Many entities have anxiously awaited amendments to Topic 842 Leases (ASC 842) and challenges surrounding common control arrangements.
In answer to these issues, FASB released Accounting Standards Update 2023-01 – Leases (Topic 842): Common Control Arrangements on March 27, 2023.
What Were the Primary Issues Faced Under Existing Guidance?
The following two issues are frequently encountered in assessing common control arrangements under existing ASC 842 guidance, and are the focal point of the new ASU:
The terms and conditions an entity should consider in determining whether a lease exists and the classification and accounting for that lease
ASC 842 requires entities to evaluate if a contract is or contains a lease.
- A contract is defined as an arrangement that creates enforceable rights and obligations.
FASB received feedback from private company stakeholders that applying the new lease standard to common control arrangements was uniquely challenging, because the entire arrangement (lessor entity and lessee entity) is controlled by one party or a control group. This has posed issues in determining the legally enforceable terms and conditions of those arrangements since the controlling party or control group typically can amend the terms and conditions of a common control arrangement at any time without approval by the lessor or lessee.
Accounting for leasehold improvements associated with leases between entities under common control
ASC 842 currently requires that leasehold improvements be amortized over the shorter of the remaining lease term or the useful life of the leasehold improvements.
FASB received feedback from private companies that it is not unusual for common control leases to have short lease terms and for the lessee to invest in leasehold improvements with a useful life that far exceeds the term of the lease. This could result in the lessee fully amortizing leasehold improvements over a period shorter than the useful life of the improvements and financial reporting that does not represent the economics or common control nature of the improvements.
Additionally, FASB noted that diversity in practice may exist in the accounting for these leasehold improvements.
How Does the New ASU Address the Above Issues?
The ASU provides a practical expedient for private entities and nonprofit entities that are not conduit debt obligors under common control. This allows them to use the written terms and conditions in determining whether the arrangement is or contains a lease and, if a lease exists, in classifying and accounting for the lease.
Following the written terms and conditions is a simpler approach to evaluating common control arrangements than evaluating what is legally enforceable. The ASU also allows this practical expedient to be elected on an arrangement-by-arrangement basis. This provides additional flexibility for entities to decide if following the written terms and conditions or evaluating the legally enforceable terms and conditions is best for a given arrangement.
If no written terms or conditions exist, entities will need to evaluate the legally enforceable terms and conditions. Accordingly, entities are encouraged to document the terms of their arrangements in writing.
For entities who have not yet issued their first interim or annual financial statements under the new lease standard, the ASU permits them to document any existing unwritten terms and conditions of an arrangement between entities under common control before the date on which their first interim or annual financial statements are available to be issued. It also allows them to follow the new written terms and conditions in evaluating their common control arrangements as part of preparing their financial statements under the new lease standard.
This written documentation does not need to be in a prescribed legal form as the purpose of the practical expedient is to provide relief from determining whether or not the contract is legally enforceable, so long as it is in writing; therefore, a great amount of flexibility is allowed with respect to the written form of these arrangements.
The ASU requires that leasehold improvements between entities under common control be amortized by the lessee over the useful life of the improvements if the lessee controls the use of the underlying asset.
The useful life would be used regardless of the lease term unless the lessor obtained the right to control the underlying asset through a lease with a party that is not under the same common control group. If the right to control the underlying asset was obtained through a lease with a party outside of the same common control group, the amortization period cannot exceed the lease term associated with the common control group.
When the lessee no longer controls the use of the underlying asset, any remaining value of the leasehold improvement will be accounted for as a transfer between entities under common control through an adjustment to equity (or net assets for nonprofit entities).
The accounting for leasehold improvements associated with common control leases applies to all entities.
Effective Dates for Lease Accounting Update
The effective date for both issues is for annual fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted for both interim and annual financial statements that have not yet been made available for issuance. If an entity adopts the amendments in an interim period, it must adopt them as of the beginning of the fiscal year that includes the interim period.
Related to Issue #1, entities that have not yet adopted ASC Topic 842 on or before the effective date of the ASU would follow the transition requirements of ASU 2016-02 for the amendments in this ASU using the same transition method elected to apply Topic 842.
For entities that have adopted Topic 842 before the effective date of this ASU, the entity can choose one of the following options:
- Apply prospectively to arrangements that commence or are modified on or after the date that the entity first applies the amendments.
- Apply retrospectively to the beginning of the period in which the entity first applied Topic 842 for arrangements that exist at the date of the adoption of the amendments. The amendments are not applicable for arrangements no longer in place at the date of the adoption of the ASU.
Regardless of which approach is applied, the entity is permitted to document any existing unwritten terms and conditions of an arrangement between entities under common control before the date on which the entity’s first interim (if applicable) or annual financial statements are available to be issued in accordance with the amendments in this ASU.
For Issue #2, the following options apply:
- Entities that have not yet adopted ASC Topic 842 on or before the effective date of this ASU would follow the transition requirements of ASU 2016-02 for the amendments in this ASU using the same transition method elected to apply Topic 842 or may use either of the prospective approaches below to avoid retrospectively accounting for leasehold improvements.
- For entities that have adopted Topic 842 before the effective date of this ASU, the entity can choose one of the following options:
- Prospectively to all new leasehold improvements recognized on or after the date of adoption of the ASU.
- Prospectively to all new and existing leasehold improvements recognized or after the date of adoption of the ASU. The unamortized balance of existing leasehold improvements would be amortized over the remaining useful life to the common control group determined at that date.
- Retrospectively to the beginning of the earliest period presented in accordance with Topic 842 for all leasehold improvements that exist at the date of adoption of the ASU, with any leasehold improvements that would not have otherwise been amortized or impaired recognized through a cumulative effect adjustment to the to the opening balance of retained earnings (or net assets of a not-for-profit entity) at the beginning of the earliest period presented in accordance with Topic 842.