Under the Financial Accounting Standard Board’s Accounting Standards Update Topic 842, organizations are required to report their long-term lease obligations on their balance sheet. (This is a significant change that went into effect for private companies and nonprofit organizations for fiscal years beginning after December 15, 2021.)
As is common, new standards can need fine-tuning after they are issued. In September 2022, the FASB voted to propose a pair of amendments to clarify two outstanding issues:
- How to account for leases under common control
- Accounting for leasehold improvements when the lease term is shorter than the useful life
Practical expedient for common-control leases
Under Topic 842, organizations are required to account for a lease under common control based on the legally enforceable terms of the lease. However, complications arose because some organizations don’t have written agreements for common-control leases. Furthermore, the term “legally enforceable” could require a certain level of evaluation and interpretation.
The proposed amendments would offer a practical expedient indicating that when common-control leases are written, organizations can assume such leases are legally enforceable as written. Essentially, that means there’s no need to evaluate other terms and conditions that might be implied or whether there are intentions beyond what is written.
Where there is no written agreement, the practical expedient would not apply. In other words, if the arrangement is carrying on as a verbal agreement or a mutual understanding, the entity is still required to evaluate what terms and conditions are legally enforceable and account for the lease accordingly. So the easiest way to simplify the evaluation of these common control leases is to make sure you’re documenting your leases in writing.
Q: How do you define common control?
Typically you see this when one owner controls an operating company as well as a real estate company. But generally, you consider an entity under common control when an individual or company has more than 50% ownership in each entity. Common ownership can also include a group of shareholders with more than 50% ownership in total when there’s a written agreement that they’re going to vote in concert or as a group. It might also include immediate family members when there’s 50% ownership.
Q: Do you have to consider renewal options?
Basically, the amendments specify you consider only what’s written. However, if a renewal option is written into that lease agreement, it would still need to be evaluated as part of a determination of a reasonably certain holding period.
For example, a 12-month lease with a written renewal option would need to consider whether the entity is reasonably certain to exercise that option, and if so, include it in the lease term.
Alternatively, if the written lease is for 12 months and there is no written renewal option, it would qualify as a short-term lease under the proposed amendments, and you wouldn’t need to evaluate the potential that this written lease might be extended or amended in the future.
Q: How formal does the lease agreement need to be to qualify for these new rules?
Generally, the lease can be a basic one-page agreement as long as it’s a drafted, signed document that clearly outlines the terms of the arrangement. Simple should suffice, as long as it’s something more than an email or handwritten note.
Q: Can you back date your leases to use the expedient?
We believe the FASB intends to allow leases that are amended prior to financial statement issuance and back dated to January 1, 2022, to still be effective as of the beginning of the period, at least during this first year of transition.
However, it wasn’t completely clear if they intend to extend that after year end. So for now, if an entity wants to apply this practical expedient and they don’t have a written lease in place, they should probably do so before the end of the year.
Q: Does the expedient apply to all types of leases?
Based on what we’ve seen so far, these amendments apply to all lease agreements, such as real estate, equipment, vehicle or transportation entity, as long as they are between entities under common control.
Clarification on leasehold improvements
The second FASB amendment would clarify how entities under common control should account for leasehold improvements when the lease term is shorter than the useful life of the improvements.
The proposed amendments would specify that these leasehold improvements should be amortized over their useful life as long as the lessee continues to use those leasehold improvements. In other words, the amortization period would not be limited to the shorter of the useful life or the lease term. Only when the lessee ceases use of that leasehold improvement would they need to apply some sort of different treatment.
The leasehold improvement would apply to all leases between entities under common control and is not restricted only to private companies.
Once these proposals are issued, the FASB is expected to open a 45-day comment period. We anticipate the FASB will issue the proposal in mid-to-late November. After the comment period expires, it will redeliberate and vote. In the meantime, organizations must continue to move ahead with adopting Topic 842.
How Wipfli can help
Wipfli will continue to watch and update our clients on these developments. Contact Wipfli’s audit and accounting team for assistance, including how to handle leases under common control.
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