book value of the improvement at the end of the lease contract take note it's the estimated book value of the improvement at the end of the lease contract so if the cost of the improvement was 2 million then we will multiply by 120 over minus 7 months over 180 months so what is this 120 minus 7 okay so remember that the lease contract is effective for 10 years therefore 10 years is equal to 120 months right whereas upon completion of the improvement there has been seven months already that has lapsed right from january to july 31 remember that the completion happened on august 1. so from jul from january to july 31 it's been seven months since the lease contract has started the 180 months is the actually the useful life of the improvement that is 15 years times 12 months so the estimated value of the improvement at the end of the lease contract is actually two million minus one million two five five five hundred physics seven therefore 744 thousand and 44 444 pesos is actually the estimated book value of the improvement at the end of the lease contract that one million two hundred fifty five thousand five hundred fifty-six is the accumulated depreciation during the analysis use of the improvement so that is 113 months okay again 2 million times 120 minus 7 this is 113. this is the number of months that the lessee will use the property okay why we deduct seven months because the lease contract started on january 1 2018 but the completion of the improvement only happened in august 1 2018 therefore there's been seven months that has been lapsed since the start of the lease contract okay so 101 million 255 is our accumulated depreciation of the improvement so we deduct document depreciation to get the estimated book value of the improvement at the end of the lease contract so now we have the estimated book value that has 744 444 we will now spread that amount over the remaining useful life of the lease contract okay so this is the remaining value of the property to the lessor so this is the amount that 744 the amount that the lessor shall recognize as his income but we will spread that over the remaining life or months of the lease contract so our second step step will be we need to compute the apportion or spread the remaining value of the property throughout the remaining period of the lease so if the remaining estimated book value of the list of improvement is 744 444 then we will divide that by 120 minus 7 months again why do we need to divide the estimated book value because from august 1 2018 when the when the completion of the of the leasehold improvement no so there's only 113 months that the lessee will use the property even though the lease contract is 420 months even though it's 10 years but the less he can only use the improvement for 113 months the remaining life or the remaining period of the lease because again seven months has been already lapsed okay so our monthly spread or monthly income will be 600 6588 pesos so this 6508 pesos is the income the monthly income of the lessor has spread no from the leasehold improvement okay so again that 6588 is the monthly reportable income from the improvement so now let's uh compute how much is the income of the lessor in 2018 so the annual rent fee of 50 000 pesos we have the income from the improvement that is 6588 times five months why five months let's count august september october november and december we have five months since the last improvement is available for use therefore the lessor for the year 2018 will only recognize 32 940 from the income from the leasehold improvement okay a total of 82 940 so the next question will be how about in 2019 so you just add 50 000 and then we have the annual income from improvement that's 6488 times 12 months okay so that's it that's how we compute income under spread out method so again in outright method we recognize the entire cost or fair value outright or one time the entire cost upon completion of the construction of the improvement whereas in spread out method we spread the estimated book value of the improvement over the remaining life or period of the lease contract okay so what about the security deposits remember that luigi the the lessee was required to pay a security deposit of 100 000. what about that what will happen to that secretary posits are refundable to the lessee once the contract is terminated upon maturity okay it's refundable to the lessee the secret deposits are an insurance or guarantee to the lessor that the lessee will faithfully comply to the contract therefore as these are fundable to the lessee the lessor has no right to declare or to report such deposit as his income in fact the lessor will recognize this deposit as a liability to his part to the let's see this again is not an income to the letter however in the event of breach of contract and if the parties agreed for an acceleration clause what's the constitution clause for example if the lessee defaulted a payment let's say one year two years a non-payment of the annual rent therefore the lessor will use the security deposit as a payment to the defaulted rent okay such deposits shall be surrendered in favor of the lessor and only upon such time that the lessor will recognize this deposit as an income okay how about the changes in the fair value of the property or improvement if at the end of the lease contract the fair value of the improvement is greater or lesser than the book value the lessor should recognize an additional income or loss respectively okay always remember that the lessor is a service oriented party being listing certain properties therefore income payments to him is recognized on cash basis also alessi may be engaged in servicing or merchandising business therefore payments made by the lessee is an expense either using cash basis or accrual basis so i hope you learned a lot from this discussion and i hope you watch the next videos for the next discussions thank you