On March 27, 2023, FASB passed ASU 2023-01 Leases (Topic 842): Common Control Arrangements.
ASU 2013-01 provides more straightforward determinations of common control leasing arrangements. It also allows lessees to amortize leasehold improvements over their economic life.
Why this is important
ASC 842, Leases, created unforeseen problems for common control transactions related to leases and leasehold improvements. The March 27, 2023, amendment helps resolve those issues.
For example, accountants evaluated leases between commonly controlled entities based on legally enforceable terms. Since these lease arrangements were often loose (e.g., some were verbal), it was difficult to determine the “legally enforceable terms.” Consequently, some companies were incurring legal expenses to determine the legally enforceable terms of their lease agreements (a waste of money).
Additionally, ASC 842, Leases, required the amortization of leasehold improvements over the shorter of the remaining lease term and the useful life of the improvements. Such accounting could result in the amortization of improvements over a period shorter than the asset’s expected useful life, resulting in an inaccurate representation of the economics of the activity. For example, the lease term might be four years, but the leasehold improvements might have an economic life of ten years. Amortizing leasehold improvements over four years is inappropriate for commonly controlled arrangements.
ASU 2023-01 addresses two issues:
- Consideration of terms and conditions
- Accounting for leasehold improvements
Consideration of Terms and Conditions
Commonly controlled entities (private companies and nonprofits) can now use written terms and conditions of a common control arrangement to determine the following:
- Whether a lease exists and, if so,
- The classification of and accounting for the lease
The use of written terms and conditions is available by use of a practical expedient in ASC 2023-01. The practical expedient can be applied on an arrangement-by-arrangement basis. Additionally, the entity is not required to determine whether those written terms and conditions are legally enforceable.
Private entities should create written terms and conditions for common control arrangements if they don’t already exist.
Why? Without them, entities must use the legally enforceable terms of the arrangement to determine whether a lease exists and the classification and accounting. In short, writing down the terms and conditions is easier than paying an attorney to interpret the legally enforceable terms.
FASB does not prescribe a specific form or approach for creating written terms and conditions, so entities will use their judgment in making this documentation.
Accounting for Leasehold Improvements
ASU 2023-01 requires that leasehold improvements associated with leases between entities under common control be:
- Amortized by the lessee over the useful life of the leasehold improvements to the common control group (as long as the lessee controls the use of the underlying asset through a lease).
- Accounted for as a transfer between entities under common control through an adjustment to equity when the lessee no longer controls the use of the underlying asset.
The leasehold accounting changes provide a better picture of the economic reality of commonly controlled arrangements.
If, for example, the lessee makes leasehold improvements with a twenty-year economic life, but the lessee ceases to control the underlying asset (e.g., building) after ten years, the lessee will remove the amortized leasehold improvements from its books and adjust equity at the end of ten years. The leasehold assets transfer to the lessor.
The amendments in this Update are effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted for interim and annual financial statements.