Secure Act 2.0

Invest In The Future

On December 29, 2022, as part of the Consolidated Appropriations Act of 2023, President Biden signed the SECURE 2.0 Act of 2022 into law.

The law enacted numerous new retirement-related provisions with various effective dates. Many of the provisions are designed to encourage citizens to invest in their future. The law is very extensive and complex. Below is a snapshot of a few of the provisions.

  1. Required Minimum Distributions. The law requires when you reach a certain age, required minimum distributions (RMD) must be made from tax-sheltered accounts (IRA, 401(k)s) and, therefore, be subject to tax. The RMD age was raised to 73 in 2023 and 75 in 2033. So, if you turn 72 in 2023, you must take your first RMD by December 31, 2024, or you could delay it to no later than April 1, 2025. In addition, penalties for neglecting to take the RMD were cut in half beginning in 2023 and reduced further if promptly corrected. Also, starting in 2024, Roth accounts will be exempted from RMD requirements.
  2. Automatic Enrollment and Portability. Effective in 2025, almost all new retirement plans (401(k) and 403(b) plans) with employee deferral features must automatically enroll employees at a rate of at least 3%, but not more than 10%, contribution rate. Employees may choose not to participate. Companies in business for less than three years and employers with ten or fewer workers are exempted from this requirement. Plan service providers can also offer automatic portability services whereby an employee’s low-balance account can be transferred to a new plan.
  3. Catch-Up Provisions. Contribution catch-up provisions have increased for individual participants age 50 and older. The catch-up amount increased from $6,500 to $7,500 annually in 2023. In addition, in 2025, the catch-up contribution will increase to $10,000 annually (indexed for inflation) for participants ages 60 to 63. Beginning in 2024, all catch-up contributions for participants fifty and older earning over $145,000 the prior calendar year must be made on an after-tax basis in a Roth account.
  4. Part-Time Workers. Effective in 2025, eligibility to participate in defined contribution retirement plans changed under Secure Act 2.0 to include workers who attain 500 to 999 hours for two consecutive years.
  5. Student Loans. Effective 2024, student loan payments can be construed as employee retirement contributions to qualify for employer matching contributions. Accordingly, employees must certify annually to their employer the amount of their qualifying student loan payments.
  6. Retirement Plan Mandatory Cash-Out Limits. Effective in 2024, retirement accounts with balances of $7,000 or less for participants no longer employed by the sponsoring company can be paid out to the former employee. Previously, this amount was $5,000. The $7,000 amount is not indexed in future years.
  7. Emergency Savings. Beginning in 2024, defined contribution plans can make available a Roth-designated account eligible to accept emergency savings. Contributions would be limited to $2,500 annually, with the first four withdrawals a year distributed as tax-free and penalty-free. In addition, the contributions would be eligible for employer match if permitted under the plan’s terms.
  8. Self Correction. The number of infractions that can be self-corrected internally by a plan without submission to the IRS or DOL increased under the Act.
  9. Incentives to Participate. Effective in 2023, employers may offer modest incentives to increase participation in the retirement plan. However, the financial incentives must be de minimis and cannot be paid from plan assets.

Leases – A Follow-Up

Helpful Changes Made by the FASB

The FASB issued the much anticipated ASU No. 2023-01 on March 27, 2023. It made changes that affect related party arrangements between companies under common control. The positive changes will help smooth the road for this part of lease accounting. The changes affect two broad areas for related party leases: between entities under common control:

  1. Terms and conditions to be considered and,
  2. Leasehold improvements.

In a Nutshell: Companies with related party leases between entities under common control should elect the new practical expedient to strictly apply written terms and conditions of lease arrangements between entities under common control instead of the legally enforceable terms. NOTE: If the terms and conditions are unwritten, those terms can be (and should be) documented in writing during the transition to the practical expedient. Also, leasehold improvements associated with related party leases under common control are to be amortized over the useful life of the improvements to the controlled group (instead of the shorter of the remaining lease term or useful life of the improvements.)

Here are the key points:

  1. Common Control. First, ensure your “arrangement” qualifies for treatment under FASB ASU No. 2023-01 Common Control Arrangements (“Update”). The Update ONLY applies to related party arrangements between entities under common control. What is common control? The FASB Board does not define it. The Background Information and Basis for Conclusions section of the Update refers you to EITF Issue No. 02-5, Definition of Common Control in Relation to FASB Statement 141″ for help. It was issued several years back and summarized the SEC’s view of what is common control. Strictly speaking, the definition only applies to public companies. Regarding this Update, the FASB Board believes that common control should be understood broader for private companies than what the SEC staff dictated for public companies. The critical question is whether the lessee and lessor are controlled (more than 50%) by a common group.
  2. The Practical Expedient. ASC 842 generally requires arrangements to look at legally enforceable terms and conditions to determine if a  lease exists and how it should be classified and accounted for. However, the Update provides a practical expedient whereby the Company can apply the written terms and conditions (instead of legally enforceable terms and conditions) to determine the following:

    • Whether a lease exists, and if so,
    • The classification and accounting for that lease.

