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Breaking it down
Background
Topic 842, “Leases,” requires entities to account for related-party leases based on the leases’ legally enforceable terms and conditions, which is a change in practice from legacy GAAP under Topic 840. While public companies that have already adopted Topic 842 have not voiced significant concerns with this concept, some private companies face different challenges. For example, a private company might lease real estate or equipment from an entity under common control, and the party responsible for approving and executing the terms and conditions of the lease for the lessee and the lessor might be, in some cases, the same person. Consequently, related-party leases, particularly those between entities under common control, might not be at arms-length terms and often have less or no formal documentation of the relevant terms and conditions of the lease.
As private companies began implementing Topic 842, stakeholders raised questions regarding how oral and implicit terms should be considered when determining an arrangement’s legally enforceable terms. Similarly, some entities have voiced concerns regarding whether written lease terms between entities under common control suffice as legally enforceable under Topic 842.
In a related issue, because the legally enforceable terms and conditions of a lease are used to determine the lease term and account for the lease, stakeholders have questioned how to account for leasehold improvements associated with related-party leases – specifically those between entities under common control – when the term of the lease differs significantly from the estimated period of benefit of the leasehold improvements. Topic 842 currently requires entities to amortize leasehold improvements over the shorter of the asset’s useful life or the lease term.
To illustrate the issue, some private companies have determined that their common control leasing arrangements have a very short lease term (for example, one month). This presents challenges when determining the amortization period for significant leasehold improvements associated with the lease – for example, private companies might ask whether the asset should be expensed over a one-month period, accounted for as an asset transfer to the related-party lessor at the end of the one-month period, or some combination of the two.
Summary of changes
Issue 1: Practical expedient to use written terms and conditions
The amendments give private companies an optional practical expedient allowing them to account for common control lease arrangements based on the written terms, without considering whether such terms are legally enforceable or not. If the arrangement is not documented in writing, the entity would apply existing guidance – that is, determining the legally enforceable rights and obligations of the arrangement. If the entity determines a lease does not exist, the entity would apply other GAAP to account for the arrangement. The practical expedient may be elected on an arrangement-by-arrangement basis.
Crowe observation: The practical expedient is expected to reduce costs of applying the standard. For example, private company stakeholders voiced concerns to the FASB that they might need to seek legal counsel or extensively analyze their lease contracts, whether written or not, to determine the legally enforceable terms and conditions of the arrangement. Entities that apply the practical expedient to an arrangement with written terms can avoid a costly analysis of determining whether those terms are legally enforceable.
An entity that anticipates becoming a public business entity (PBE) should be aware that if it elects the practical expedient, it later might need to reassess whether the accounting for lease contracts to which the practical expedient was elected would have been different had the practical expedient not been elected. For example, if an entity that applies the practical expedient to a common control leasing arrangement later becomes a PBE, the entity would need to evaluate the legally enforceable terms and conditions of its lease contracts subject to this guidance, even if documented in writing, and determine if a difference in accounting arises.
Issue 2: Changes to subsequent accounting for leasehold improvements
The amendments require that leasehold improvements associated with leases between entities under common control be amortized over the useful life of the improvements as long as the lessee controls the use of the underlying asset through a lease. If the lessee ceases to control the use of the underlying asset, the remaining value of the leasehold improvements is accounted for as a transfer between related-party entities – that is, the lessee derecognizes the leasehold improvement asset with the corresponding offset recorded as an equity contribution to the lessor.
Crowe observation: Issue 2 was significantly debated by respondents to the exposure draft and by the board alike. Ultimately, the amendment was affirmed and reflects a practical outcome aimed at reducing diversity in practice in accounting for leasehold improvements and the underlying lease. The board acknowledged that after applying the ASU, some entities might intentionally structure common control leasing arrangements to be accounted for off balance sheet (that is, as a short-term lease) while reporting related leasehold improvements as long-term assets to be amortized over a period of several years. Entities in this position are reminded of the new disclosure requirements in the following paragraph.
New disclosures
The amendments require reporting entities to disclose the following information when leasehold improvements have an amortization period longer than the underlying lease term:
- The unamortized balance of the leasehold improvements at the balance sheet date
- The remaining useful life of the leasehold improvements
- The remaining lease term
Transition and effective date
An entity that adopts this ASU concurrently with Topic 842 is required to apply the amendments using the transition requirements and same transition method elected to apply Topic 842.
The ASU allows reporting entities that already have adopted Topic 842 to adopt the provisions of both issues on either:
- A prospective basis for all leases commencing on or after the date of adoption of the final update
- A retrospective basis to the beginning of the earliest period presented in accordance with Topic 842 for all arrangements that exist at the date of adoption of the update
Issue 2 (accounting for leasehold improvements) also may be adopted on a prospective basis for all new and/or existing leasehold improvements recognized on or after the date of adoption of the ASU, with the unamortized balance of existing leasehold improvements being amortized over their remaining useful life.
The amendments allow private companies to document previously existing unwritten terms and conditions of an arrangement between entities under common control before adopting the amendments. This means entities may act now to document the terms of existing arrangements so that they can reduce time and costs of determining whether the arrangements’ terms and conditions are legally enforceable.
The ASU is effective for all entities to which Issue 1 and Issue 2 apply for fiscal years beginning after Dec. 15, 2023, including interim periods within those fiscal years. Early adoption is permitted.
Crowe observation: We believe the spirit of the FASB’s accommodation to allow reporting entities to document previously unwritten terms and conditions is not intended to result in new or significantly different terms of otherwise previously enforceable terms. Furthermore, the FASB decided not to prescribe the form or content of a written arrangement because entities can apply reasonable judgment when deciding how the terms and conditions are conveyed in writing.
