As the Financial Accounting Standards Board (FASB) makes changes to lease accounting rules for private companies and nonprofits yet again, we’re here to clear up a few things. Phillip Hann, senior manager at 415 Group, breaks down the highlights and provides guidelines for implementation.
Accounting Standards Codification Topic 842 (“Topic 842”), Leases, requires organizations to report the full magnitude of all their long-term lease obligations on their balance sheets — an historic first. For private companies and nonprofits, the changes take effect this year. Public entities adopted the rules in 2019.
A major issue that has surfaced relates to leases under common control. In a surprise move, the FASB voted on September 21 to propose changes to address stakeholder concerns.
Practical expedient for related-party leases
Topic 842 requires an organization to account for a lease that’s under common control on the basis of the legally enforceable provisions. Problems arose for private companies because some don’t have formal written documentation of related-party leases. As a result, there is uncertainty about what’s “legally enforceable.”
FASB members unanimously agreed to propose a practical expedient for private entities to simplify the guidance for determining whether a lease exists for arrangements between entities under common control. A practical expedient is an accounting workaround with a simpler approach to arriving at the same answer as the initial rule.
The proposal specifies that entities would only consider the written terms and conditions when determining whether a lease exists, its classification and the accounting for that lease. Entities wouldn’t be required to determine whether those written terms and conditions are legally enforceable. Moreover, if no written terms and conditions exist, an entity would apply Topic 842 to any verbal or implicit terms and conditions. If no lease exists, other rules would apply.
Clarity on leasehold improvements
An ancillary affiliated issue that came up during the FASB’s review of Topic 842 is how to handle the treatment of leasehold improvements when there’s a verbal related-party lease. In many cases, the life of the related-party lease could substantially differ from the actual life of the underlying lease asset.
The term “leasehold improvement” generally refers to changes, buildouts or upgrades to real property made by a commercial tenant. For example, you might update or build out a space.
FASB members voted 4-3 to propose an amendment to Topic 842 that would specify that leasehold improvements associated with leases between entities under common control be “amortized by the lessee over the useful life of the improvements (regardless of the lease term) as long as the lessee continues to use the underlying asset.” If the lessee stops using the leased asset, it would then be “accounted for as a transfer between entities under common control.”
To be clear, if approved, this change would apply to both public and private entities. Public companies already implemented the updated standard in 2019.
It’s important to note that three FASB members dissented to proposing changes to leasehold improvement rules. The dissenters said that they didn’t have enough information to vote to propose changes for public companies and were uncertain about any secondary or indirect implications of the proposal. The members who were in favor of the proposal indicated that public companies would largely be unaffected by the changes. Their leases tend to be arm’s length, written agreements, regardless of whether the lessors are third parties or under common control.
Stay tuned
Since the updated lease guidance was issued in 2016, it has been deferred twice and amended five times. After these two last-minute proposals were issued, a comment period was open through January 16, 2023. In the meantime, private organizations must continue pushing forward with adopting the updated guidance for 2022.
Contact us for help adopting the changes, including any amendments for leases under common control.
© 2023
Public companies have adjusted to the new lease accounting rules over the past few years. Now, it’s time for private companies and nonprofits to catch up.
The new rules reformat financial statements in a major way. Organizations will now have to include certain operating leases – and their future liabilities – on their balance sheet. Some people see this change as a negative in creating more work for companies with not a lot of advantages.
On the other hand, some companies might find the changes beneficial. When you list any future outflow of cash as a liability, you’ll get a clearer snapshot of potential cash deployment. This can help your company better plan and prepare for any curveballs.
At 415 Group, we understand the lift it takes for organizations to make this change. That’s why we created a new internal team to focus on these lease accounting rules and related implementation. This cross-functional team of tax, audit, and administration experts have been learning and training for nearly ten months. We’ve already begun helping clients implement the changes needed using a specialized software.
If you’re panicking about incorporating all of your lease information into your financial statements, first take a deep breath. Then, review our recommendations:
FASB’s lease guidance details are very nuanced. You’ll need some help getting through all of it, so it’s smart to work with a trusted partner like 415 Group. Our team stays up to date on the ever-changing rules and regulations and soaks up all of the little details. We’ll help you through the process and properly implement everything. If you’re ready to get started, reach out to us today.