    The practical expedient may be applied on an arrangement-by-arrangement basis. IMPORTANT. If no written terms and conditions exist (including when an entity does not document existing unwritten terms and conditions in writing upon transition to the practical expedient), the Company is prohibited from applying the practical expedient. It must evaluate the enforceable terms and conditions to apply Topic 842. Not a good thing,

    Therefore, the Company must put unwritten terms and conditions in writing at the transition date to the practical expedient. If the terms and conditions are summarized in writing, then the written terms determine the classification of the lease. For example, if the written lease provides a lease term of one year, with no options to renew, the classification will be a short-term lease, assuming the Company made the short-term lease election.

  3. Leasehold Improvements. ASC 842 generally requires that leasehold improvements have an amortization period consistent with the shorter of the remaining lease term and the useful life of the improvements. The Update changes this for leasehold improvements associated with related party leases between companies under common control, whereby such leases are:

    • 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.
    • However, if the lessor obtained the right to control the use of the underlying asset through a lease with an unrelated party not under common control, the related party sublessee would generally amortize the leasehold improvements over a period that does not exceed the term of the lease between the lessee/intermediate lessor and the unrelated party.
    • If and when the lessee no longer controls the use of the underlying asset, this loss of control is accounted for as a transfer between entities under common control through an adjustment to equity.
  4. Effective Date. The practical expedient and leasehold improvements amortization amendments are effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted for 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 that interim period.

    • As I’m reading it, if the Company’s annual 2022 financial statements have not been issued, then early adoption is permitted for the calendar year 2022 (and  every year end through December 31, 2023.)
  5. Transition Requirements for the Practical Expedient
    • Entities adopting the practical expedient in the Update concurrently with adopting ASC 842 (i.e., calendar year 2022 private clients) must follow the same transition requirements used to apply ASC 842.
    • IMPORTANT. The Company is permitted to document any existing unwritten terms and conditions of a common control arrangement before the date on which the Company’s first interim (if applicable) or annual financial statements are available to be issued in accordance with the practical expedient.
  6. Transition Requirements for Accounting for Leasehold Improvements
    • Companies adopting the amendments relating to leasehold improvements  concurrently with adopting ASC 842 may follow the same transition requirements used to apply ASC 842 or may use either of the prospective approaches described below to avoid retrospectively accounting for leasehold improvements:
      • Prospectively to all new leasehold improvements recognized on or after the date the Company first applies the amendments in this Update (January 1, 2022, for 2022 calendar year clients).
      • Prospectively to all new and existing leasehold improvements recognized on or after the date that the entity first applies the amendments in this Update (January 1, 2022, for 2022 calendar year clients), with any remaining unamortized balance of existing leasehold improvements amortized over their remaining useful life to the control group, determined at that date.

Time Shrinkage

“Don’t Squander Time…”

A lot is written on call center time shrinkage and ways to address it to increase productivity. This blog is not about call centers. This article is not based on scientific or statistical research. It’s not about whether time is real or illusionary (we’ll leave that for the theoretical physicists.) This article, instead, is about time as it relates to the accounting profession.

Those in public accounting believe that time is real. Over the years, time shrinkage has crushed us, causing many to miss untold evening newscasts, home-cooked meals, favorite TV programs, monster hide-and-seek with the kids, school events, concerts, sporting events, and sufficient sleep, to name just a few. And clients of public accountants think time is real too. That is, those who receive engagement quotes and invoices based on standard hourly rates and those who have habitual monthly deadlines.

Those in private accounting are keenly aware of the nature of time. First of all, it’s circular, not linear. Specific tasks are performed daily, some weekly, and others monthly or annually. And then it comes at you again, the same functions, ever so quickly – it’s circular. And this has nothing to do with Eastern philosophy. It just seems that way when you are in the thick of it.

Time is precious. Any bad habit, unnecessary interruption, meaningless process, or anything that snatches our time, never to be seen again, is not our friend. But, on the other hand, what saves time should be identified and cherished.

Time Snatchers. Based on my observations, below are some typical thieves of our time.

  • Mistakes. Mistakes are not all equal. Some are big, and some are not so big. But they generally have one thing in common – they are time snatchers. They cost you some measure of time. That loss of time is often multiplied because of the human error chain reaction. For example, the mistake, whatever it may be, delays the processing of the report for a few hours, which in turn delays report delivery until the next day, a day later than promised.

    Humans, of course, will always make mistakes. It’s the human condition. However, the way we deal with our mistakes is what counts. Do we admit them and apologize or find ways to hide them? Do we have a mindset to learn from them or have a cavalier attitude? On the positive side, our mistakes can be a great teacher. What is the saying – good judgment comes from bad judgment.

  • Bad Habits. Here is a list of everyday bad habits that may rob time from the accountant.

