Related Party Leases Under ASC 842: Enforceable Terms, Common Control and Leasehold Improvements

The accounting for related party leases under ASC 842 rests on the legally enforceable terms and conditions of the lease, under 842-10-55-12. In each party's own financial statements, the lease is classified and accounted for like a lease between unrelated parties. There is one exception. Under 842-10-15-3A, an entity that is not a public business entity may use the written terms of a lease between entities under common control.

Accounting Standards Update (ASU) 2023-01 added that practical expedient. It also added a rule for leasehold improvements in common control leases, at 842-20-35-12A. The usual case is an owner who holds the building in one company and runs the business in another. This page follows that case through the books.

What terms does ASC 842 use for a lease between related parties?

The starting point is the same as for any contract. Under ASC 842-10-15-2 and 842-10-15-3, the question at inception is whether the contract conveys the right to control the use of an identified asset.

ASC 842-10-55-12 then says related party leases are classified "on the basis of the legally enforceable terms and conditions of the lease". The one carve-out in that paragraph is a common control lease that uses the expedient. This was a change from ASC 840. Under the old standard, a company looked past the paperwork to the deal's economic substance when the relationship had shaped the terms (ASU 2023-01, paragraph BC12).

On the books, the lease term and the payments come from the terms the parties could actually enforce. KPMG's Handbook says that turns on the law that governs the contract. Such terms can come from other agreements, from what was said, or from the way the parties usually do business.

ASC 842-10-55-23 ties the noncancelable period to the period for which the contract is enforceable. ASC 842-10-30-1 then adds any renewal period the lessee is reasonably certain to exercise. Those inputs drive the lease liability, and the right-of-use asset follows from it.

The plain-language overview of ASC 842 covers the basic model. For private companies, 842-10-65-1(b) made ASC 842 effective for fiscal years beginning after December 15, 2021, with interim periods a year later.

Why is "legally enforceable" hard to pin down when one owner controls both sides?

Because the same person sits on both sides of the table. In paragraph BC13 of ASU 2023-01, private company stakeholders noted that "a common owner or owners typically can amend the terms and conditions of an arrangement at any time". The owner can also choose not to enforce them. Paragraph BC14 adds that these leases are often unwritten or thin on detail, such as whether the tenant holds a renewal option.

The KPMG Handbook: Leases takes up the same problem in Question 6.2.50. Its view, for a company that has not elected the expedient, is that the enforceable terms of a common control lease typically do not reach outside the written contract. It then flags cases where the written term does not match the economics of the arrangement. Its example is a one-month lease beside a build-out meant to last for years.

There, KPMG says, "Involvement of qualified legal counsel may be necessary". Whether an unwritten understanding is enforceable is a legal question. The reasonably certain judgment that ASC 842-10-30-1 then calls for is an accounting one.

A written lease may say five years, while the business has sat in the building for twenty and will stay. The answer can move the lease liability by a large amount, as the example below shows.

Which companies can use the written terms of a common control lease instead?

ASC 842-10-15-3A gives the election to an entity that is not one of three types:

• A public business entity.
• A not-for-profit entity that has issued, or is a conduit bond obligor for, securities that are traded, listed or quoted on an exchange or an over-the-counter market.
• An employee benefit plan that files or furnishes financial statements with or to the Securities and Exchange Commission (SEC).

A typical private company is none of these. The test is whether the written terms convey "the practical (as opposed to enforceable) right to control the use of an identified asset". If a lease exists, the entity classifies and accounts for it on the same written terms. Three limits matter in practice.

• It is lease by lease. Paragraph 842-10-15-3A makes the election arrangement by arrangement.
• It needs something in writing. Under 842-10-15-3B, the expedient is not available when no written terms or conditions exist. The entity goes back to legally enforceable terms under 842-10-55-12.
• It covers common control only. Paragraph BC9 says the Board chose not to include other related party leases.

ASU 2023-01 does not define common control. In paragraph BC10 the Board pointed to the SEC staff's views in Emerging Issues Task Force (EITF) Issue No. 02-5 as one reference. Paragraph BC11 adds that the term should be read more broadly for private companies. Its example is an entity owned by a grandparent and another owned by a grandchild.

