The Financial Accounting Standards Board (FASB) has issued a Proposed Accounting Standards Update (ASU) related to Accounting Standards Codification (ASC) Topic 842 Leases. Specifically, the proposed ASU would address common control lease arrangements and the accounting for such leases.
Many owners maintain real estate in separate entities, often times limited liability companies (LLC). This real estate is typically leased to the operating entity. To recap, as discussed in detail here, the accounting for long-term leases was amended in ASC 842, whereby lessees are now required to capitalize all leases in excess of 12 months. Furthermore, within ASC 842, the lessee must analyze the likelihood of lease renewal or extension and potentially include the extended lease terms in the right-of-use asset and corresponding lease liability. ASC 842 resulted in major subjectivity in regard to related party leases and assessing the likelihood that the operating entity would leave the property after the legally enforceable terms of the lease.
The newly issued proposed ASU provides a practical expedient for privately held businesses to simply use the legally enforceable written terms and conditions of a common control leasing arrangement, without any consideration given to the likelihood of renewal or extension. Our preliminary interpretation of this is that any related party leases that are under one year in duration would be excluded from the capitalization rules of ASC 842, provided that the lease terms are documented in a legally enforceable lease agreement. The most important concept to note here is that the lease MUST be documented in a written agreement. If no written terms and conditions exist, an entity may not apply the practical expedient.
The proposed ASU goes on to discuss the accounting for leasehold improvements that are owned by the lessee in related party leases. Legacy Generally Accepted Accounting Principles require that leasehold improvements be amortized over the shorter of the economic life of the leasehold improvement, or the remaining lease term. The proposed ASU would require the asset to now be amortized over the economic life of the leasehold improvement (regardless of the lease term) as long as the lessee controls the use of the underlying asset through a lease.
The implementation of ASC 842 is upon us and many companies are scrambling to get their accounting straightened out for these changes. The proposed ASU appears to simplify the accounting for related party leases. The proposed ASU is available for review and comments through January 16, 2023.
As always, discuss your facts and circumstances with your CPA to identify the proper accounting for your related party leases.