    • Procrastination. Yeah – almost everyone procrastinates from time to time. But when it becomes habitual, then it’s a time problem.
    • Copying the prior accountant (a.k.a. CPA). Blindly following the preceding year’s workpapers may be exceedingly inefficient. This is true even if the previous accountant is yourself.
    • Not embracing change. Some repeatedly cling to the old way of doing things, even if inefficient compared to the modernized way. Let’s face it, the car is faster than the horse and buggy. Innovative technology has proven to be a tremendous time saver. There was a time I would scribble something out on paper and give it to the secretary to type. Now, I type it myself. It saves time.

  • Due Date Bunching. Many due dates for federal and state informational returns and tax returns bunch up from January through April 15. This includes gift tax returns, form 1099 series, form W-2 and W-3 series, individual tax returns, pass-through entities tax returns (partnership, most S-Corporations, and LLCs), federal and state unemployment tax returns, and many others.

    This bunching was exacerbated several years back when the rules changed for flow-through entities, requiring most to report on the calendar year. Provisions were made under the tax code whereby the company could retain its fiscal year. But this required enhanced estimated tax payments and added complexity to the process.

    Make intelligent use of extensions to spread out the workload. I understand that this is easier said than done. Many clients may resist because of personal reasons or concerns it may trigger an audit by the IRS.

  • Social Media. Yeah. I’m not a big fan of social media. A Google search pulled up the top 20 social media platforms. My gosh, I had no idea there were so many. I’m talking about Facebook, YouTube, WhatsApp, Instagram, and TikTok. At the very bottom of the list of 20 was Linkedin. That’s the one I’m signed up for. Figures. I do use YouTube from time to time. It can be helpful and entertaining. I understand that WhatsApp has a business platform that can be useful.

    But on the whole, it’s apparently too easy to misuse social media platforms, be sucked in and brainwashed with bizarre misinformation, repeated over and over, and become addicted. What I’m describing is a sad waste of precious time. So perhaps we should carefully choose the ones we use and not be hooked and fooled by the endless hype.

  • Technology. Technology is also on my list of friends of time. So I’m not anti-technology. But as an accountant, I’m not anxious to be on the cutting edge. Artificial intelligence technology sounds like a game-changer, and by all accounts, it will be, but please, let others work out the bugs.

    I recall that MS-DOS performed in a stable and mature environment, but the introduction of Windows was somewhat buggy until it matured. So our firm began using Windows with version 3.1. But even version 3.1 was problematic. Remember the blue screen of death? That meant a total system failure – and lost data. Becoming so enamored with technology before it has matured can be counter-productive, expensive, and a time waster.

Friends of Time. Here is my short list of time savers for accountants.

  • Organization/Planning. In my view, the number one required trait for an accountant is organization. If anything, we should be organized. We should think in an organized fashion. And organization involves the habit of planning. Plan your day, your week, your month, plan the audit, plan whatever. Just plan. It’s a huge time saver and pays dividends.
  • Information Technology. IT has removed much of the drudgery of accounting work and replaced it with speed and accuracy. We’re talking about tax preparation programs, electronic spreadsheets, word processing applications, mobile phones, internet search engines, email, texting, scanners, cloud applications, cloud storage, audit workflow management tools, etc. These tools were developed or introduced to main street accountants since I entered the profession. These mature applications are time savers.
  • Sleep. Sleep is a friend of the time you are awake. It enables you to perform at your best and is essential for good health. Functioning on inadequate sleep is not a badge of honor, as some who wear it must think. On the contrary, a chronic lack of sleep directly steals quality from your waking hours.
  • Be Diligent in Your Work. Diligence makes the task at hand more enjoyable. Strive for excellence, but not perfection. The former produces a suitable and spot-on work product, but the latter is a heavy burden for yourself and those that work with you. So diligence is a friend of time because it results in balance.
  • Listen and Delegate. Listen to your co-workers. Truly listen. When you pick up on their interest and strengths, delegate where you can. They will appreciate having an assignment that plays to their interest and strengths. You will benefit by freeing up your time and perhaps having a better work product than you may have produced. Not a bad thing.

My high school basketball coach would tell us don’t squander time; it’s the stuff that life is made from. I’m sure the words of wisdom were a quote, but he never told us who. Perhaps he thought unnecessary elaboration was a waste of time.

Revenue Recognition For Contractors

Does it Seem Easier Now?

Now that contractors have a few years of practical experience working with the revenue recognition standards under ASC 606, does it seem a bit friendlier than expected? Perhaps so. Or maybe it seems that way because we’ve been working with it for a while now.

We thought this would be an excellent time to review a few significant tenants of the standard. After working with ASC 606 for a time, a refresher of pivotal provisions may help solidify our understanding. So briefly–here we go.

Remember the five steps?

  1. Identify the contract(s) with a customer
  2. Identify the performance obligation(s)
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations
  5. Recognize revenue when (or as) performance obligations are satisfied.
  1. Identify the Contract. For a contractor, identification of a contract is usually the easy part. It’s in the name– right? Unfortunately, a contractor’s contract may be a mountain of documents, including the core contract, specs, drawings, and many change orders. Or depending on the nature of the contractor’s business, it may be very sketchy and driven by purchase orders. Nevertheless, if there’s a meeting of the minds between two or more parties and it creates enforceable rights and obligations – you have a contract. However, to recognize revenue under ASC 606, all of the following must be met:

    • It has the approval and commitment of the parties
    • Rights are identified
    • Payment terms are identified
    • It has commercial substance, and
    • The collectibility of substantially all consideration is probable. Probable means it is likely to be collected.

