NetLease - Related-Party Leases

FASB’s Proposed Changes to Related-Party Lease Accounting Guidance 

 Under the current GAAP framework, companies are required to determine the legal enforceability of the terms and conditions for related-party leases. Private company stakeholders and practitioners have notified the FASB that this analysis is difficult in practice and being applied with varying levels of diligence. As a result, the FASB has recently voted to issue a proposal to amend the required procedures for analyzing related-party transactions. 

The FASB has tentatively decided to allow companies to elect a practical expedient to avoid determining the legal enforceability of written terms and conditions for leases between related parties:

For arrangements between entities under common control, the Board decided to amend Topic 842, Leases, to provide entities within the scope of paragraph 842-10-65-1(b) (that is, entities that are not public business entities, not-for-profit bond obligors, or employee benefit plans that file or furnish financial statements with or to the U.S. Securities and Exchange Commission) a practical expedient to use written terms and conditions for:

  1. Determining whether a lease exists and, if so,
  2. The classification and accounting for that lease.

An entity applying the practical expedient would not be required to determine whether those written terms and conditions are legally enforceable. If no written terms and conditions exist, an entity would apply Topic 842 on the basis of the legally enforceable terms of an arrangement. If an entity determines that a lease does not exist, other GAAP would apply. The Board also decided that the practical expedient could be applied on an arrangement-by-arrangement basis.

This practical expedient is not intended to provide a loophole for unwritten or implicit terms and conditions, however. As one FASB board member stated “If no written terms and conditions exist, an entity would apply the existing topic 842 requirements to any verbal or implicit terms and conditions. That is, entities would use legally enforceable oral and implicit terms to determine if a lease exists, and if so, to classify and account for the lease. If an entity concluded that a lease did not exist, other GAAP would apply.” Based on comments from the board members during the meeting, the board’s official release of this practical expedient is likely to include language addressing the ability for companies to retroactively document these arrangements as of the transition date to ASC 842. 

We still believe the best practice is to get all related-party arrangements into writing to avoid determining if a verbal agreement is legally enforceable. Once an agreement is documented, the written terms and conditions can be taken at face value, with no legal enforceability analysis required.


The FASB is also expected to include updates to the accounting for leasehold improvements associated with related-party leases:

The Board decided to amend Topic 842 for all entities with leases between entities under common control to specify that a lessee should account for associated leasehold improvements as follows:

  1. Amortize leasehold improvements over the economic life of the improvements as long as the lessee continues to use the underlying asset. If the lessor obtained the underlying asset through a lease with an entity not under common control, the economic life over which the leasehold improvements are amortized by the lessee should not exceed the lease term associated with the lessor’s lease with the entity not under common control.
  2. Account for any remaining leasehold improvements as a transfer between entities under common control if, and when, the lessee ceases using the underlying asset.

The Board decided that a lessee should disclose information about leases in which the economic life of the leasehold improvements is longer than the lease term.

The FASB intends to issue the proposed ASU in the fourth quarter of 2022, with a 45-day comment period. We will keep you updated as the changes are finalized. 


Current Guidance (before proposed ASU)

In general, if the arrangement allows Lessee or Lessor to terminate without permission from the other party with no more than an insignificant penalty, the arrangement is not enforceable and would not need to be recognized under ASC 842

Under ASC 842: only the legally enforceable terms of the lease are to be considered

-Lack of documentation can be challenging

-Determining legal enforceability can be challenging

-Continue to apply ASC 850, Related Party Disclosures 

-Legal counsel may be required to evaluate legal obligations


Implied lease term:

-Consider intent: the Lessee intends to continue renewing the lease, and past actions support that conclusion

-Consider economic incentives

  • Specialized asset
  • Unique location
  • Other economic factors


Example (AICPA / Center for Plain English Accounting):

Lessee leases equipment from related party Lessor - it is an oral, month-to-month arrangement and has been in existence for some years and is expected to continue for many additional years. 

Analysis: 

  1. Determine that the arrangement creates enforceable rights and obligations and does meet the definition of a lease contract
  2. Identify renewal and termination options exercisable by the Lessee and Lessor
  3. Determine lease term

Determine that the arrangement creates enforceable rights and obligations and does meet the definition of a lease contract:

  • Consider the laws in the relevant jurisdiction and legal counsel 
  • If the arrangement allows Lessee or Lessor to terminate without permission from the other party with no more than an insignificant penalty, the arrangement is not enforceable, and FASB ASC 842 recognition and measurement would not apply
  • May still have disclosure under FASB ASC 842 

Identify renewal and termination options:

  • An option to renew the lease each month exists and may be exercisable by either or both parties, depending on the nature of the contract
  • The contract may contain termination options exercisable by either the Lessee or Lessor; however, as indicated above, if the arrangement allows both the Lessee and Lessor to terminate the lease without permission from the other party with no more than an insignificant penalty, the arrangement is not enforceable.

