The Financial Accounting Standards Board is considering a change in its leases standard to address leases that are under the common control of related-party businesses as FASB's parent prepares to move headquarters within Norwalk, Connecticut, and there may be changes in federal accounting standards for leases as well.
During a meeting last week, FASB heard from its staff about feedback they had received on the application of the leasing standard to entities under common control.
The standard, often referred to as Topic 842 or ASC 842 for its place in FASB's Accounting Standards Codification, changed the classification and accounting requirements for related-party leases from the earlier leases standard, Topic 840. The new standard requires entities to classify and account related-party leases based on the legally enforceable terms and conditions of the arrangement, which is consistent with the requirements for leases between unrelated parties. In contrast, the earlier standard required that entities classify and account for related-party leases based on the economic substance of the arrangement as opposed to the arrangement's legally enforceable terms when terms of the transaction were significantly affected by the fact that the lessee and lessor are related. However, FASB has heard from its constituents that determining the economic substance of arrangements between related parties often wasn't practical because the terms and conditions, if any, between the parties may not consummated at arms-length and acknowledged that in certain situations (such as month-to-month arrangements), no legally enforceable terms and conditions exist. Some stakeholders from private companies told FASB's Private Company Council that determining the legally enforceable terms and conditions in related-party arrangements, particularly in arrangements between entities under common control, is complex, according to a
After the June meeting, FASB's staff did additional outreach to find out whether the complexities associated with applying the Topic 842 related-party requirements were for all related party arrangements or limited to those between entities under common control. Broadly, that outreach indicated that the complexities were most frequently associated with applying the requirements to common control arrangements.
"The staff's research indicates that practitioners have interpreted 'legally enforceable terms and conditions' as including written and oral terms — both explicit and implicit — when considering related party leases," said FASB. "Specific emphasis is given to considering whether implicit lessee renewal rights exist for purposes of determining the lease term, particularly when the lessee is (a) constructing significant leasehold improvements or (b) the underlying asset is integral to the lessee's operations (for example, a customized production facility)."
Private company stakeholders have consistently told FASB that arrangements between entities under common control often are unwritten or they lack sufficient details. For example, the agreements don't always explicitly specify whether lessee-controlled renewal options exist. They've also said the terms and conditions of the arrangements often are uneconomic and don't align with other related transactions or agreements. "In those cases, private company stakeholders are concerned that they are required to determine whether implicit legally enforceable terms and conditions exist, which may require legal counsel," said FASB. "Additionally, several practitioners indicated that there is 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 arrangements between entities under common control."
The differences in leasing practices are being seen in the real estate industry as well as the software industry.
"The guidance says for leases that are under common control the entity should account for that based on what is written in the legally enforceable contract," said Jennifer Booth, vice president of accounting at LeaseQuery, a provider of lease accounting software. "That makes sense for third parties because third parties are going to have their lease decisions in an enforceable contract signed by both parties, but we're finding for some of these related-party agreements that the terms and conditions may not be complete. There may be verbal contracts that have been incorporated and the entities are following, and there also may not be specific termination dates based on that, so we're seeing contracts that are just written month to month which historically was not at issue, but now if you're putting these contracts on your balance sheet, entities are needing to understand how long am I going to be using this property, what is the appropriate term of this lease, and that especially becomes complex if there were were significant leasehold improvements that were put out there. So you may have a month-to-month lease, but if you just put in a million dollars worth of leasehold improvements, that probably means you're going to use the lease for more than the just next month. That's what they're having to work through because if you were only going to use that lease for the next month, you would be expensing that million dollars' worth of leasehold improvements in this month — that's how this guidance reads — rather than if you're actually planning to stay in that facility for three years, you could then amortize that over three years, so it has significant accounting consequences for different entities."
FASB didn't make any decisions at the meeting, but the staff is going to keep doing more research.
"I think the approach that FASB is taking with regard to leases under common control is helpful," said Booth. "The fact that they are opening this topic back up does makes sense because we're seeing a number of private companies that have had questions about how to account for these arrangements, but I do like the fact that FASB is trying to continue to do education and outreach, especially since the standard as it's written has already been effective for public companies and some of the private companies have already adopted it."
