Implementation efforts for Accounting Standards Codification (ASC) 842, Leases, are now underway for private companies. The new guidance updated the accounting for leases between related parties and raised concerns as many private company lease arrangements may not be consummated at arm’s length or formally documented. With unprecedented speed, FASB voted on September 21, 2022 to approve an exposure draft to address the following issues:

Terms and conditions to be considered for arrangements between entities under common control in determining whether a lease exists, and if so, the classification and accounting
The accounting for leasehold improvements under ASC 842 when the lease term in a common control lease is shorter than the useful life of the leasehold improvements

The proposal will have a comment period for 45 days and FORVIS will have a follow-up article with full details once that document is issued.

Background

ASC 842 updated ASC 840’s requirements for related-party leases. ASC 842 requires entities to classify and account for related-party leases based on an arrangement’s legally enforceable terms and conditions (consistent for leases between unrelated parties). ASC 840 required entities to classify and account for related-party leases based on the arrangement’s economic substance when transaction terms were significantly affected by the fact that the lessee and lessor are related. FASB initially concluded that determining the economic substance of arrangements between related parties often was not practicable because terms and conditions, if any, between the parties may not be consummated at arm’s length and noted that in certain situations, i.e., month-to-month arrangements, legally enforceable terms and conditions may not exist.

Private companies must comply with required disclosures in ASC 850, Related Party Disclosures, including information necessary to understand the nature of related-party leasing arrangements that are not recognized and measured on the balance sheet.

ASC 840	ASC 842
Lessees and lessor must consider economic substance Required significant judgment in some circumstances Resulted in diversity in practice Some preparers imputed market terms	Lessees and lessors must classify and account for leases between related parties on the basis of legally enforceable lease terms and conditions Treated in the same manner as leases between unrelated parties

Challenges

Legal Enforceability

In many common control arrangements, lease contracts can be made verbally, and lease terms may be explicit or implicit outside of a formal lease contract, e.g., a management or operating agreement may create enforceable rights and obligations related to leases without specifically contemplating those leases.

Private companies have consistently highlighted that arrangements between entities under common control often are unwritten or lack sufficient detail, and arrangement terms and conditions may be uneconomic or not aligned with other related transactions or agreements. In these cases, private companies are concerned that they are required to determine whether implicit legally enforceable terms and conditions exist, which may require legal counsel. FASB outreach indicates that auditors also have seen diversity in practice in the extent of diligence that an entity is expected to undertake to evaluate the legal enforceability of written terms and/or identify implicit terms in common control arrangements.

Leasehold Improvements

If a lessee adds significant leasehold improvements or the underlying asset is integral to the lessee’s operations, e.g., a customized production facility, considering whether implicit lessee renewal rights exist to determine the lease term could impact the recognition and amortization of those leasehold improvements.

The amortization period for leasehold improvements depends on whether ownership of the leased asset transfers to the lessee at the end of the lease term or the lessee is reasonably certain to exercise a purchase option. If either condition is met, the leasehold improvement should be amortized over its useful life. In other lease arrangements, a leasehold improvement should be amortized over the shorter of its useful life or the remaining lease term. As ASC 842 is currently written, it would be misleading to conclude the amortization period for a leasehold improvement exceeds the lease term.

Under ASC 840, there also was diversity in practice on how leasehold improvements were accounted for. There is no specific U.S. GAAP guidance on how assets transferred in a common control transaction should be treated. Some companies amortized significant leasehold improvement over its useful life while others treat the transfer as a dividend.

Approved Proposal

Terms & Conditions to Be Considered for Arrangements Between Entities Under Common Control

The proposal would amend ASC 842 to specify that an entity would consider only written terms and conditions. An entity would not be required to determine whether those written terms and conditions are legally enforceable. If no written terms and conditions exist, an entity would continue to apply the existing ASC 842 requirements. That is, an entity would need to consider legally enforceable terms and conditions (oral and implicit) for purposes of determining whether a lease exists and, if so, the associated classification and accounting of a lease. Consistent with ASC 842, if no legally enforceable terms and conditions exist, the arrangement would not be a lease and other GAAP would apply.

No additional disclosures would be required.

As part of the transition to ASC 842, entities are permitted to document or amend any existing arrangements.

Scope

The amendments would generally apply only to private companies, specifically entities other than the following:

Public business entities
Not-for-profit bond obligors
Employee benefit plans that file or furnish financial statements with or to the SEC

Accounting for Leasehold Improvements (Lessee Only)

The proposal would amend ASC 842 to specify that leasehold improvements for leases between entities under common control be:

Amortized by the lessee over the improvement’s useful life (regardless of the lease term) as long as the lessee continues to use the underlying asset
Accounted for as a transfer between entities under common control if, and when, the lessee ceases using the underlying asset

Some additional disclosures would apply.

Scope

These amendments would apply to all entities.

Transition & Effective Date

The proposal will contain flexible transition terms using either a modified retrospective approach or a prospective approach. The effective date will be determined after feedback is reviewed.

All details are subject to change pending release of the exposure draft.

Conclusion

FORVIS will continue to follow this developing situation. For some entities, ASC 842’s adoption will be complex and likely will require significant hours to implement correctly. FORVIS can help educate your team, provide implementation tools, and assist with analysis and documentation. If you would like assistance complying with the new guidance, contact us.