By Ane Ohm on May 28, 2019 at 6:45 AM
Update March 27, 2023:
The first amendment in this update allows for private and certain not-for-profit entities to use the written terms of the related party arrangement to determine if a lease exists and if so, the classification and accounting for the lease. Prior to issuance of this ASU, organizations were seeking outside counsel to determine what is legally enforceable, which was costly. This practical expedient is expected to reduce costs and can be applied on an arrangement-by-arrangement basis.
The second amendment requires that leasehold improvements for related party leases be amortized by the lessee over the useful life of the improvement as long as the lessee controls the use of the asset.
Both amendments are effective for fiscal years beginning after 12/15/23 with early adoption permitted.
Important note: This is a judgment-based standard, which means there are few hard-and-fast rules and the treatment of your leases will depend on your unique situation. It's important that you always double-check decisions with an accounting professional who knows your circumstances. This blog should not be considered, or take the place of, professional advice or services.
This month, we’re bringing back industry expert John Hepp to discuss related party leases. John is a retired partner from Grant Thornton and a former FASB project manager. He holds a PhD from the University of Wisconsin-Madison and is currently on the faculty at the University of Illinois at Urbana-Champaign.
With John’s help, this blog will examine leases between related parties, specifically the lease term that should be booked.
FASB was very clear
Unlike some other topics related to the new lease standard that are somewhat ambiguous and require judgment, FASB was very clear on their stance regarding lease terms for related parties.
John shared: “Related party leases may be undocumented or at conditions that differ from an arm’s length market transaction. The FASB made an outright decision that they were not going to ask accountants to try to determine the economic substance of the arrangement, or how the lease compared to market terms, even if the arrangement is a sale and leaseback. Just account for the lease according to the enforceable terms and conditions.”
Of course, the related party disclosures in ASC 850 still apply.
Applying to the balance sheet
As we know, a related party lease may or may not have renewal terms. The length and number of renewal terms make a big difference in recording the right-of-use asset and lease liability, and some judgment is required to determine the lease term to book. When determining the lease term of a related party lease, apply the same logic that you would use for all leases.
The deciding factor is economic incentive. If you spent a lot of money on improvements or would need a lot of time to find a new location, there is an economic incentive to stay longer, in which case you should consider renewal periods when recording the lease.
John shared this example: “For a one-year lease of a manufacturing plant with annual renewal options, obtaining zoning and building permits for a new site could take five years, and they can’t just shut down the business in the meantime. So if it’s an essential asset for the business and difficult to replace, I would start with three renewal terms and go north from there.”
On the other hand: “For something like generic office space, leasing a new facility and relocating may be uncomplicated and inexpensive. You could make a case for recording a one-year lease term without the renewal periods.”
The new lease standard has many intricacies and complexities, prompting questions from novices and experts alike. Here are some past blogs we’ve done on specific topics related to the new lease standard:
- Embedded leases
- Common area maintenance
- Why equity isn’t affected
- Lease and nonlease components
- Lease classification
Curious about LeaseCrunch®? Check out this case study of how LeaseCrunch® helped a bank vastly simplify the implementation of the new lease standard.