In March 2023, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2023-01, Leases (Topic 842): Common Control Arrangements. The ASU includes two updates. Issue 1 is a new practical expedient for entities with leasing arrangements under common control and is only available to private companies and not-for-profit (NFP) entities that are not conduit bond obligors. Issue 2 updates the accounting for leasehold improvements (LHI) and is required for all entities under common control leasing arrangements, including public companies.

BACKGROUND

ASU 2023-01 was issued by the FASB in response to concerns raised by private companies regarding the application of ASU 842 in common control leasing arrangements. Often, determining the enforceability of the terms and conditions of the leasing arrangement, even when written, can be a challenge for entities under common control since the terms may lack sufficient detail and the party who controls the common group could amend the terms and conditions at any time or choose to not enforce the terms and conditions of the arrangement. Additionally, the terms and conditions may not be written, just orally acknowledged or implied. All of these scenarios could require obtaining a formal legal opinion on the specific terms and conditions of the leasing arrangement. This would be costly and burdensome to the entities involved. As a response, the FASB issued ASU 2023-01 to allow certain entities under common control to use the written terms and conditions of a common control arrangement to determine if a lease exists, and if so, the classification and accounting for that lease. ASU 2023-01 also updates the amortizable life of leasehold improvements recognized by a lessee under a lease between entities under common control.

Concept of Common Control
Despite numerous requests over the years, the FASB has declined to provide an authoritative definition of "common control". However, in general, common control exists between, or among, separate entities when an individual or entity holds more than 50% of the voting ownership interest of each entity. A classic example is a parent company that is the holding company of a subsidiary (lessor subsidiary) who owns the building and land which it then leases to another subsidiary (lessee subsidiary) of the parent company. In this example, the lessor subsidiary and lessee subsidiary are entities under common control of the parent company and would be subject to the provisions of ASU 2023-01. It is important to note that not all related party relationships fall under the umbrella of common control. Consult with your trusted accounting advisors when in doubt.

ISSUE 1 – PRACTICAL EXPEDIENT FOR PRIVATE COMPANIES AND CERTAIN NOT-FOR-PROFIT ENTITIES

Issue 1 is a practical expedient provided to private companies and NFP entities that are not conduit bond obligors to use the written terms and conditions of a common control arrangement to determine if a lease exists, and if so, the classification and accounting for that lease. This practical expedient may be applied on an arrangement-by-arrangement basis.

Accounting Insight: Practical expedients are optional and therefore are not required to be elected.

The practical expedient also allows for a one-time catch-up during the period in which ASU 2023-01 is adopted (transition period) for entities to document any existing unwritten terms and conditions of an arrangement between entities under common control. After the transition period, if no written terms or conditions exist for an arrangement between entities under common control, then this practical expedient is not available and the entity must determine the enforceable rights and obligations under that unwritten arrangement, same as the requirements for arrangements between parties not under common control.

By allowing for the written terms and conditions to be relied on for determination of lease existence and subsequent classification and accounting, this practical expedient alleviates the potential burden of needing an attorney to provide an opinion on the enforceable rights, both explicit and implicit, within the lease agreement. It also provides for possible accounting relief for common control lessees with operating leases if the common control leases are structured as one-year leases with no auto-renewal provision and certain other considerations. This would allow for the short-term lease exception to be utilized and, therefore, would avoid capitalizing those operating leases on the entity's balance sheet. Bear in mind that there are additional factors to consider if your entity would like to pursue this route. Discuss with your trusted accounting advisors accordingly.

ISSUE 2 – ACCOUNTING FOR LEASEHOLD IMPROVEMENTS

Issue 2 updates the accounting requirements for leasehold improvements associated with leases between entities under common control. The accounting updates are required for all entities, including public companies, with leases between entities under common control. The update also includes additional required disclosures for lessees when the leasehold improvement's useful life to the common control group exceeds the related lease term.

The below table summarizes the accounting updates in Issue 2:

Prior to ASU 2023-01 (Old GAAP)

Post-ASU 2023-01 (New GAAP)

Amortizable Life of Leasehold Improvements (LHI)

Amortize over the lesser of:

  • LHI's useful life; or
  • The term of the lease.