    What does “likely to be collected” mean? From a practical viewpoint, if the likelihood of collection is 75% or better, many practicing accountants consider the probable threshold met.

    When should the contractor reassess collectability? Question 10 of the FASB’s Revenue Recognition Implementation Q&As (January 2020) (FASB Q&A) addressed this question. There must be a significant change in the customer’s ability to pay before the contractor reassess whether revenue recognition must stop.

  2. Identify the performance obligation(s). Are the costs of pre-production activities included in the percentage of completion (POC) measurement? For example, consider the cost of mobilizing equipment, labor mobilization, and construction of a temporary site office. Do those activities provide goods or services impacting POC revenue recognition? Also, what about pre-construction design services? Do such cost activities transfer a service measured under the POC calculation?

    The FASB Q&A attempts to shed some light on this. Question 16 is as follows: How should an entity assess whether pre-production activities are a promised good or service (or included in the measure of progress toward complete satisfaction of a performance obligation that is satisfied over time)?

    The pre-production activity will enter into the POC measurement if the activity is a promised good or service. However, if the activity does not transfer a good or service to the customer, it is not included in the POC measurement.

    Whether or not to include pre-production activities in the POC measurement is a matter of judgment. Consider whether there has been a transfer of goods or services to the customer. Suppose mobilization is a line item on the schedule of value, whereby the company has the right to payment for its cost plus a reasonable profit. In that case, mobilization represents progress toward completion because it is a contractual promised good or service, as evidenced in the contractual schedule of values.

    On the other hand, if the site office is not included in the schedule of value, its cost probably doesn’t transfer a good or service to the contract owner. Therefore, it would not be a cost included in the POC revenue measurement.

    An acid test that the FASB Q&A offers is whether control of the good or service is ever transferred to the customer. The overriding question is whether the customer simultaneously receives and consumes the benefits provided by the construction company. For example, if pre-construction design drawings are provided to the contract owner, the owner has received and consumed the benefit. This is because he has the drawings in hand and under his control. Therefore, the cost of the design services would impact the POC calculation.

  3. Determine the transaction price. Due to the nature of construction contracts, estimating total revenue at completion is complex. Much of the complexity relates to variable consideration. Variable consideration can take many forms. For example, variability can relate to performance bonuses, incentive payments, liquidated damages, unpriced change orders, and contract claims.

    ASC 606 provides two methods for estimating variable consideration.

    1. Expected value approach
    2. Most likely amount approach

    The choice of approach is not an election. Instead, the company can select whichever method is expected to predict the amount better.

    After estimating variable consideration, the company must consider the revenue recognition restraints. Then, based on an evaluation of those restraints, variable consideration is included in the transaction price when it is probable that a significant reversal of cumulative revenue recognized will not occur or when the uncertainty is resolved. In other words, the contractor includes the amount they expect to be entitled to in the transaction price.

  4. Allocate the transaction price to the performance obligations. This step is required if you identify more than one performance obligation embedded in the construction contract. In that case, the contract price will be allocated between the several performance obligations.

    On the other hand, the contractor may find that many complex tasks in a contract intertwine into a single performance obligation. This happens when the contractor provides a significant service of integrating a complex set of tasks and components into a single project.

  5. Recognize revenue when (or as) performance obligations are satisfied. For a contractor, the question is, at inception, will revenue recognition be over-time or at a point in time? To decide this, the company must first determine if the revenue stream meets the over time recognition criteria. If not, then revenue is recognized at a point in time by default.

    ASC 606 provides three criteria to determine if control of a good or service transfers to the customer over time. If any of the criteria described below are met, revenue recognition is over time. If none of the criteria below are met, revenue is recognized at a point in time.

    1. The customer simultaneously receives and consumes the benefits as the company performs.
    2. The customer controls the asset as it is created or enhanced by the company.
    3. The company creates or enhances an asset that has no alternative use to the company, and the company has a right to be paid for work completed to date.

    An example of the first criterion noted above would be hauling services. If the customer contracted for materials to be hauled from Nashville to Memphis, it’s likely that the customer simultaneously receives and consumes benefits as the trucker performs (over time). Why? If the truck breaks down at Bucksnort 60 miles up Interstate 40, the customer could (theoretically, anyway) hire another nearby trucker to haul the materials for the remainder of the route. The replacement trucker would obviously not be required to repeat the trip from Nashville to Bucksnort. That means the customer both received and consumed the benefit of the materials being hauled from Nashville to Bucksnort.

    An example of the second criterion would be a commercial building constructed on real property owned by the customer (contract owner). As the contract owner is progress billed, he accepts control of the asset as work is completed in stages. That’s the justification for percentage-of-completion revenue recognition and, for that matter, progress billing. It’s revenue recognition over time.

