On March 27, 2023, the Financial Accounting Standards Board (FASB) published narrowly drawn amendments to the lease accounting rules. This updated guidance clarifies issues pertaining to rental agreements between businesses with the same owner.
Written vs. verbal leases
Accounting Standards Update (ASU) No. 2023-01, Leases (Topic 842) Common Control Arrangements, explains how related business entities controlled by the same owner determine whether a lease exists.
This guidance settles questions about how to approach verbal common control leases and whether legal counsel is required to determine the terms and conditions of a lease. Specifically, it gives an optional practical expedient to private businesses and not-for-profit organizations that aren’t conduit bond obligors. (A practical expedient is an accounting workaround that enables a business to use a more straightforward route to end up with the same outcome.)
The practical expedient is only applicable for written leases. Under the updated guidance, a business electing to use the practical expedient must follow the written terms and conditions of a common control arrangement to determine whether a lease exists and how to account for it.
With a verbal lease agreement, as is typically the case between private entities under common control, the company must document the existing unwritten terms of the agreement before applying these lease accounting rules.
The lessee isn’t required to determine whether written terms and conditions are enforceable when applying the practical expedient. Additionally, businesses can use the practical expedient on an arrangement-by-arrangement basis.
Leasehold improvements
The accounting rules for certain leasehold improvements have also changed for public and private organizations under ASU 2023-01. Examples of leasehold improvements include:
- Installing carpet
- Painting
- Building out the space for the lessee’s needs
For example, a salon might install new plumbing fixtures and sinks, a chemical manufacturer could require ventilation for its production process, and a neighborhood restaurant may create a rooftop garden to attract new customers.
Under these amendments, lessees must amortize leasehold improvements over the improvements’ useful lives to the common control group, regardless of lease terms.
When the lessee no longer controls the underlying asset, the transfer of those improvements must be accounted for with either net asset or equity. The improvements will remain subject to the impairment requirements of Accounting Standards Codification (ASC) Topic 360, Property, Plant and Equipment.
Guidance for implementation
ASU No. 2023-01 is an amendment to ASC Topic 842, Leases, which was issued in 2016. It went into effect for public entities in 2019 and for private entities in 2022. This standard requires the full effect of entities’ long-term lease obligations to be reported on the balance sheet.
Starting on December 15, 2023, the updated regulations will be implemented for this and subsequent fiscal years. If a company decides to adopt these modifications during an interim period, it must be done at the beginning of the fiscal year that includes that interim period. However, early adoption is allowed for both interim and financial statements that have yet to be issued.
If your business opts to adopt ASU 2023-01 concurrently with the adoption of Topic 842, you should use the same transition approach as this standard. If your company chooses to adopt these rules in a subsequent period, it must do this prospectively or retrospectively.
Need help understanding these rules? Get in touch.
If your company rents from a related party, we can help you report these arrangements in alignment with this updated guidance. The accounting professionals at Smolin Lupin know how to determine whether a common control lease exists and how to report improvements and other fixes made to rented property.