Changes You Need To Know: Common Control Leases and Leasehold Improvements
On March 27, 2023, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2023-01, Leases (Topic 842), Common Control Arrangements, (the Update) that introduces changes to lease accounting under common control arrangements. The Update comes as a response to private company stakeholders’ concerns about applying Topic 842 to related party arrangements between entities under common control. In the Update, FASB chose not to include other related party arrangements within the scope of the Update, as they were not considered to present the same issues as common control arrangements.
The Update is available for early adoption for financial statements that have not been issued or made available for issuance; for example, this might include a private company’s Dec. 31, 2022 financial statements that are not yet available for issuance. Adoption of the standard may result in simplification of applying Topic 842 to certain common control lease arrangements.
Definition of Common Control
The term “common control” was not defined in the Update. Rather, the Board encouraged entities to reference the U.S. Securities and Exchange Commission (SEC) staff observations documented in EITF Issue No. 02-5, Definition of ‘Common Control’ in Relation to FASB Statement No. 141, to determine if entities are under common control. In addition, the Board reaffirmed its belief that the term “common control” should be broader for private companies and most not-for-profit entities than what the SEC staff observed in EITF Issue No. 02-5, including an example that an entity owned by a grandparent and an entity owned by a grandchild could be considered entities under common control for the purposes of applying the Update. Each determination will be facts-and-circumstances dependent. Judgment will need to be applied.
Terms and Conditions of the Arrangement
Determining the enforceable terms and conditions in common control arrangements is often challenging, with the terms and conditions frequently unwritten or lacking sufficient detail. For example, common control lease agreements frequently do not explicitly specify renewal terms controlled by the lessee. Private company stakeholders expressed concerns that determining enforceable terms and conditions could necessitate obtaining a formal legal opinion, which is challenging and costly due to the common control nature of the arrangement, even for written arrangements.
To address stakeholders' concerns, the new Update provides a practical expedient for private companies (i.e., entities that are not public business entities, not-for-profit conduit bond obligors or employee benefit plans that file or furnish financial statements with or to the U.S. SEC) 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. When determining whether a lease exists under this practical expedient, an entity shall evaluate whether the written terms and conditions convey the practical (as opposed to enforceable) right to control the use of an identified asset for a period of time in exchange for consideration. This practical expedient can be applied on an arrangement-by-arrangement basis. However, if no written terms and conditions exist, an entity must evaluate the legally enforceable terms and conditions to apply Topic 842. The application of the practical expedient does not eliminate the need for an entity to apply relevant guidance in Topic 842 to account for the lease.
As part of the adoption of the Update, an entity is permitted to document any existing unwritten terms and conditions of an arrangement between entities under common control. The Board chose not to prescribe a specific form or approach for documenting the arrangement, nor did it choose to describe the specific terms and conditions that must be included in the written document. Rather, the Board observed that entities have the latitude to use reasonable judgment in determining the form and approach for documenting the arrangement and noted that Topic 842 has existing specific requirements for determining whether a lease exists and then classifying and accounting for that lease.
Entities adopting the practical expedient concurrently with adopting Topic 842 are required to follow the same transition requirements used to apply Topic 842. All other entities are required to apply the practical expedient either:
- Prospectively to arrangements that commence or are modified on or after the date that the entity first applies the practical expedient, or,
- 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 the practical expedient. The practical expedient does not apply to common control arrangements no longer in place at the date of adoption of the amendments in this Update.
If after an entity has applied the practical expedient, an arrangement is no longer between entities under common control, the entity should determine whether a lease exists in accordance with the provisions of ASC 842 for entities that are not under common control. Then, the Update contains guidance on the proper accounting treatment. If the existing lease continues to meet the definition of a lease, the entity applies modification guidance based on the legally enforceable terms and conditions of the arrangement. If the existing lease is determined to no longer meet the definition of a lease, the entity follows the termination guidance. If an existing arrangement was previously determined not to be a lease and now meets the definition of a lease, the entity should account for it as a new lease.
Finally, common control lease arrangements continue to be subject to the Topic 850, Related Party Disclosures. The Board concluded that the Topic 850 disclosure requirements should provide investors and other readers of the financial statements with sufficient information to analyze the entity’s common control arrangements, which were not negotiated at arm’s length and, therefore, may not reflect the economic substance of the arrangement.
