The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2023-01, Leases (Topic 842): Common Control Arrangements.
The ASU is intended to improve the accounting guidance under Topic 842, Leases, for arrangements between entities under common control.
The amendments address areas identified by the FASB as part of its post-implementation review of ASU 2016-02, Leases (Topic 842), regarding concerns with applying Topic 842 to related party arrangements, specifically those between entities under common control. Those areas identified are:
- Which terms and conditions should be considered when determining whether a lease exists among entities under common control and, if so, the classification and accounting for the lease
- The accounting for leasehold improvements associated with leases between entities under common control
Terms and Conditions
As a change from the economic substance requirements in Topic 840, Leases, Topic 842 requires entities to evaluate an arrangement among entities under common control on the same basis as an arrangement between unrelated parties. This means the determination of whether a common control arrangement is a lease and, if so, the classification and accounting for such lease is based on legally enforceable terms and conditions.
The FASB received feedback stating the requirements under Topic 842 can be difficult to apply to common control arrangements. In particular, determining the legally enforceable terms and conditions of common control arrangements could require obtaining a formal legal opinion, which can be challenging given the nature of common control arrangements.
ASU 2023-01 provides a practical expedient for certain entities to consider only the written terms and conditions of a common control arrangement to determine whether such an arrangement is, or contains, a lease and, if so, the classification of and accounting for such lease.
An entity isn’t required to determine whether the written terms and conditions are legally enforceable when applying the practical expedient.
Any existing unwritten terms and conditions of an arrangement between entities under common control may be documented, so long as documentation is completed before the date on which the entity’s first interim—if applicable—or annual financial statements are available to be issued.
If no written terms and conditions exist, an entity cannot apply the practical expedient and is required to use the legally enforceable terms and conditions to apply Topic 842.
The practical expedient may be applied on an arrangement-by-arrangement basis.
The practical expedient is available to private companies and certain not-for-profit entities and employee benefit plans. It doesn’t apply to the following:
- Public business entities
- Not-for-profits that have issued or are a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market
- Employee benefit plans that file or furnish financial statements with or to the SEC
Accounting for Leasehold Improvements
Under Topic 842, lessees recognize leasehold improvements when they’re the owner of the improvements. Leasehold improvements must be amortized over the shorter of the remaining lease term and the useful life of the improvements.
For short-term leases, this can result in the amortization of leasehold improvements over a short period. However, if the lessee is reasonably certain to exercise an option to purchase the underlying leased asset or ownership of the underlying leased asset is otherwise transferred to the lessee through the terms of the lease, then the lessee-owned improvements should be amortized over their remaining useful life.
The FASB received feedback noting the requirement to amortize leasehold improvements associated with common control leases over the shorter of the remaining lease term and the useful life of the improvements could result in financial reporting that doesn’t faithfully represent the economics of those arrangements, particularly for leases with short lease terms.
This accounting also doesn’t recognize the transfer of value between the entities under common control when the lessee no longer controls the use of the underlying asset.
The amendments require lessee-owned leasehold improvements associated with leases among entities under common control to be 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.
Under the amended guidance, the lessee’s amortization period can’t exceed the common control group lessor’s amortization period if the lessor obtained the right to control the underlying leased asset through a lease with another entity not within the same common control group.
The value of the lessee-owned leasehold improvements transfers to the lessor when the lessee no longer controls the use of the underlying asset. The lessee recognizes the transfer through an adjustment to equity—or net asset for not-for-profit entities.
The leasehold improvements are also subject to the impairment guidance in Topic 360, Property, Plant, and Equipment.
When the useful life of leasehold improvements to the common control group exceeds the related lease term, a lessee must disclose the following information:
- The amount of unamortized leasehold improvements at the reporting period end date
- The remaining useful life of the leasehold improvements to the common control group
- The remaining lease term
The amendments relating to the accounting for leasehold improvements affect all lessees who are a party to a lease between entities under common control in which the lessee is the owner of leasehold improvements. The amendments apply to all entities, including:
- Public business entities
- Private companies
- All not-for-profit entities
The amendments are effective for 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 haven’t 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.
We’re Here to Help
For more information on how the amendments could affect your business, contact your Moss Adams professional.