The leases standards took effect for public companies for fiscal years beginning after Dec. 15, 2018, and for most other entities (mostly private companies and most not-for-profits) for fiscal years starting after Dec. 15, 2021. For those other entities, the leasing standard is applicable for interim periods within fiscal years beginning after Dec. 15, 2022.
Leasing myths
Even with the deadline fast approaching, Booth is finding that some private companies continue to delay implementation of the new standard, perhaps because of certain myths about leases:
Myth 5: "There's no difference between an operating lease and a finance/capital lease." It's important to understand the differentiating criteria between the types of leases on the balance sheet.
Myth 4: "We rented it. There's no lease." Many companies have equipment leases that they aren't tracking because they believe that if they rented the equipment, it doesn't count.
Myth 3: "All the leases are accounted for." Companies need to know where all their embedded leases are, and if there are their unaccounted-for service contracts in other departments.
Myth 2: "A month-to-month lease is different." After compiling a lease portfolio, it's crucial to understand which dates are pertinent and how they will affect lease accounting.
And the No. 1 myth when it comes to leases is: "Our company implemented ASC 842, so we're all done with lease accounting challenges." Companies have dynamic needs and finite resources. Increased lease modifications and terminations during the pandemic have shed light on the arduous processes any time there's a change in a contract.
"Sometimes there's the myth that all leases are on the balance sheet under 842 and it doesn't really matter what type it is, but the expense structures are different between an operating and a finance lease, and it's also really important when somebody is doing modifications that the accounting modifications differs depending on whether it's an operating or a finance lease," said Booth. "While all leases go on the balance sheet, it is still important to understand which classification you're in."
Change of address
FASB itself seems to be going through a change in location, with its parent organization, the Financial Accounting Foundation, saying Monday that it is moving to a new location in Norwalk, Connecticut, along with the staffs of both FASB and the Governmental Accounting Standards Board. The new offices are located at 801 Main Avenue in Norwalk. During a brief transition period, employees will work remotely, remaining fully available to stakeholders. All staff are expected to be working in the new office space by Monday, Oct. 3, 2022.
The FAF did not respond to a request for comment on the reason behind the move, but it may well be related to leases. During the pandemic, many companies have opted to downsize their office space while employees work remotely, as
FASAB leasing standards
The federal government may be modifying its lease accounting standards as well. Separately on Monday, the Federal Accounting Standards Advisory Board released an
Under intragovernmental leasehold reimbursable work agreements, one reporting entity (the provider-lessor) acquires, constructs, improves, and/or alters an underlying asset that is or will be leased to another reporting entity (the customer-lessee) and the customer-lessee agrees to reimburse the provider-lessor for direct and indirect costs for the acquisition, construction, improvement and/or alteration. These reimbursable costs are beyond what may be included in the tenant improvement allowances of the lease agreement for the related underlying asset.
"Staff received numerous technical inquiries and requests for Board action to clarify aspects of intragovernmental leases-related reimbursable work agreements," said FASAB executive director Monica R. Valentine in a statement Monday. "This proposal was developed by staff based on extensive walkthroughs and consultations with affected parties, including the Department of the Treasury and the General Services Administration. Staff encourages affected reporting entities and other interested parties to submit comments for consideration."
The proposal would require customer-lessees to recognize an intragovernmental reimbursable work asset for reimbursable acquisition, construction, improvement, and/or alteration costs (unless the leasehold improvement asset is recognized by the customer-lessee). Provider-lessors would recognize an intragovernmental unearned reimbursable work revenue liability for reimbursable acquisitions, construction, improvements, and/or alterations provided to the customer-lessee on a reimbursable basis (unless the leasehold improvement is recognized by the customer-lessee).
Accounting for the substance of these agreements inherently involves professional judgment in determining which reporting entity should report the leasehold improvement asset (or PP&E) — especially in situations when both parties are expected to derive economic benefits and services from the reimbursable work over the useful life of the resulting PP&E. The proposal would help reporting entities recognize the appropriate types of assets and liabilities embodied under these intragovernmental agreements in a similar manner.
FASAB is asking for comments on the exposure draft by Nov. 4, 2022.
