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.
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