Common Control Lease Standard Update
Leases: As we assisted our clients through the implementation of the new lease accounting standard (which became effective as of Jan. 1, 2022 for calendar year-end entities), questions arose surrounding related party leases. Similar questions were brought to the attention of the Financial Accounting Standards Board (“FASB”) by various stakeholders.
Two lease accounting provisions were issued in the accounting standards update by the FASB just last month. These provisions are specific to related party arrangements between entities under common control. Stay with me as we go through the technical parts with the summaries below:
Provision 1: Terms and Conditions to Be Considered
Topic 842 (the lease standard we’re all working so hard to implement) requires that entities determine whether a related party arrangement between entities under common control meets the technical definition of a lease. If the arrangement is determined to be a lease, it must be accounted for on the same basis as an arrangement with an unrelated party (ie: on the basis of legally enforceable terms and conditions). This update now allows private companies and not-for-profit entities to elect a practical expedient to use the written terms and conditions of the related party arrangement to determine (1) whether a lease exists and (2) if a lease exists, the classification of and accounting for that lease.
What’s the difference here and why would you want to elect this practical expedient? The feedback that the FASB received related to the difficulty in determining the enforceable terms and conditions of a related party lease with Topic 842. If your related party lease is written (not oral), you can elect this practical expedient and use the written arrangement as the basis for determining whether a lease exists and, if so, the classification of and accounting for that lease, rather than having to make judgmental determinations on what those enforceable terms and conditions may actually be.
When considering the “terms and conditions to be considered” above and whether an agreement constitutes a lease under Topic 842, be sure to consider whether the lessee has the right to control the identified asset. Some arrangements with related parties may specify strict stipulations regarding the use of the identified asset in which the lessee may not actually have control of the asset.
Here’s an example: an agreement with the lessor specifically identifies rent to be paid (consideration) to use a building (identified asset), which would be typical in identifying a lease agreement. However, the agreement also states that (1) no leasehold improvements can be made without written approval from the lessor and for a very low amount (ie: no changes can really be made to the building), and (2) no other use of the building other than a specified purpose. There may be other strict stipulations, but an argument could be made that the lessee doesn’t truly have the right to control the building in which a lease doesn’t exist.
Still with me? Let’s go to provision 2…
Provision 2: Accounting for Leasehold Improvements
Under Topic 842, leasehold improvements must be amortized over a period consistent with the shorter of (1) the remaining lease term, and (2) the useful life of the improvements. This standard update allows leasehold improvements associated with related party leases (common control leases) to be:
Amortized by the lessee over the useful life of the leasehold improvements to the common control group (regardless of the lease term) as long as the lessee controls the use of the underlying asset through a lease, and
Account for the leasehold improvements returned to the related party at the end of the lease as a transfer between entities under common control through an adjustment to equity if, and when, the lessee no longer controls the use of the underlying asset.
At this point, you may be thinking “what benefit does this have and why should I adopt this part of the standard update?” The FASB received additional feedback noting that for related parties, when the common control lease agreement has ended and the leasehold improvements are transferred back to the lessor, the leasehold improvements may not faithfully represent the economics of those leasehold improvements or the true value in the transfer due to the shorter amortization period used and potential salvage value assigned. By adopting this standard update, the leasehold improvements can now be amortized over a longer life (relevant for the related party) that is more representative of the value to be transferred back to the lessor once the lease has ended and the lessee no longer controls the use of the identified asset. In more concise terms, if you have a related party lease with a remaining term of five years and leasehold improvements are placed into service at the start of the remaining five year lease term, you don’t necessarily have to amortize them over the five year remaining lease term if it’s in the interest of the common control group to amortize them over ten years.
You’ve made it this far…let’s talk about when this is effective and how to adopt this new standard update. This standard update is effective for fiscal years beginning after Dec. 15, 2023. I know what you’re thinking – I’d like to adopt this now or as soon as possible to help with the original Topic 842 implementation! You’re in luck; early adoption is permitted and this update provides a few options for implementation, depending on when you plan to implement:
Concurrently with Topic 842: if you have not yet issued financial statements for the period in which you are adopting Topic 842, you can concurrently elect the practical expedient and/or adopt this standard update with the same transition requirements for Topic 842.
Prospectively: For the election of the practical expedient related to the terms and conditions, you can prospectively apply the practical expedient to arrangements that commence or are modified on or after the date that the entity first applies the practical expedient.
For the adoption of the standard update related to leasehold improvements, you can adopt prospectively to (1) all new leasehold improvements recognized on or after the date that the entity first applies the amendments, or (2) to all new and existing leasehold improvements recognized on or after the date that the entity first applies the amendments.
Retrospectively: for both the election of the practical expedient related to the terms and conditions and the application of the standard update for leasehold improvements, you can retrospectively elect / apply to the beginning of the period in which the entity first applied Topic 842.
Do you want more information or assistance with the application of this accounting standards update? Feel free to reach out to Jessica Yohe at email@example.com or call 803-771-8943.