Required Changes to Leasehold Improvements
The changes to leasehold improvements associated with common control leases apply to all entities. Leasehold improvements refer to improvements made by a lessee to the underlying asset subject to a lease for which the lessee is determined to be the accounting owner. The accounting owner determination involves significant judgment and no separate generally accepted accounting principles exist for making the determination. The Board had noted that common control leases are economically different from those associated with third-party and other related-party leases. In common control leases, leasehold improvements are expected to benefit all common control parties.
To clarify the accounting for leasehold improvements associated with common control leases, better reflect the economics of those transactions, and reduce diversity in practice, the Update requires that those leasehold improvements be amortized by the lessee over the useful life of the leasehold improvements to the common control group (regardless of the lease term). If the lessor obtained the right to control the use of the underlying asset through a lease with another entity not within the same common control group, the amortization period may not exceed the amortization period of the common control group. If the useful life of leasehold improvements to the common control group exceeds the related lease term, the entity must disclose (a) the unamortized balance of the leasehold improvements at the balance sheet date; (b) the remaining useful life of the leasehold improvements to the common control group; and (c) the remaining lease term.
The Board observed that entities may need to obtain information from the lessor or common owner or owners to determine the useful life of leasehold improvements to the common control group. In addition, the Update reaffirms that the leasehold improvements are subject to the impairment guidance in Topic 360, Property, Plant, and Equipment.
If after the initial measurement date the lessee and lessor become within the same common control group or are no longer within the same common control group, any change in the required amortization period for leasehold improvements shall be accounted for prospectively as a change in accounting estimate.
The Update further states that if, and when, the lessee no longer controls the right to use the underlying asset, leasehold improvements associated with common control leases should be accounted as a transfer between entities under common control through an adjustment to equity (or net assets for not-for-profit entities). If the carrying amount of the asset exceeds its fair value at the transfer date, the entity should recognize an impairment.
The change to the amortization period for leasehold improvements related to common control arrangements is applicable for all entities, including public business entities. Entities adopting the amendments in the Update concurrently with adopting Topic 842 may follow the same transition requirements used to apply Topic 842 or may use either of the prospective approaches described below to avoid retrospectively accounting for leasehold improvements. All other entities are required to apply the amendments in the Update using one of the following methods:
- Prospectively to all new leasehold improvements recognized on or after the date that the entity first applies the amendments in the Update.
- Prospectively to all new and existing leasehold improvements recognized on or after the date that the entity first applies the amendments in the Update, with any remaining unamortized balance of existing leasehold improvements amortized over their remaining useful life to the common control group determined at that date.
- Retrospectively to the beginning of the period in which the entity first applied Topic 842, with any leasehold improvements that otherwise would not have been amortized or impaired recognized through a cumulative-effect adjustment to the opening balance of retained earnings (or net assets of a not-for-profit entity) at the beginning of the earliest period presented in accordance with Topic 842.
The Update is effective for fiscal years beginning after Dec. 15, 2023, including interim periods within those fiscal years. Early application is permitted for both interim and annual financial statements that have not 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.
Now that the Update has been issued, entities with common control arrangements should evaluate whether to early adopt the Update’s provisions. At the time of the adoption of the Update, entities have an opportunity to document the existing terms and conditions of unwritten leases. By doing so, the written terms and conditions can be used to evaluate and record a contract under ASC 842. If the terms and conditions are not written down at adoption, then the legally enforceable terms and conditions must be determined, which may require the involvement of legal counsel. If an unwritten arrangement is later formally memorialized after the financial statements with the Update’s adoption are issued, the arrangement will be evaluated under the modification guidance. As such, entities should determine their population of unwritten arrangements and are encouraged to formalize the documentation concurrently with this adoption.
Furthermore, with the required changes to the amortization period for leasehold improvements, entities should evaluate the three transition options and determine the impact on the financial statements. Since the change to the amortization period is required for all leases under common control arrangements, it is important for entities to evaluate whether arrangements are under common control and what leasehold improvements will be impacted by the change.
For assistance with this Update or ASC 842, please reach out to our team members. Published on March 28, 2023