Common Control Lease Arrangements – Give Me a Break?
On November 30, 2022, the FASB issued, for public comment, Exposure Draft 2022-ED500 Leases (Topic 842)-Common Control Arrangements (Update). The Update proposes significant changes to common control arrangements (leases between related party entities) in two areas:
Issue 1. Determining if a related party lease between entities under common control exists and, if so, the classification and accounting for that lease, and
Issue 2. Lessee accounting for leasehold improvements associated with leases between parties under common control.
The proposed amendment to Issue 1 above would be available as a practical expedient for private companies and most not-for-profit entities. The proposed changes to Issue 2 above would be open to all entities (public, private, and not-for-profit.)
Comments are due January 16, 2023. Based on the AICPA’s discussions with the FASB staff, the Board will attempt to promptly issue a final ASU after considering public comment.
Will it be effective for private companies implementing ASC 842 in 2022? Maybe. However, in the exposure draft, the Board decided it would establish the effective date of the final amendment after receiving comments. If the exposure draft is issued as written, it will provide improved clarity and simplification to the determination, classification, and accounting for related party entity leases. Additionally, it will more faithfully represent the economic realities of leasehold improvement for related party leases between entities under common control.
Related Party Arrangements. Under ASC 842, companies are to determine if a related party arrangement is a lease and, if so, classify and account for the lease based on legally enforceable terms and conditions. However, what is legally enforceable between related parties under common control can be complex. Often, related party entities are owned by the same individual or group of individuals; thus, determining legally enforceable terms is ambiguous at best. In addition, there are often roadblocks in obtaining a meaningful legal opinion on a hypothetical with such a potentially fluid fact pattern.
This determination is often complicated by the existence of substantial leasehold improvements to the underlying lease asset made and owned by the related party lessee. ASC 842 generally requires leasehold improvements to be amortized over the shorter of the remaining lease term or the useful life of the leasehold improvements. This approach often does not recognize the economic realities between related parties under common control and may distort the presentation of operations.
But the Update appears to provide some much-needed relief. Here’s what it proposes.
Issue 1: Terms and Conditions to be Considered. A practical expedient is provided whereby the written terms and conditions of a common control arrangement (in contrast to the legally enforceable terms and conditions provision found in ASC 842) are used to determine the following:
- Whether a lease exists and, if so,
- The classification of and accounting for that lease.
Under the practical expediency, the Company would not be required to determine if the written terms are legally enforceable. Additionally, the practical expediency may be applied on an arrangement-by-arrangement basis. However, the practical expedient is not available if there are no written terms and conditions (i.e., no written contract). In such a case, the Company must continue using legally enforceable terms and conditions to apply the provisions in ASC 842.
Importantly, the Update permits the Company to document any existing unwritten terms and conditions of an arrangement between entities under common control before the date on which the Company’s first interim or annual financial statements are available to be issued in accordance with the amendments of the proposed Update.
Issue 2: Accounting for Leasehold Improvements. The Update would require the following for leasehold improvements associated with related party leases between entities under common control:
- Leasehold improvements should be amortized by the lessee over the economic life of the leasehold improvements (regardless of the lease term) as long as the lessee controls the underlying asset under a lease agreement.
However, if the lessor obtained the right to control the underlying asset through a lease with an entity not part of the same controlled group, the amortization period may not exceed the lease term of the lessor’s unrelated party lease.
- Leasehold improvements should be accounted for as a transfer between related parties via an adjustment to equity when the lessee no longer controls the use of the underlying asset.
This is a significant change. As stated above, ASC 842 generally requires that leasehold improvements be amortized over the shorter of the remaining lease term or the useful life of the improvements. If the related party lease is classified as a short-term lease, the lessee’s operations could be punished because of misleading rapid amortization. Under the Update, generally, the amortization period would be the economic life of the leasehold improvements with respect to the related party group. This would be a significant and much-needed amendment to ASC 842.
Stay tuned. We’ll see what the FASB decides to do. And if the Board acts quickly enough, whether it will be applicable to unissued 2022 financial statements.