FASB Issues Guidance on Common-Control Lease Arrangements (March 28, 2023)

As part of the FASB’s postimplementation review of ASC 842, private companies asserted that this requirement creates unnecessary cost and complexity for financial statement preparers, since the terms and conditions of such common-control lease arrangements may lack sufficient details, may be uneconomic, or may be changed without approval, given that one party in the common-control group generally controls the arrangement. Therefore, stakeholders have indicated that it is challenging to determine the legally enforceable terms and conditions of these arrangements and that legal counsel may need to be involved in making this determination, thereby incurring additional cost.

In response to that feedback, the ASU provides an optional practical expedient under which private companies, as well as not-for-profit entities that are not conduit bond obligors, can use the written terms and conditions of an arrangement between entities under common control to determine (1) whether a lease exists and (2) the subsequent accounting for (and classification of) the lease. This practical expedient can be applied on an arrangement-by-arrangement basis, and an entity is not required to consider the legal enforceability of such written terms and conditions. However, if no written terms and conditions of an arrangement between entities under common control exist, an entity is not allowed to elect the practical expedient and is required to apply ASC 842 in a manner consistent with how it is applied to other arrangements.

 

Connecting the Dots

Although the FASB considered whether this practical expedient should be available to all entities, it ultimately decided to limit its application to private companies and not-for-profit entities that are not conduit bond obligors because public registrants have already adopted ASC 842 without raising concerns related to arrangements between related parties under common control.

As part of the FASB’s postimplementation review of ASC 842, some stakeholders stated that leasehold improvements associated with leases between entities under common control are economically different from those associated with leases between entities not under common control. In lease arrangements between entities not under common control, leasehold improvements made by the lessee can either be for the lessee’s own benefit or for the benefit of the lessor. However, leasehold improvements made under leases between entities under common control are expected to benefit the parties under the common-control arrangement. Therefore, private-company stakeholders have noted that, in a lease arrangement between entities under common control, the amortization requirements of ASC 842 are inconsistent with the underlying economics of the arrangement, since (1) the lessee may continue to control the use of the underlying asset after the lease term and (2) another party in the common-control group may benefit from the leasehold improvements after the lessee no longer controls the use of the underlying asset.

In response to that feedback, the ASU requires a lessee in a common-control lease arrangement to amortize leasehold improvements that it owns over the improvements’ useful life3 to the common control group, regardless of the lease term, if the lessee continues to control the use of the underlying asset through a lease.

In situations in which a lessee obtains control of an underlying asset through a lease with an unrelated party not under common control and subsequently subleases the asset to an entity under common control, the sublessee would generally amortize the leasehold improvements over a period that does not exceed the term of the lease between the lessee/intermediate lessor and the unrelated party. However, if the lease between the lessee/intermediate lessor and the unrelated party contains an option to purchase the underlying asset and the lessee/intermediate lessor is reasonably certain to exercise that option, the leasehold improvements should be amortized over the useful life to the common-control group.

Further, a lessee that no longer controls the use of the underlying asset will account for the transfer of the underlying asset as an adjustment to equity (i.e., as with a transfer of assets between entities under common control).

 

Connecting the Dots

Unlike Issue 1, Issue 2 applies to all entities. The FASB believes that Issue 2 is more pervasive and that all entities are currently applying multiple methods to account for leasehold improvements in leases between related parties under common control. For example, according to the FASB, some entities are accounting for these leasehold improvements by (1) amortizing them over the shorter of the lease term or the useful life of the leasehold improvements, (2) amortizing them over the lease term to an estimated salvage value and accounting for the unamortized balance as a transfer between entities under common control at the end of the lease term, or (3) amortizing them over the lease term with a portion recognized as a lease payment.

Accordingly, the FASB’s objective is to eliminate this diversity in practice by requiring both public and private entities to apply the amendments in Issue 2.