The Board also set no format for the writing. Paragraph BC22 leaves it to reasonable judgment how the terms are put in writing. Paragraph BC21 notes that the rest of ASC 842 still applies. The company still has to find the lease and nonlease components, for example.

One later event undoes the election. If the two entities stop being under common control, 842-10-15-3C puts a lease that goes on back onto its enforceable terms. If those differ from the written terms used before, the modification requirements in 842-10-25-9 through 842-10-25-17 apply.

How are leasehold improvements amortized in a common control lease?

The general rule is in 842-20-35-12. Leasehold improvements are amortized over "the shorter of the useful life of those leasehold improvements and the remaining lease term". The same paragraph has two exceptions: a lease that transfers ownership, and a purchase option the lessee is reasonably certain to exercise. Then the improvements run to the end of their useful life.

The general rule hit related party leases hardest when the lease term was short. A one-year lease term meant a one-year write-off, even for a build-out that would last fifteen.

ASU 2023-01 added 842-20-35-12A for leases between entities under common control. The improvements are amortized "over the useful life of those improvements to the common control group". That holds "as long as the lessee controls the use of the underlying asset through a lease". The lease term no longer caps the period.

One limit applies when the lessor itself leases the asset from a party outside the group. The period then cannot be longer than the group's own period under 842-20-35-12.

Item (b) of the paragraph covers the day the tenant leaves. The balance left is accounted for as "a transfer between entities under common control through an adjustment to equity". The whole remaining balance goes to equity, so nothing is left to run through earnings.

PwC's Leases guide, section 8.9, shows the same step. The lessee takes the rest of the balance off its books, and the other side of the entry goes to equity. Four more points complete the picture:

• It is not an election. The paragraph says "shall be". The summary of ASU 2023-01 says this part applies to all entities, public business entities included.
• Impairment still applies. ASC 842-20-35-12B points to the impairment requirements in 360-10-40-4, considering the useful life to the common control group.
• The improvements are not lease payments. ASC 842-10-30-6(d) keeps them out.
• Group changes are prospective. If the parties join or leave the same group after commencement, 842-20-35-12C treats a new amortization period as a change in accounting estimate.

What do the two treatments look like for an owner's building leased to the operating company?

The figures below are made up for this page. Every input is stated so the math can be checked.

• One owner holds 100% of Operating Co. and 100% of Realty LLC. Neither is a public business entity.
• Realty LLC leases a building to Operating Co. under a signed 60-month lease. Rent of $20,000 is due at the end of each month. The written lease has no renewal option.
• The discount rate is 6.00% per year, applied as 0.50% per month. The same rate is used for both lease terms, to show the effect of the term alone.
• There are no prepaid rent, lease incentives or initial direct costs. Under 842-20-30-5, the right-of-use asset at commencement then equals the lease liability.
• At commencement Operating Co. spends $600,000 on leasehold improvements it owns. Their useful life to the common control group is 15 years. Amortization is straight-line with no salvage value.

Assumed fact, for this example only: a legal review finds that an unwritten five-year renewal option is legally enforceable. Operating Co. is reasonably certain to exercise it. Under 842-10-30-1 that makes the lease term 120 months on enforceable terms. Nothing here suggests how such a review would come out on real facts.

ASC 842-20-30-1 measures the lease liability at the present value of the lease payments not yet paid. The present-value factor for 60 monthly payments at 0.50% is 51.72556075. For 120 payments it is 90.07345333.

The gap in the lease liability is $766,957.85. That amount is what turns on the legal question. With the expedient elected, Operating Co. books the signed lease and the question needs no answer.

The leasehold improvements are a separate matter. The lease is between entities under common control, so 842-20-35-12A applies whichever column is used above. The second table sets it beside the general rule, applied to the 60-month written term.

