UPDATE as of February 16, 2023: The FASB met February 15, 2023 and approved the amendments for common control leasing arrangements described below. However, a final ASU may not be issued until the end of March 2023. Entities desiring to implement these amendments will need to delay issuing financial statements until the final ASU is released.
Based on stakeholder feedback on the implementation of ASC 842, Leases, the Financial Accounting Standards Board (FASB) has proposed amendments that would provide relief for common control lease arrangements. While the amendments would not become effective until early 2023, it’s helpful to know how they would affect your organization if approved as proposed.
What are common control arrangements?
The proposed amendments apply only to arrangements between entities under common control, which may make you wonder whether they would apply to your related party leases. That answer depends on the nature of the related party relationship. The FASB has not defined “common control” but has pointed to SEC staff observations in EITF Issue No. 02-5, Definition of ‘Common Control’ in Relation to FASB Statement No. 141, in determining whether there is common control. In those observations, SEC staff indicated that common control exists when:
- An individual or organization holds greater than 50% of the voting ownership interest in each entity,
- Immediate family members (i.e., married couples and their children) hold greater than 50% of the voting ownership interest in each entity, and there is no evidence that those family members would not vote in concert, or
- A group of shareholders holds greater than 50% of the voting ownership interest of each entity, and there is written evidence of an agreement to vote a majority of the entities’ shares in concert.
However, the FASB also indicated the concept of common control should be broader for private companies and not-for-profit entities than the SEC outlined for public entities. As such, family relationships may extend beyond just immediate family members (e.g., a grandparent and a grandchild), but the facts and circumstances should be considered in determining that voting and ownership interests are aligned.
Issue 1: Terms and Conditions to Be Considered
ASC 842 requires related party leases be accounted for on the basis of legally enforceable terms and conditions, which is the same for leases between unrelated parties. However, it may be unduly difficult to determine legally enforceable terms and conditions in common control arrangements without obtaining a legal opinion, even when agreements are written. In these arrangements, the terms and conditions can be very fluid. A single owner or group of owners can change the terms and conditions at any time or choose not to enforce the agreement of behalf of either party. The FASB has proposed the following accounting relief:
Practical expedient: In common control arrangements, entities may use the terms as written to determine whether a lease exists and, if so, the classification and accounting for that lease. If no written terms exist, entities must determine and use the legally enforceable terms and conditions.
Applicability: Available on an arrangement-by-arrangement basis for common control leasing arrangements between entities that are not (a) public business entities, (b) not-for-profit conduit debt obligors, or (c) employee benefit plans that file or furnish financial statements with or to the U.S. Securities and Exchange Commission (SEC).
KEY TAKEAWAY: Entities that wish to use this practical expedient for common control leases MUST document terms and conditions in writing. The proposed amendments allow any unwritten terms and conditions to be documented at any time prior to the date on which the entity’s first financial statements are issued in accordance with a final ASU.
Issue 2: Accounting for Leasehold Improvements
ASC 842 requires that lessees amortize leasehold improvements over the shorter of the remaining lease term or the remaining economic life of the leasehold improvements. However, in common control leases, lessees often construct or install leasehold improvements which have economic lives in excess of written lease terms. In those situations, amortization of leasehold improvements over the shorter lease term does not accurately reflect the economics of the arrangement. It also does not allow for the transfer of any remaining value of the leasehold improvements between the entities at the end of the lease term. The FASB has proposed the following accounting treatment:
Accounting treatment: For leasehold improvements associated with leases between entities under common control, a lessee shall amortize leasehold improvements over their economic lives as long as the lessee controls the use of the underlying asset. However, if the lessee is subleasing an asset also leased by the lessor, the amortization period should not exceed the term associated with the lessor’s lease. When the lessee no longer controls the use of the underlying asset, the remaining unamortized balance should be accounted for as a transfer between the entities under common control through an adjustment to equity (or net assets).
Disclosure requirements: When economic lives of leasehold improvements exceed their related lease terms, a lessee will need to disclose the unamortized balance of the leasehold improvements, the remaining economic lives and the remaining lease terms.
Applicability: Applies to all leasehold improvements associated with common control leases arrangements for all entities.
Due to a 45-day comment period, these proposed amendments will be approved no earlier than January 2023.
Entities that have not yet adopted ASC 842 on or before the effective date of a final Accounting Standards Update (ASU) for these amendments would follow the same transition requirements and method elected for ASC 842. Entities that have adopted ASC 842 before a final ASU becomes effective would have the following transition options.
For issue 1, the practical expedient to use written terms in common control leases: entities may apply the amendments (a) prospectively or (b) retrospectively to the beginning of the period in which the entity first applied Topic 842 for arrangements that exist at the date of adoption of a final ASU.
For issue 2, accounting for leasehold improvements: entities may apply the amendments (a) prospectively for all new leasehold improvements, (b) prospectively for all new and existing leasehold improvements, or (c) retrospectively to the beginning of the period in which the entity applied ASC 842 for leasehold improvements that exist at the date of adoption of a final ASU, with any leasehold improvements that otherwise would not have been amortized recognized through a cumulative-effect adjustment to retained earnings (or net position) at the beginning of the fiscal year of adoption.
Using the retrospective transition methods, it is anticipated that eligible entities that have not yet issued financial statements in accordance with ASC 842 will be able to apply these amendments for the first annual reporting period under ASC 842.
We will keep you posted on the outcome of this proposal, and in the meantime, please contact our team if you have any questions.