A Lease Accounting Update

The first Accounting Standards Update (ASU) of the year was issued in March. ASU 2023-01 Leases (Topic 842): Common Control Arrangements clarifies treatment for related party leases to be incorporated with the new lease standard Topic 842 effective for years beginning after December 31, 2021.

In this ASU, the practical expedient provides options for private companies (including non-profits) that have leases under common control and clarifies treatment of leasehold improvements connected with those leases under common control. The ASU is in effect for those issuing GAAP financial statements for years beginning after December 15, 2023, but can be early adopted for those financials not yet issued. For both options, the practical expedient, if elected, can be applied retroactively to the beginning of the period Topic 842 was first adopted or applied prospectively on date the practical expedient is applied.

The first issue addressed in this ASU relates to leases under common control. Based on the new guidance, private companies (including non-profits) can elect to follow written lease terms, regardless of legally enforceable rights. This allows month-to-month related party leases to be written as such, and would therefore fall under the short-term leases exemption for calculating right-of-use assets and liabilities. If written leases are already in place, those agreements should be followed to evaluate for the standard as written.

Key reminders and takeaways on leases under common control

  • If there are no written terms put in place for related party leases before issuance of financial statements, an entity is prohibited from using the practical expedient and must evaluate following the regular Topic 842 standards for enforceable rights.
  • At any point in time, if the lease under common control changes to a lease with an unrelated party, the lease needs to be re-evaluated based on the legally enforceable terms.

The second issue addressed in this ASU relates to leasehold improvement life. Typically, leasehold improvements have an amortization period following the shorter of the remaining lease term or estimated useful life. However, due to the above treatment of leases under common control, the amortization period may not accurately reflect the useful life if based on the documented lease terms.

The changes from this ASU allow for leasehold improvements for leases under common control to be accounted for by:

  • Amortizing the leasehold over the economic life of the leasehold improvements (as long as the lessee controls the use of the asset).
  • Transferring the asset through equity (or net assets if a non-profit) to the entity under common control when the lessee no longer controls the asset.

If the useful life of the leasehold improvements exceeds the related lease term, the lessee is also required to disclose:

  • The unamortized balance of the leasehold improvements.
  • The remaining useful life of the leasehold improvements.
  • The remaining lease term.

In addition to these terms, the ASU clarifies that lease payments in right-of-use assets and lease liability calculations should exclude leasehold improvements recognized by the lessee. And similar to the first issue addressed in this ASU, if the lease with common control transitions to an unrelated party, the leasehold improvement amortization period must be re-evaluated prospectively and may require a change in accounting estimate if significant.

For any further guidance on the new lease accounting standards, please call 317-608-6699 and ask for Lisa Blankman or Eric Woodruff.