Defining Issues | December 2022
Insight
The proposed amendments would change ASC 842 for common control lease arrangements and related leasehold improvements.
If finalized, private entities would be permitted to use any written terms and conditions between the parties, without regard to their legal enforceability, to identify, classify and account for common control leases. In addition, all lessees (public or private) would, in general, amortize leasehold improvements related to a common control lease over their ‘economic life’, regardless of the ASC 842 ‘lease term’, as long as they continue to control the use of the underlying leased asset.
Applicability
- All private entities (i.e. private companies and private not-for-profit entities) with common control arrangements that may contain or be leases
- All lessees (public or private) with recognized leasehold improvements related to common control leases
Relevant dates
- September 21, 2022, the FASB:
- added a project to its technical agenda on (1) applying ASC 842 to arrangements between entities under common control, and (2) accounting for leasehold improvements that relate to common control leases; and
- reached tentative decisions reflected in the proposed ASU.
- November 30, 2022 – FASB issued proposed ASU
- January 16, 2023 – Comments due
Project overview
Background
Under ASC 842, related-party leases (including those between parties under common control) are classified, recognized and measured based on the legally enforceable terms and conditions of the arrangement, as opposed to the economic substance of the arrangement. However, identifying the enforceable rights and obligations in an arrangement between parties under common control may be difficult because of its related-party nature.
There are presently diverse views about the extent to which entities must look for legally enforceable rights and obligations outside of any written terms and conditions, or consider the legal enforceability of any written terms (e.g. whether legal counsel must be involved or a legal opinion obtained).
Objective
To clarify (1) when private entities can look solely to written terms and conditions – i.e. without considering legal enforceability – in applying ASC 842 to arrangements between entities under common control; and (2) how lessees (public or private entities) should account for leasehold improvements related to common control leases.
Proposed amendments
Identifying terms and conditions (applicable to private entities only)
- A private entity would be able to elect, as a practical expedient, to use the written terms and conditions of a common control arrangement to determine whether a lease exists and, if so, the classification of and accounting for that lease.
- If there are no written terms and conditions, those entities would not be permitted to use the practical expedient; they would instead evaluate whether legally enforceable terms and conditions otherwise exist and, if so, use those terms and conditions in applying ASC 842.
- The practical expedient would be electable arrangement-by-arrangement.
Leasehold improvements (applicable to all entities)
- A lessee in a common control lease would amortize related leasehold improvements that it owns for accounting purposes over their estimated economic life, regardless of the ASC 842 lease term, as long as the lessee controls the use of the underlying (leased) asset.
- However, if the lessor is leasing the underlying asset through a lease with another entity that is not part of the same common control group, the leasehold improvements’ amortization period would be limited to the lease term associated with the underlying asset lease.
- If, before the end of the improvements’ economic life, the lessee relinquishes control over the use of the underlying asset (e.g. vacates the building and returns control over its use to the lessor), it would account for the improvements as being transferred to the lessor, derecognizing the remaining carrying amount of the improvements with a corresponding adjustment to equity (or net assets for not-for-profit entities).
- The amendments would clarify that these common control leasehold improvements are subject to the long-lived asset impairment guidance in ASC 360, with specific reference to ASC 360-10-40-4.
- A lessee would be required to disclose information about leasehold improvements associated with common control leases being amortized over an economic life that exceeds the ASC 842 lease term of the related leases.
Transition and effective date
- Under both proposals (terms and conditions; leasehold improvements), entities would, in general, have the option to adopt the amendments (1) prospectively to new common control arrangements that commence and new leasehold improvements recognized after the entity’s adoption date of any final amendments; (2) prospectively to both new (see #1) and existing common control arrangements and leasehold improvements at the entity’s adoption date of any final amendments; or (3) retrospectively to the entity’s ASC 842 adoption date.
- For the terms and conditions proposal, entities would be permitted to document any previously unwritten terms and conditions of an existing arrangement between entities under common control, and therefore use the ‘terms and conditions’ practical expedient, any time before the entity’s first interim or annual financial statements applying the proposed amendments are available to be issued.
- The effective date of any final amendments will be decided later. However, the proposed amendments would be effective for all entities during interim periods within the fiscal year of adoption of a final ASU unless those entities have not yet applied ASC 842. In that case, the amendments would not be applicable during those interim periods.
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