Amortize over the LHI's useful life to the common control group (regardless of lease term) as long as the lessee controls the use of the underlying asset through a lease.

If the lessor obtained the right to control the leased asset through a lease with another entity not in the same common control group, then the amortization period should not exceed the amortization period of the common control group. *

Disposition of Leasehold Improvements (LHI)

Depends.

  • If at end of lease term or LHI's useful life (lesser of rule), LHI would be fully amortized. No profit/loss impact on disposition.
  • If lease terminates early, LHI's remaining basis is recognized in profit/loss in that period.
 Any remaining LHI basis is accounted for as a transfer (equity adjustment) between the entities in the common control group. There is no profit/loss impact on either party.


* This applies to subleasing arrangements when a lessor in a common control group leases an asset from a third party and then subleases that asset to a lessee in the same common control group.

EFFECTIVE DATE FOR ISSUES 1 AND 2

Effective Date

Fiscal years beginning after December 15, 2023,, including interim periods within those fiscal years. If adopted in an interim period, then must adopt as of the beginning of the fiscal year that includes that interim period.

Early Adoption?

Yes, permitted for both annual and interim periods.


TRANSITION OPTIONS FOR ISSUES 1 AND 2

For both Issues 1 and 2, the transition method options available depend on when the provisions of ASC 842 were initially adopted and include additional disclosures depending on the transition method used. The transition options are numerous and include both prospective and retrospective application methods. As a result, your entity's financial reporting will be impacted by the transition option selected and the impact could be significant. Be strategic when selecting your entity's transition method and consult with your trusted accounting advisor when in doubt.

The transition method options available for each Issue within ASU 2023-01 are summarized below.

Issue 1 – Practical Expedient for Private Companies and Not-For-Profit Entities

Reminder: Issue 1 is an optional practical expedient.

WHEN WILL ASU 2023-01 BE ADOPTED?

Concurrent with provisions of ASC 842, Leases

Same transition method options as required under ASC 842.

After Adoption of ASC 842, Leases

Option to adopt either:

1) Prospectively to common control leases that start or are modified on or after the date that the practical expedient is first applied; or

2) Retrospectively to the beginning of the period in which ASC 842 was adopted for common control leases that exist at the adoption date. For common control arrangements no longer in place at the adoption date of ASC 842, this practical expedient does not apply.


Issue 2 – Accounting for Leasehold Improvements

Reminder: Issue 2 is required for all leases between entities under common control.

WHEN WILL ASU 2023-01 BE ADOPTED?

Concurrent with Provisions of ASC 842, Leases

Option to adopt using either:

1) Same transition options as required under ASC 842; or

2) Using either of the prospective approaches described below (available to entities adopting ASU 2023-01 after ASC 842).

After Adoption of ASC 842, Leases

Option to adopt using one of the following methods:

1) Prospectively to all new LHI recognized on or after the date that the entity first applies ASU 2023-01; or

2) Prospectively to all new and existing LHI recognized on or after the date that the entity first applies ASU 2023-01, with any remaining unamortized basis of existing LHI amortized over the remaining useful life to the common group determined at that date; or

3) Retrospectively to the beginning of the period in which ASC 842 was adopted, with any LHI that otherwise would not have been amortized or impaired recognized through a cumulative-effect adjustment to the opening balance of retained earnings (net assets) at the beginning of the earliest period presented in accordance with ASC 842.


WHAT NOW?

Tackle each issue independently. Determine if your entity would benefit from the practical expedient in Issue 1. Are there significant leasing arrangements between entities under common control? Are those arrangements written or does your entity need to prioritize documentation of those arrangements to be eligible for this practical expedient? This practical expedient should be beneficial for many entities since it is intended to reduce the burden of ASC 842's application. Separately, take an inventory of your entity's leasehold improvements, determine which are associated with leases between entities under common control and calculate the financial impact of each transition option offered for Issue 2 to determine which makes the most sense for your entity's current and future financial reporting.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.