By Colin M. Hannifin, CPA, Business Assurance & Advisory Services Senior Manager
New lease standard for non-public entities focuses on related parties
On Monday, March 27, 2023, the Financial Accounting Standards Board (the “FASB” or the “Board”) issued its first Accounting Standards Update (“ASU”) of the year, ASU 2023-01 Leases (Topic 842): Common Control Arrangements. The new standard provides non-public entities additional guidance around leases with related parties.
- The new ASU 2023-01 offers additional guidance and insight on how to account for common control leases.
- It offers a practical expedient that entities may elect to use to ease the burden of determining the legal enforceability of a written contract.
- It clarifies and updates the guidance on how leasehold improvements in common control leases should be treated.
- For those entities still working through the adoption of ASC 842, this can provide some relief.
Lease standard background
The FASB issued the new lease standard, Accounting Standards Codification (“ASC”) Topic 842 in February 2016. After several deferrals, ASC 842 was effective for non-public entities for periods beginning after December 15, 2021. It had been effective in prior years for public entities. The most significant impact of the standard is that lessees are required to capitalize all leases longer than 12 months as a right-of-use asset on the balance sheet, with an accompanying lease liability.
ASC 842 does not provide significant guidance on related party leases, however, resulting in many non-public entities struggling with adoption. ASU 2023-01 is an attempt to address this by offering additional guidance.
Guidance on common control leases
Common control arrangements
Under ASC 842, entities are required to determine whether a related party arrangement for entities under common control is a lease. If the arrangement is determined to be a lease, entities are required to follow the guidance of ASC 842, accounting for the lease as though it were with a third party – that is, based on the legally enforceable terms and conditions. However, determining the legally enforceable terms and conditions of a related party lease can often prove difficult and costly, requiring the assistance of legal opinions.
ASU 2023-01 provides a new practical expedient for non-public entities (including not-for-profit organizations that are not conduit bond obligors) to use the written terms and conditions of a common control arrangement to determine whether a lease exists and, if so, the classification of the lease and the appropriate accounting treatment.
This new practical expedient can only be elected when there are written terms and conditions; otherwise, the entity must evaluate the legally enforceable terms and conditions, as required under the original ASC 842. The practical expedient can be elected on an arrangement-by-arrangement basis.
While this can provide relief for many entities that have related party leases, it should be noted that it does not solve some of the more difficult considerations these entities may face, such as determining the appropriate lease term to use in a perpetual related party lease or determining the appropriate discount rate to use in the calculation of a right-of-use asset and lease liability.
Under ASC 842, leasehold improvements have an amortization period consistent with the shorter of the remaining lease term and the useful life of the leasehold improvements. This was largely unchanged from prior accounting guidance. However, in instances where the term of related party lease was short, the amortization period would be similarly short, misrepresenting the economic realities of the arrangement.
The new standard, ASU 2023-01, requires that leasehold improvements associated with common control leases, be amortized over the useful life of the leasehold improvements as long as the lessee controls the use of the leased asset. However, if the lessor obtained the right to control the use of the underlying asset through a lease with a third-party, the amortization period of the leasehold improvements may not exceed the term of the third-party lease.
If Company A owns a facility and leases it to an entity under common control, Company B, any related leasehold improvements owned by Company B should be amortized over the life of the leasehold improvements for as long as it leases the facility.
However, if Company A leases a facility from a third-party, and sublets it to an entity under common control, Company B, any leasehold improvements owned by Company B should be amortized over the lesser of the life of the leasehold improvements and the term of the lease between Company A and the third-party.
Additionally, leasehold improvements associated with a common control lease should be accounted for as a transfer between entities through an adjustment to equity if and when the lessee no longer controls the use of the underlying asset.
Effective date for ASU 2023-01 Leases (Topic 842)
The new ASU is effective for fiscal periods beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted for financial statements that have not yet been made available for issuance.
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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.