    The third criterion can be illustrated as follows. The contractor has a long-term contract with the U.S. Department of Energy for civil construction on a project unique to the Department’s classified purpose. Therefore, the contractor has no alternative use for the asset under construction. Additionally, if the DOE halted construction after 50% completion, the contractor has a contractual right to payment for the work completed. Accordingly, revenue recognition will be measured over time.

Leases – Part Five

Five Areas Where It’s Easy to Stump Your Toe

ASC 842 is in full swing now. Most private companies and CPA firms have been in the weeds for some time. It would be an understatement to say the standard is massive and not entirely transparent. Because ASC 842 is principle-based and yet very specific in certain areas, it’s far too easy to make implementation errors. In no particular order, here are my top five areas prone to mistakes.

  1. Misunderstanding the Effective Date for Interim Financial Statements. The effective date for private companies and private not-for-profit entities is fiscal years beginning after December 15, 2021. This includes all annual financial statements with dates that begin in 2022. However, it does not include interim periods that begin in 2022. For example, a company that prepares interim financial statements for May 1, 2022, through October 31, 2022, would account for leases under ASC 840 unless the company implements ASC 842 early. This is because the FASB set the effective date for interim financial statements for a year later, i.e., interim periods beginning after December 15, 2022.

  2. Not Giving Sufficient Thought to Elections. The standard is replete with various elections that can significantly affect the complexity and results of lease accounting. These elections include:
    • Short-term lease. This is a very beneficial election made at the class level to not apply the lease standard to leases of twelve months or less.
    • Nonlease components. This is an election, made at the class level, to combine lease and non-lease components as a single lease component. This election can significantly reduce the complexity of accounting but may increase the lease liability.
    • Discount rate. This is an election, made at the class level, to use the risk-free rate to measure the lease liability. This election reduces complexity but will generally increase the lease liability.
    • Classification Criteria. One classification criterion is determining if the lease term is a major part of the underlying asset’s economic life. A policy election may be made to define major part as 75%. Another classification criterion is determining if the lease payments’ present value is substantially all of the fair value of the underlying asset. An election can be made to define substantially all as 90%.

      These elections bring back the bright-line rules under ASC 840. The good thing about these elections is that they provide a bright line. But the bad thing about these elections is that the decision is made using bright lines instead of professional judgment.

    • Transition Package Election. Transition relief must be elected as a package that streamlines and simplifies the transition of leases under the old standard to ASC 842.

  3. Embedded Leases. Are you familiar with the Shakespearian expression “beware the Ides of March”? Well, beware of embedded leases. They can hide in service contracts, subcontracts, and who knows where? Even though not described as such, they are leases in sheep’s clothing that must be carved out and accounted for as leases under ASC 842. Think in terms of significant underlying assets, like cranes and scaffolding.

  4. Reasonably Certain. What is reasonably certain? This one is hard to tie up into a nice pretty bow. Even though the concept of reasonably certain is critical under the standard, it is not defined in ASC 842.

    In which areas does the concept of reasonably certain become important?

    • Options to extend the lease term
    • Options to purchase the underlying asset
    • Options to terminate the lease
    • Lease classification (finance or operating)
    • Short-term lease election
    • Lease liabilities measurement
    • Lease ROU asset measurement

    As can be seen, the concept impacts several essential areas. Even though important, there are no bright lines. Some commentators have suggested that reasonably certain is 75% or better certainty. Others have suggested that it is “almost certain.” One thing is certain, though. The certainty rests in the minds of the company’s decision-makers. It will take sound professional judgment to ascertain the degree of reasonableness.

  5. ROU Asset Life. It’s far too easy to stump your toe in this area and, therefore, really mess up the ROU amortization. The ROU asset life is usually the same as the lease term. “ROU asset life equals the lease term” can become automatic to us. After all, this is lease accounting. However, suppose you have a finance lease that transfers ownership or is almost certain to transfer ownership of the underlying asset to the lessee. In that case, the ROU asset’s life is the useful life of the underlying asset (not the lease term.)

    ASC 842-20-35-8 states the following:

    A lessee shall amortize the right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the right-of-use asset to the end of the useful life of the underlying asset.

Leases – Part Four

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:

  1. Whether a lease exists and, if so,
  2. 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:

  1. 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.

  2. 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.

Leases – Part Three

Lease Accounting is No Cake-Walk

I remember when the Financial Accounting Standards Board issued FAS No. 13, Accounting for Leases, in November 1976. I was tasked with outlining the standard for the firm where I worked. Now, here it is in November, some 46 years later, and I’m looking at the latest rendition of the lease standard—ASC 842. When comparing the two, FAS 13 was much kinder and gentler than ASC 842, even though FAS 13 did not seem that way at the time. Under FAS 13, there were bright lines, and the accounting was more straightforward. For example, operating leases were not capitalized nor depreciated. On the other hand, capital leases, as the name implies, were capitalized and depreciated; thus, you could account for them in much the same way as you did with property, plant, and equipment.

