Plenty of ink has been spilled over the FASB’s Accounting Standards Codification (ASC) 842 on leases, but accounting departments have adapted since the new standard took effect. The latest wrinkle came in November 2022 when the FASB proposed an Accounting Standards Update (ASU) regarding common control arrangements. Those proposed changes are intended to help clarify and simplify accounting guidance for arrangements between entities under common control, so it should not slow down current adoption efforts, but complexities related to the updates could pose challenges for some organizations.
The FASB board met on Feb. 15 to discuss the 29 comment letters received during the comment period, which closed on January 16, and it tentatively approved the proposed updates on both issues. As stated during the meeting, the board expects to issue the final ASU before the end of March. The FASB describes the two distinct issues as follows:
- Issue 1: What terms and conditions an entity should consider for determining whether a lease exists and, if so, the classification and accounting for that lease.
- Issue 2: Accounting for leasehold improvements associated with leases between entities under common control.
Below, we examine key details of the two issues, with particular focus on complexities under Issue 2, and related considerations for accounting professionals.
Issue 1: Practical Expedient for Written Terms and Conditions
The proposed update for Issue 1 applies only to private entities but not public companies and certain non-profits. Under Issue 1, in situations in which a lessor and lessee are under common control, both entities can rely on the written terms and conditions in the contract to determine if a lease exists and the appropriate accounting for it. Critically, the entities would not need to determine whether those written terms and conditions are legally enforceable.
Generally, the feedback received by the FASB was positive, and the proposed update seems consistent with the original intent of the requirements for leases between related parties. A private entity would be able to apply the proposed practical expedient on an arrangement-by-arrangement basis in cases where written terms and conditions exist. However, the contract must have written terms and conditions to apply the practical expedient. If no written terms and conditions exist, then the entity is required to apply the general guidance, which requires assessing the legally enforceable terms and conditions. The proposal does provide a transition provision that allows entities a one-time option to document any existing but unwritten terms and conditions, which may be a good option for entities in this situation.
Issue 2: Accounting for Leasehold Improvements
Issue 2 applies to all entities, including public companies. ASC 842 generally holds that entities cannot depreciate leasehold improvements over a longer period than the lease term, since the leasehold improvements do not provide benefit to the lessee without the ability to use the underlying asset. However, the proposed ASU would require lessees that are parties to a common control lease to depreciate any leasehold improvements over the useful life of those improvements, regardless of the lease term.
Because Issue 2 would mark a change in standard practice, it’s not surprising that more significant concerns were raised about it during the comment period. The proposed update creates unique guidance that only applies to common control arrangements. As one example, an entity in a common control lease with a five-year term could still depreciate leasehold improvements over 10 years if that is the full economic life of the improvements.
Potential Concerns Regarding Issue 2
BDO noted several concerns about Issue 2 in our comment letter to the FASB, including:
- It creates an exception to the guidance on property, plant and equipment and right-of-use assets in Topic 360.
- A reporting entity considering economic benefits related to entities outside the reporting group’s financial statements may be inconsistent with the concept of a reporting entity.
- The proposed amendments could incentivize entities to structure lease arrangements with shorter terms in order to keep such arrangements off the balance sheet.
While some of these concerns were addressed during the meeting, it’s still worth examining these issues in more detail to understand how accounting professionals may need to navigate the updates.
On the first item, guidance in Topic 360 on property, plant and equipment directs reporting entities to depreciate long lived assets over their useful life, which is defined in reference to the reporting entity’s use of the asset. The proposed update would instead require amortizing leasehold improvements over their useful life to the common control group, which leads us to the second concern.
U.S. GAAP typically focuses on the reporting entity, but depreciating an asset over a longer period requires assessing the use of the asset to the collective group under common control. Considering how another party might use an asset deviates from current accounting practices. It’s also not clear how the update would potentially impact existing guidance about testing leasehold improvements for impairment, which requires determining the undiscounted cash flows to be realized by the reporting entity from the use of the asset being tested. That guidance generally would not allow consideration of any use by a related party.
Additionally, there’s a provision in the standard that allows a lessee to avoid recognizing leases with a term of 12 months or less on the balance sheet. Instead, those leases can continue to be accounted for on a straight-line expense basis consistent with prior guidance. An unintended consequence of the proposed update could be that more parties entering into leases with entities that are part of the same common control group will seek to execute one-year leases so they don’t have to recognize them on the balance sheet — despite any potential long-lived leasehold improvements. It could be inconsistent to have short lease arrangements not recorded on the balance sheet while corresponding leasehold improvements still appear on the balance sheet as assets. It is important to note that the proposed update includes various disclosure requirements that will provide information about lease terms and useful lives of leasehold improvements, thus potentially alleviating some of this concern.
Looking Ahead
With the final ASU expected by the end of March, accounting professionals should take a proactive approach to identify any applicable leases where the proposed updates could apply and determine how to incorporate the guidance.
Angela Newell is Deputy National Managing Partner – Accounting at BDO USA, LLP.