Under the common control rule, yearly expense is $80,000 lower for the first five years. At the end of year 1 the useful life to the group is longer than the lease term. That triggers 842-20-50-7A. The note shows an unamortized balance of $560,000, a remaining useful life of 14 years and a remaining lease term of 4 years.

When did ASU 2023-01 take effect, and how does a company move onto it?

Both parts are effective for fiscal years beginning after December 15, 2023, including interim periods within those years. ASC 842-10-65-7 covers the practical expedient, and 842-10-65-8 covers leasehold improvements. Early adoption was allowed for any period whose statements had not yet been made available for issuance. KPMG's Handbook gives January 1, 2024 as the date for a calendar-year entity that did not adopt early.

A company already on ASC 842 has two ways to apply the expedient under 842-10-65-7. The first is prospective, for leases that commence or are modified on or after the date of first application. The second is retrospective, to the start of the period in which the company first applied ASC 842. It does not reach leases no longer in place at adoption.

Paragraph 842-10-65-7(d) also gave a company time to put existing unwritten terms in writing. The cut-off was the date on which its first interim or annual financial statements were available to be issued.

For leasehold improvements, 842-10-65-8 gives that company three methods. Two are prospective: new improvements only, or new and existing ones. The third is retrospective, with the catch-up booked to opening retained earnings.

What goes in the related party note?

The expedient changes the measurement, not the disclosure. ASC 842-20-50-7 states that "A lessee shall disclose lease transactions between related parties in accordance with paragraphs 850-10-50-1 through 50-6." Those paragraphs sit in Topic 850, Related Party Disclosures. The lessor has a matching duty under 842-30-50-4.

In paragraph BC17 the Board tied the two together. It concluded that the expedient, coupled with the Topic 850 disclosures, should give users enough to analyze common control leases. The written terms alone do not give users that context. The disclosure note does.

Where the useful life of leasehold improvements to the common control group is longer than the lease term, 842-20-50-7A adds three items:

• The unamortized balance of the leasehold improvements at the balance sheet date.
• The remaining useful life of the improvements to the common control group.
• The remaining lease term.

The general lease disclosures still apply as well. The ASC 842 disclosure requirements article lists them.

The papers an auditor asks for follow from the rules above. They are the signed lease, a record of which leases use the expedient, and support for the useful life to the group. That list is part of a wider lease accounting control framework. The complete ASC 842 guide places these rules within the full standard.

Frequently asked questions

Can a private company use the written lease for a building it rents from its owner?

Yes, if the two entities are under common control and the terms are in writing. ASC 842-10-15-3A lets an entity use the written terms of the lease, one lease at a time. Those terms decide whether a lease exists, how it is classified and how it is accounted for. Three kinds of entity are shut out: public business entities, not-for-profit entities that have issued, or are conduit bond obligors for, traded securities, and benefit plans that file with the SEC.

What if the lease between two commonly owned companies was never written down?

Then the practical expedient is not open for that lease. ASC 842-10-15-3B sends the company back to the general rule. It decides whether a lease exists under 842-10-15-3. It then classifies and accounts for the lease on its legally enforceable terms and conditions, under 842-10-55-12.

Sources and further reading

• KPMG Handbook: Leases. It reproduces the Codification paragraphs quoted here. The KPMG views used are in Question 6.2.50 and section 13A.3.4.
• PwC Leases guide, section 8.9, Leasehold improvements. The source of the derecognition step described above.
• FASB Accounting Standards Update No. 2023-01, Leases (Topic 842): Common Control Arrangements. The source of the summary and of paragraphs BC9 through BC22.
• Deloitte Roadmap: Leases, section 13.2, Related-Party Leases.
• Deloitte Heads Up, FASB Issues Guidance on Common-Control Lease Arrangements (March 28, 2023).

Explore how iLeasePro can streamline your lease portfolio management!

Tour of iLeasePro

Schedule a Demo

Check Out Knowledge Base

If this guide proved beneficial, please share it with fellow colleagues or bookmark it for future reference. Keep an eye out for more deep dives into the intricate world of lease accounting and corporate taxes and how the ASC 842 Lease Accounting Standard impacts them.