However, ASC 842 requires capitalization of all leases on the balance sheet, both operating and finance leases. That is, unless you choose to make the short-term lease election not to capitalize a lease with a term of twelve months or less. Additionally, after the initial recording of the right-to-use asset and lease liability, ASC 842 requires different accounting for operating and finance leases on the income statement. This is because the FASB conceptually views finance leases more akin to property, plant, and equipment. But it considers operating leases conceptually more like the old FAS 13 operating leases and, therefore, affords them treatment on the income statement similar to that found in FAS 13.

This article will describe a few complex areas of ASC 842 for the lessee as a heads-up to those who have not yet made the deep dive into the (semi) new accounting standard. And by the way, if you are not up to speed on ASC 842 yet, it might be wise to set aside some time over the holidays to become more familiar with its oddities. It isn’t easy to wrap your head around it because leases are structured in countless ways. While the standard is principle-based to accommodate the many variations in lease agreements, it is also very specific in numerous areas to facilitate consistency in practice. And some of it may seem counter-intuitive.

The Components of a Lease Contract. A lease contract may specify payments for more types of components than just a lease component. Identifying each component of a lease contract is essential because each component type is to receive an allocation of the contract consideration, which is accounted for under different sections of the ASC.

A lease contract can have three broad components:

  1. Lease component
  2. Non-lease component
  3. Non-components

A good or service must be transferred to the lessee or customer to be considered a contract component. This is important because consideration in the contract is only allocated to components that transfer a good or service. Contract components are the first two identified above (i.e., lease component and non-lease component).

If the transfer of goods or services relates to an asset used in a leasing arrangement, it is considered a lease component subject to the rules of ASC 842. This includes leases for:

  • Real property (building and land)
  • Vehicles
  • Construction equipment
  • Copiers, etc.

All other payments for goods and services transferred in the contract are non-lease components accounted for under other GAAP (e.g., ASC 606 Revenue Recognition). This would include payments for:

  • Common area maintenance services
  • Management fees
  • Security services
  • Repairs and maintenance of the leased asset

Payments in the contract that are not for the transfer of goods and services are considered non-components. This would include the following:

  • Reimbursements of insurance and property taxes to the lessor or third party for the benefit of the lessor.
  • Administrative tasks to initiate the lease.

As stated above, contract consideration (see ASC 842-10-30-5 and ASC 842-10-15-35) is only allocated to lease and non-lease components. Notice that contract consideration is not assigned to non-components of the contract. This allocation can be a difficult and time-consuming process. However, the standard provides a way to simplify the accounting via an election to combine lease and non-lease components and treat all payments as lease payments.

The Consideration in a Contract. So what is consideration in a lease contract? Under ASC 842-10-30-5 – Consideration in the contract at the commencement date includes:

  • Fixed payments, including in substance fixed payments, less any lease incentives paid or payable
  • Variable lease payments that depend on an index or rate, initially measured using the index or rate at the commencement date
  • The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise the option
  • Payments for penalties for terminating the lease
  • Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction
  • Amounts probable of being owed by the lessee under residual value guarantees

Additionally, ASC 842-10-15-35 specifies that consideration in a contract includes all payments described above in paragraph 842-10-30-5 as well as the following payments made during the lease term:

  • Any fixed payments or in substance fixed payments, less any incentives paid or payable
  • Any other variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date.

Notice that consideration in a contract can include payments for lease components, non-lease components, and non-components if it meets the criteria stated above. For example, fixed payments for lease components, non-lease components, and non-components would all be included as consideration in a contract. However, the contract consideration would only be allocated to the lease and non-lease components unless the election not to allocate is made. In such a case, all the fixed payments mentioned would be considered lease component payments.

The Underlying Land in a Building Lease. Building leases are somewhat problematic. Should the underlying land be considered a separate lease? The answer is “maybe yes and maybe no—it ain’t necessarily so.”

The initial question is whether the underlying land can even be considered a lease. ASC 842-10-15-3 defines a lease as follows:

A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.

So the overriding question is whether the lessee has the right to control the use of the underlying land. A follow-up question is, does the lessee have the right to control all or a substantial portion of the use of the building? If so, it would seem that the lessee also has the right to control the use of the underlying land. This right to control the use of identified property (land) determines that the contract contains a land lease. So how much control is “substantial”? It’s a matter of judgment, but many commentators think the ability to control 90% or more of the economic benefits of the building is substantial control that enables the lessee to control 100% of the underlying land.

Once control of the underlying land is established and considered a separate lease component, should part of the consideration in the contract be allocated to the land lease? ASC 842-10-15-29 states that:

…an entity shall account for the right to use land as a separate lease component unless the accounting effect of doing so would be insignificant (for example, separating the land element would have no effect on lease classification of any lease component or the amount recognized for the land component would be insignificant.)

Therefore, land should be considered a separate component and be allocated a portion of the consideration in the contract unless doing so would be insignificant.

A Viable GAAP Alternative?

And in This Corner – FRF for SMEs

FRF for SMEs stands for Financial Reporting Framework for Small and Medium-Sized Entities. It’s a non-authoritative, non-GAAP, special-purpose accounting framework developed by the AICPA almost a decade ago. It stands in contrast to U.S. GAAP (“GAAP”) and other special-purpose frameworks, such as the income tax and cash basis of accounting, which have been used for many decades.

