Understanding Depreciation on Leasehold Property

Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. For leasehold property, which represents the right to use an asset for a fixed period, the cost incurred to acquire this right needs to be written off over the lease term. This process is similar to depreciation but is often referred to as amortization when dealing with intangible assets or rights like a leasehold.

Let's examine the common methods of depreciation and amortization to determine the most appropriate one for leasehold property.

Common Depreciation Methods

• Replacement Method: This method is typically used for assets like small tools or parts that are frequently replaced and are not individually significant in value. It involves charging the cost of replacement to revenue or a separate fund. This method is not suitable for writing off the cost of a leasehold right.
• Revaluation Method: This method is generally applied to assets whose value fluctuates significantly and are difficult to depreciate using standard methods, such as livestock or loose tools. The asset is revalued at the end of the accounting period, and any decrease in value is charged to the profit and loss account. This method is not appropriate for the fixed term nature of a leasehold property.
• Fixed Instalment Method (Straight-Line Method): Under this method, a fixed and equal amount of the asset's cost is written off as depreciation expense each year over its estimated useful life. The formula for depreciation is:

\(\text{Annual Depreciation} = \frac{\text{Cost of Asset} - \text{Salvage Value}}{\text{Useful Life}}\)

For leasehold property, the 'cost of asset' is the cost incurred to obtain the lease, the 'salvage value' is usually zero at the end of the lease term, and the 'useful life' is the duration of the lease period. This method systematically reduces the book value of the leasehold right over the period the entity benefits from it.

Appropriate Method for Leasehold Property

Leasehold property is acquired for a specific period. The benefit derived from the leasehold diminishes predictably over its term. The Fixed Instalment Method, also known as the Straight-Line Method, is the most appropriate way to amortize the cost of a leasehold property because it spreads the initial cost evenly over the fixed lease period. This method reflects the systematic consumption of the economic benefit of the leasehold over time.

Therefore, the appropriate method for depreciating (or amortizing) leasehold property is the Fixed Instalment Method.