The FASB on Nov. 30, 2022, proposed what could be the eighth round of changes to lease accounting rules, this time relevant to subsidiaries that are involved in inter-company agreements and that are controlled by the same parent company.
The guidance aims to clarify under Topic 842, Leases, for related parties controlled by a common entity: a) how to determine whether a lease exists, its classification and accounting treatment; b) how to account for leasehold improvements, i.e. upgrades to commercial property such as carpeting, painting or other repairs.
This round of proposed changes was not endorsed by the full seven-member FASB as three— academic Christine Botosan, analysts Frederick Cannon and Gary Buesser — dissented, disagreeing on the portion related to leasehold improvements “on conceptual and pragmatic grounds.”
The board said it is seeking public feedback by Jan. 16, 2023, on the potential changes which were published as Proposed Accounting Standards Update (ASU) No. 2022-ED500, Leases (Topic 842) Common Control Arrangements.
The issues being addressed surfaced during the board’s post-implementation review (PIR) of Topic 842 to determine whether it worked as intended. The standard, which requires the full magnitude of long-term lease obligations to be reported on the balance sheet, went into effect in 2019 for public companies and took effect this year for private companies. Since its issuance in 2016, Topic 842 was amended seven times.
Changes on Leasehold Improvements Would Apply to Public and Private Companies
Under the main tenets of the proposal, the standard would be amended – for both public and private companies – to specify that leasehold improvements associated with leases between related parties that are controlled by the same parent company should be “amortized by the lessee over the useful life of the improvements (regardless of the lease term) as long as the lessee continues to use the underlying asset” and “accounted for as a transfer between entities under common control if, and when, the lessee ceases using the underlying asset.”
Currently, Topic 842 generally requires that leasehold improvements be amortized over the shorter of the remaining lease term and the useful life of the improvements. But the board said it heard from private companies that it is not uncommon for leases that are controlled by the same parent entity to have a short lease term, even when significant leasehold improvements with an economic life that far exceeds the lease term.
“Those stakeholders raised concerns that fully amortizing leasehold improvements over a period shorter than the economic life of the improvements may result in financial reporting that does not faithfully represent the economics or the common control nature of those improvements,” text from the “Basis for Conclusions” section of the proposal explains.
Further, among other reasons, the board developed the changes over concerns “that diversity in practice may exist for accounting for leasehold improvements associated with common control leases accounted for under Topic 842 and that the diversity may not be limited to private companies.”
A Practical Expedient for Private Companies and Nonprofits Only
Also proposed is an accounting workaround (practical expedient) for private companies and not-for-profit organizations that are not conduit bond obligors to specify that companies would only consider the written terms and conditions when determining whether a lease exists and the classification and accounting for that lease.
Further, the company would not need to determine whether those written terms and conditions are legally enforceable. If no written terms and conditions exist a company would apply Topic 842 to any verbal or implicit terms and conditions. If no lease exists, other rules would apply.
Many “private company stakeholders have stated that determining the legally enforceable terms and conditions in common control arrangements may present unique challenges, even when those terms and conditions are written,” the proposal explains.
Specifically, a common owner or owners “can amend the terms and conditions of an arrangement at any time without approval by the lessee or lessor under common control,” and “common control arrangements often are unwritten or lack sufficient detail,” were among various concerns board text cited.
Joint Dissents
Botosan, Cannon and Buesser, in their jointly written dissent, approved of the practical expedient for private companies and not-profits, but said they could not support the proposed changes for leasehold improvements as they “believe that beyond the lease term a leasehold improvement does not meet the definition of an asset.”
Among other concerns, they said that “recognizing a leasehold improvement asset while failing to fully recognize the associated lease asset and obligation could yield misleading financial reporting information,” would not provide a “faithful representation of the underlying economic activity because generally it is uneconomic for an entity to fund leasehold improvements with a longer duration than the lease term,” and that the proposed guidance “could incentivize month-to-month common control lease arrangements, thereby compounding the potential harm.”
This article originally appeared in the December 1, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.
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