The subject of accounting standards is of utmost importance in the business world. With the ever-evolving nature of the global economy, it becomes imperative to align accounting practices and regulations with the changing needs of organizations. To this end, the Accounting Standards Update 2023-01 Leases (Topic 842): Common Control Arrangements offers valuable insights and guidelines for entities involved in such transactions. The following insight aims to provide an overview of this particular accounting update, highlighting its key aspects and potential impact on financial reporting.
The amendments in this update addressed the concerns of private company stakeholders when applying Accounting Standards Codification 842 – Leases (“ASC 842”) when there are related party arrangements and between entities under common control. This update addressed two issues: Terms and Conditions and Leasehold Improvements.
Issue 1 – Terms and Conditions
If an arrangement between related parties is determined to be a lease in accordance with ASC 842, the entity must classify the lease the same as it would if the parties are unrelated. This is a change from previous lease guidance under ASC 840 – Leases. Under previous guidance, the entity would account for the lease arrangement based on economic substance. The determination of enforceable terms of a lease amongst related parties can be difficult and costly and could necessitate a formal legal opinion due to the nature of the common control relationship.
The amendment allows for a practical expedient for private companies and not-for-profit entities that are not conduit debt obligors that would allow the use of written terms and conditions of a common control arrangement to determine:
- Whether a lease exists
- The classification of and accounting for the lease
The practical expedient is prohibited when there is no written agreement between the parties and the amendment; however, in the period of adoption only, an entity may document exiting unwritten terms and conditions before the date on which the entity’s first financial statements are available to be issued, and then can then use this practical expedient. The practical expedient may be applied on an arrangement-by-arrangement basis.
Issue 2 – Leasehold Improvements
Lessees amortize leasehold improvements (“LHI”) over the shorter of the remaining lease term and the useful life of the improvements when the lessee is the accounting owner of the improvements. However, private company stakeholders feel that the life of the leasehold improvements are amortized over a shorter-than-expected life of the LHI when the lease arrangement is between common control parties. The result of this could be not faithfully representing the economics of these LHI.
The amendment requires that if the lessee controls the underlying asset, the LHI associated with common control leases be amortized by the lessee over the useful life of the LHI regardless of the lease term.
Under the amended guidance, when the useful life of a LHI exceeds the related lease term, a lessee shall disclose the following:
- The unamortized balance of the LHI at the balance sheet date
- The remaining useful life of the LHI to the common control group
- The remaining lease term
Impairments of LHI are subject to guidance under ASC Topic 360 – Property, Plant and Equipment.
The amendment is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted. 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.