The Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2023-01 (ASU 2023-01) Leases (Topic 842): Common Control Arrangements in March 2023. ASU 2023-01 provides a practical expedient for evaluating the enforceability of the written terms for contractual arrangements between entities under common control (Issue 1). In addition, ASU 2023-01 provides guidance with respect to the period over which leasehold improvements associated with common control leasing arrangements should be amortized (Issue 2).

The amendments in ASU 2023-01 are effective for fiscal years beginning after Dec. 15, 2023 (e.g., calendar year 2024), including interim periods within those fiscal years. Early adoption is permitted. The amendments in ASU 2023-01 should be applied as follows:

• Issue 1 – The practical expedient is available to entities that are not:
  • Public business entities
  • Not-for-profit conduit bond obligors
  • Employee benefit plans that file or furnish financial statements with or to the U.S. Securities and Exchange Commission (SEC).
• Issue 2 – All entities that are a party to a common control leasing arrangement involving leasehold improvements.

A reporting entity may apply the amendments related to Issues 1 and 2 either prospectively or retrospectively to the beginning of the period in which such entity initially adopted Topic 842 Leases. The available transition approaches differ for each issue. Reporting entities should consider establishing written terms and conditions for those common control leasing arrangements that involve unwritten terms and conditions.

Related party leases

Leasing arrangements between related parties may have terms that have not been negotiated, may not have been determined at arms-length, or may have been entered into for tax structuring or other purposes. Under the legacy lease accounting standard (Topic 840), related party leasing arrangements were accounted for on the basis of their economic substance. In contrast, a related party leasing arrangement under Topic 842 should be classified and accounted for on the basis of the legally enforceable contractual terms and conditions, and in the same manner as a lease with an unrelated party. However, determining whether a related party leasing arrangement is legally enforceable may be difficult and may necessitate additional evaluation.

The FASB has addressed the difficulty of determining whether the written terms and conditions of an arrangement between parties under common control (i.e., common control leasing arrangements) are legally enforceable in ASU 2023-01 (Issue 1 – discussed further below).

Overview of the practical expedient (Issue 1) – Lease identification

The practical expedient described in Issue 1 of ASU 2023-01 allows eligible entities to elect to use the written terms and conditions of a common control leasing arrangement to determine whether such arrangement is or contains a lease. When this practical expedient is elected, an entity determines whether the written terms and conditions of the common control leasing arrangement convey the practical (as opposed to legally enforceable) right to control the use of an identified asset for a period of time in exchange for consideration. We believe that a practical right to control is a lower threshold than one that is legally enforceable. Therefore, we generally expect the identification of a lease to be more straightforward when a reporting entity has elected and appropriately applies this practical expedient.

This practical expedient, however, is not available to common control arrangements that do not have written terms and conditions. If no written terms and conditions exist, an entity would assess whether the terms of the common control arrangement are legally enforceable when applying Topic 842 (i.e., apply the standard consistent with how it would be applied for arrangements between related parties not under common control). 

The second issue in ASU 2023-01 (Issue 2) addresses the amortization of leasehold improvements associated with common control leasing arrangements. Under Topic 842, leasehold improvements are evaluated to determine whether they represent a significant economic penalty that would result in a lessee being reasonably certain of exercising a renewal or purchase option (see our article on Lease Term for more information). Further, leasehold improvements should be amortized over the shorter of their remaining useful life and the respective remaining lease term, unless ownership of the underlying asset transfers or is reasonably certain of transferring (e.g., through purchase option exercise) to the lessee, in which case they should be amortized over their useful lives. It may be difficult, however, for a lessee to determine the lease term and leasehold improvement amortization period in a common control leasing arrangement. For example, a common control leasing arrangement may be structured such that its term renews monthly until canceled by either the lessee or lessor (these types of leases may be referred to as “evergreen”). In such a lease, the period over which the lessee should amortize leasehold improvements made to the leased property may not be clear given the discrepancy between the multi-year useful lives of such improvements and the month-to-month lease term. Issue 2 of ASU 2023-01 addresses this. 

Overview of the practical expedient (Issue 2) – Amortization of leasehold improvements

Leasehold improvements in common control leasing arrangements should be:

1. “Amortized by the lessee over the useful life of the leasehold improvements (regardless of the lease term) as long as the lessee controls the use of the leased asset through a lease,” as stated in the ASU. However, in situations in which an entity that has entered into a lease of an underlying asset from an unrelated third party (i.e., the head lease) and subleases such underlying asset to a reporting entity under common control, the amortization period of the related leasehold improvements should not exceed the lease term of the head lease with the unrelated party.
2. “Accounted for as a transfer between entities under common control through an adjustment to equity (or net assets for not-for-profit entities) if, and when, the lessee no longer controls the use of the underlying asset,” as stated in the ASU.

Leasehold improvements continue to be subject to the impairment guidance in Topic 360. Further, leasing arrangements between entities under common control should be reassessed if and when the parties thereto cease to be under common control and vice versa. Changes to the amortization period for leasehold improvements should be accounted for prospectively as a change in accounting estimate.

Disclosure – Topic 850

Reporting entities that have common control arrangements are subject to the disclosure requirements of Topic 842 Leases and Topic 850 Related Party Disclosures. The related party disclosure requirements were developed to address the fact that arrangements between related parties often are not consummated at arm’s length and, therefore, may not reflect the economic substance of those arrangements.