The most appealing feature of FRF for SMEs is that it has much of the traditional look and feel of GAAP but without some more complex areas.

As promoted by the AICPA, FRF for SMEs was developed for small to medium-sized entities that require reliable non-GAAP financial statements for both internal and external purposes. A good fit, according to the AICPA, would include for-profit entities that:

  • Are closely held;
  • Don’t have regulatory reporting requirements that would require the use of GAAP;
  • Have no intention of going public;
  • Have management and owners that rely on financial statements to manage their business;
  • Don’t operate in an industry requiring highly specialized accounting guidance, like banking;
  • Don’t engage in complicated transactions;
  • And do not have significant foreign operations.

As stated above, FRF for SMEs’ calling card is that it has much of GAAP that is familiar while excluding more complicated areas that may not significantly enhance the usefulness of the financial statements. For example, as explained by the AICPA, under the FRF for SMEs framework, there are:

  • No other comprehensive income
  • No VIEs
  • No complicated accounting for stock compensation and derivatives
  • No hedge accounting

Additionally:

  • Disclosures are targeted and not excessive.
  • Goodwill amortization is consistent with federal tax, with no impairment testing.
  • All intangible assets are considered to have a finite life and amortized.
  • It leans toward historical cost and away from the complications of fair value accounting. There are only limited market value measurements.
  • There’s no impairment of long-lived assets.
  • It’s a policy decision to either consolidate subsidiaries (with subsidiaries defined as greater than 50% ownership) or use the equity method for such subsidiaries.
  • ASC 606 principles are not recognized for revenue recognition.
  • ASC 842 principles are not recognized for lease accounting.
  • In short, the AICPA intends that the framework have a look and feel of GAAP but, for clarity, be simplified and void of many complex and less informative areas found in GAAP.

Another benefit of FRF for SMEs is that even though it is not GAAP, it looks and feels more like GAAP than other special-purpose frameworks. And in many areas of the financial statements, the results are the same.

But there is a big caveat. Decision makers interested in switching from GAAP to FRF for SMEs should consider whether it will be acceptable to their end users of the financial statements. Many bankers, for example, may not be familiar with or even heard of FRF for SMEs. This, of course, would be a significant impediment to making such a change. Also, the impact on loan covenants must be considered. Many loan agreements require financial statements prepared under GAAP.

For those interested in exploring this more, the AICPA has placed extensive tools on its website.

Leases – Part Two

Other Things That Make You Go Hmmm

Well, it’s here for private companies. Welcome to the universe of ASC 842. The lease standard is massive and, being a principle-based standard, leaves a lot of GAAP in gray areas. Yet, the standard is also specific, especially regarding disclosure. This blog, directed at the lessee’s accounting, is a follow-up to our May 2021 blog on leases and will focus on a few of the areas of ASC 842 that have given us some — shall we say, pause.

First Things First. Before we dive into the deep gray, let’s briefly review some of the core tenants of ASC 842 as it applies to the lessee.

  • To be a lease contract, it must have two elements:
    1. There must be an identified asset, and
    2. The lessee must have a right to control the use of the asset for a period of time.
  • All leases should be accounted for under the right-of-use (“ROU”) model. This model requires the recognition of lease right-of-use assets and lease liabilities.
  • Leases with a maximum possible lease term of twelve months or less may be exempted from the right-of-use model. This exemption is a policy election.
  • There are two types of leases:
    1. Finance lease and
    2. Operating lease.
  • Both types of leases are capitalized on the balance sheet. If a lease doesn’t meet the finance lease criteria, it is accounted for as an operating lease.
  • At the implementation date, there is no grandfathering of pre-existing active leases. Accordingly, the old capital or operating leases must be capitalized on the implementation date, under ASC 842, as finance or operating leases.

Materiality. Of course, the professional decision of what is not material to financial statement presentation is not a new concept under ASC 842. However, materiality is of utmost importance under the lease standard because the standard places a heavy burden on companies performing calculations to capitalize the leases, in addition to the future effort required to account for leases to completion. Because of this burden, care must be taken not to spend precious time capitalizing immaterial leases.

So what is immaterial? Initially, the company should have a reasonable lease capitalization policy stating a threshold under which all leases will automatically be considered immaterial and, therefore, not capitalize.

Beyond the company’s capitalization policy, the overall materiality of the potential ROU assets and lease liabilities to the financial statements should be considered. While materiality is both a quantitative and qualitative assessment, in the end, the qualitative evaluation carries the most weight. For example, if capitalizing a lease liability causes the company to violate a financial loan covenant, then that lease is material to the financial statements, notwithstanding the quantitative analysis.

Reasonably Certain. The term “reasonably certain” is not defined in ASC 842. However, even though not defined, it is a critical term. The reasonably certain threshold plays a sizable part in determining the:

  • Lease term;.
  • Lease classification (finance or operating lease);
  • Amount of lease payments;
  • Amount of ROU assets; and
  • Amount of lease liabilities.

