The Financial Accounting Standards Board (FASB) recently voted to approve an update to Accounting Standards Codification (ASC) Topic 842, Leases. The update deals with two issues related to leases under common control arrangements: how to determine the terms and conditions that should be considered when applying the standard, and accounting for leasehold improvements when the term of the lease is shorter than the useful life of the underlying asset.
The final update will be effective for all entities for fiscal years beginning after Dec. 15, 2023, including interim periods within those fiscal years. Early application will be permitted. The FASB indicated during their meeting that they expect the final update to be issued by the end of March 2023.
Importance of the Update
FASB has recognized that implementing ASC Topic 842 has been a challenge for many entities. To help with transitioning to ASC Topic 842, there have been several practical expedients provided by FASB since ASC Topic 842 was issued, with the FASB vote on the common control arrangements being the most recent.
Description of the Update’s Main Provisions
- The update will provide a practical expedient for private companies (i.e., entities that are not public business entities, not-for-profit bond obligors or employee benefit plans that file or furnish financial statements with or to the U.S. Securities and Exchange Commission) 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. Further, an entity will not be required to determine whether the written terms and conditions are legally enforceable.
- The update also requires, for all entities, that leasehold improvements associated with leases between entities under common control be amortized by the lessee over the useful life of the improvements to the common control group, as long as the lessee controls the use of the underlying asset through a lease.
The practical expedient may be applied on an arrangement-by-arrangement basis. If no written terms and conditions exist, an entity will not be able to apply the practical expedient and will continue to use the legally enforceable terms and conditions to apply ASC Topic 842. However, before the first set of financial statements are available to be issued with the practical expedient elected, an entity will be permitted to document the terms and conditions of any existing unwritten common control arrangement. Those documented terms and conditions should reflect the existing arrangement, and not change it.
The practical expedient can be adopted either prospectively to all leases that commence on or after the date of adoption of the update, or retrospectively to the beginning of the earliest period presented in the financial statements in accordance with ASC Topic 842.
However, if the lessor obtained the right to control the underlying asset through a lease with another entity not within the same common control group, the amortization period may not exceed the lease term associated with the lessor's lease with the other entity.
The leasehold improvements will be accounted for as a transfer between entities under common control through an adjustment to equity if, and when, the lessee no longer controls the use of the underlying asset.
Upon adoption of the update, entities can apply the update (1) prospectively to all new leasehold improvements, (2) prospectively to all and existing leasehold improvements, with the unamortized balance of existing leasehold improvements being amortized over their remaining useful life to the common control group, or (3) retrospectively to the beginning of the period in which the update is adopted, with a cumulative-effect adjustment to the opening balance of retained earnings for any leasehold improvements that otherwise would not have been amortized or impaired.
What You Should Do
Below are some steps you can start taking now to prepare for adoption of the update, once it is issued.
Get Leases in Writing. The practical expedient in this FASB update is only available for leases that are in writing. So unless your company is prepared to follow the original guidance in ASC 842, get your leases documented.
Start Evaluating the Useful Life of Leasehold Improvements to the Common Control Group. Determine which transition approach you will apply and then determine the useful lives of leasehold improvements that are impacted. You will also be required to disclose information about leases in which the useful life of the improvement associated with a common control lease exceeds the lease term.
Coordinate Dates. The provisions of the update cannot be applied until it is released in its final form (expected by the end of March 2023), so work with your providers on the planned approach for adoption and the timing of the release of your financial statements. Develop a contingency plan if the final update is not issued before your financial statements are due.
For assistance with this update or ASC 842, please reach out to one of our team members.
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