Determine lease term:

  • Consider intent based on past practices
    • The Lessee would likely conclude that its intent is to continue renewing the lease, and past practice reinforces that conclusion -- But for how long? How many renewal options are reasonably expected to be exercised that will need to be estimated?
  • Consider economic incentives
    • The Lessee would consider the contract-, asset-, entity- and market-based factors to determine whether the options are reasonably certain of being exercised

 

Summary of Differing Big 4 Views: 

View A- All legally enforceable explicit and implicit terms should be considered. View is based on plain language of FASB ASC 842-10-55-12 

View B- Consider implied legally enforceable terms if the written contract (explicit terms) do not align with other transactions/agreements (example- leasehold improvements) or if written contract (explicit terms) are “uneconomic” -- View is based on FASB intent to simplify accounting in this area (BC 374) while acknowledging plain language of FASB ASC 842-10- 55-12 

View C- Consider only explicit terms (written contract). View is based on intent to simplify accounting in this area (BC 374) and disclosures are required for related party transactions which could address implied terms (VIEW IS NOT ADVISED)


DELOITTE:

The accounting for a lease depends on the enforceable rights and obligations of each party as a result of the contract. This principle applies irrespective of whether such rights or obligations are included in the contract or explicitly or implicitly provided outside of the contract (i.e., there may be enforceable rights or obligations that extend beyond the written lease contract). 

While it is clear that the FASB wanted to minimize the cost and complexity of the accounting for leases between parties under common control by limiting the application of the guidance in ASC 842 to rights and obligations that are enforceable (i.e., the parties would not impute any terms or otherwise be required to deviate from the enforceable terms to reflect the substance of the arrangement), we do not think that it would be appropriate to ignore any facts and circumstances related to rights and obligations outside of a lease contract. That is, terms and conditions not written in an agreement or that are included in contracts separate and apart from the lease contract may create enforceable rights and obligations for the parties subject to the lease 

For example, while the term of an arrangement may be explicitly limited to six months, factors outside the contract may indicate that the term is longer. The determination of whether terms and conditions not written in a lease agreement create enforceable rights and obligations to the parties subject to the lease involves judgment and, in some cases, may involve legal questions that should be evaluated with the assistance of legal counsel. 

KPMG: 

While an entity should generally consider that the enforceable rights and obligations of the parties may extend beyond those written into the contract, in the case of a lease between parties under common control, we believe it was the Board’s intent to significantly simplify the accounting for such leases by following easily identifiable terms and conditions. Identifying enforceable rights and obligations not included in a written contract may be extremely difficult in a lease between parties under common control because of the related party nature of the arrangement. 

Therefore, while we acknowledge that looking only to the written terms of a lease between two parties under common control is inconsistent with looking to the enforceable rights and obligations of the entities more broadly in other scenarios, we believe this is consistent with the intent of the Board when establishing the related party leasing requirements in Topic 842. [ASU 2016-02.BC374] 

That said, if the written contract (including if there is no written contract) does not align with other related transactions or agreements – e.g., a one month written lease term but the lessee is constructing significant leasehold improvements with an economic life much longer than the written lease term – it should be considered whether there is an unwritten contract or understanding. Involvement of qualified legal counsel may be necessary to determine if an unwritten contract or understanding creates enforceable rights and obligations on the parties. 

PWC:

 The lessee and lessor should look only to legally enforceable rights when classifying the lease. In identifying the legally enforceable rights, it would be reasonable to start with a review of the written contract. However, due to the relationship between the two parties, the legal lease provisions in the written contract may be uneconomic or a detailed contract may not exist at all. If this is the case, it would be helpful to involve legal counsel to understand if there are legal rights that exist outside of a written contract. For example, within office space leased from a related party under a nonrenewable, one-year managed service arrangement, a lessee may install leasehold improvements with an economic life of five years. This may indicate that the lessee expects to use the space longer than the one-year lease term and therefore the written contract terms of the arrangement may be considered uneconomic. Furthermore, that may be a reasonable expectation given that management of the lessee and lessor often include the same decision makers. Therefore, in this case it could be helpful to involve legal counsel. 

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