Even though the concept of reasonably certain is important, there are no bright lines. Some commentators have suggested that reasonably certain is 75% or better certainty. Others have suggested that it is “almost certain.” One thing is certain, though. The certainty rests in the minds of the company’s decision-makers. It will take sound professional judgment to ascertain the degree of reasonableness.

Related Party Transactions. Under prior GAAP (ASC 840), the economic substance of the lease agreement determined how related party leases were classified. This, in turn, determined lease accounting. New GAAP changed things. Under ASC 842, leases between related parties are classified and accounted for based on legally enforceable terms. In short, lease accounting for leases between related parties is the same as accounting for leases between unrelated parties.

It sounds straightforward. But it’s not. Consider the following example:

The company(lessee) has three unrelated stockholders. One stockholder holds 60% of the stock. The minority stockholders each hold 20%. The company leases its operating facilities from an LLC lessor that is owned 100% by the majority stockholder of the lessee company. The company made substantial leasehold improvements with a fifteen-year useful life. The lease is month-to-month (unwritten). Questions: What is the lease term? What would be legally enforceable?

This type of lease arrangement, or similar, may put accountants in a dilemma. The majority owner of the lessee company, because he understandably wants to keep the lease obligation off the company’s separate(unconsolidated) financial statements, tells you that it’s a month-to-month lease. No doubt about it. It is not a long-term lease. The unwritten monthly options to renew will not extend longer than one year. After all, “reasonably certain” is in the mind of management — right?. However, the short-term lease status doesn’t make sense for several reasons. But primarily, it does not make sense because the substantial leasehold improvements, with a fifteen-year life, reflect an obvious intent to lease the operating facilities long-term.

It may be necessary to remind the majority owner, in very carefully chosen non-technical words, of course, that GAAP generally requires the leasehold improvements to be amortized over the lease term. So in this example, the improvements would be written off over twelve months. Ouch!

ASC 842-20-35-12 states the following:

Leasehold improvements shall be amortized over the shorter of the useful life of those leasehold improvements and the remaining lease term, unless the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, in which case the lessee shall amortize the leasehold improvements to the end of their useful life.

In the above example, the underlying asset (building) will not be transferred to or purchased by the company. This would not be to the advantage of the majority stockholder. Accordingly, the leasehold improvements must be amortized over the shorter of the lease term (twelve months or less) or the useful life of the building. The lease term is obviously shorter. This may cause the majority owner of the company to reconsider the lease term.

Communication With The Predecessor Auditor

We Are Required To Talk With Each Other

It happens. From time to time, company management will decide to replace their current auditor. It can be for good reasons, wrong reasons, or no real reason at all. The predecessor auditor may be a repository of information that may be important to a potential successor auditor. Therefore, auditing standards require that before a new auditor can accept the engagement, they must inquire about certain matters of the predecessor auditor.

In June 2022, the Auditing Standards Board of the AICPA issued Statement on Auditing Standards 147, Inquiries of the Predecessor Auditor Regarding Fraud and Noncompliance With Laws and Regulations. SAS 147 amends AICPA, Professional Standards, AU-C Sec. 210 – Terms of Engagement. The amendments to AU-C Sec. 210 are effective for audits of financial statements for periods beginning on or after June 30, 2023.

SAS 147 provides guidance regarding auditor inquiries made of a predecessor auditor about matters that will help the auditor decide whether or not to accept the engagement. These inquiries may be either written or oral. SAS 147 adds more teeth to the inquiry and requires the predecessor auditor to respond. These auditor inquiries must be made after management authorizes the predecessor auditor to respond to such inquiries. Below is a snapshot of what the auditor must do before accepting an engagement for an initial audit when a predecessor auditor exists. And what the predecessor auditor must do.

  • The auditor should request management to authorize the predecessor auditor to respond fully to the inquiries.
  • The auditor should inquire about the following of the predecessor auditor:
    1. Fraud or suspected fraud involving management, employees with significant internal control roles, or others when fraud resulted in a material misstatement of the financial statements.
    2. Matters involving noncompliance or suspected noncompliance with laws and regulations.
  • The predecessor auditor must timely respond to the auditor (absent unusual circumstances and unless prohibited by law.) If the predecessor auditor decides not to respond fully, they must clearly state that the response is limited. The important thing here is that they must respond under the revised standard. The standard states that limited responses are expected to be rare.
  • The auditor should evaluate the response (or limited or no response) to determine if they will accept the new engagement.
  • If the engagement is accepted, the auditor should document:
    1. The inquiries of the predecessor auditor, and
    2. Results of those inquiries.

Additionally, the auditor may choose to inquire about the following:

  • Integrity of management
  • Disagreement with management about accounting policies, auditing procedures, or similar significant matters
  • Significant deficiencies and material weaknesses in internal control communicated to management and those charged with governance
  • The predecessor auditor’s understanding of the reason for the change in auditors
  • The predecessor auditor’s understanding of the company’s relationships and transactions with related parties and significant unusual transactions.
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