Financial statement preparers, including personnel across many departments (i.e., management, accounting, procurement, and IT), have been challenged with understanding the impact of the changes in accounting for leases under the Federal Accounting Standards Board’s (FASB’s) new guidance.
Accounting for related-party leases was based on the substance of the arrangement (substance over form) under the previous guidance of Accounting Standards Codification (ASC) 840. However, under the new guidance of ASC 842, it is based on legally enforceable terms and conditions (form over substance).
While the new guidance is form over substance, that doesn’t mean judgment goes by the wayside. Since ASC 842 requires that all leases, including related-party leases, are based on the lease’s legally enforceable terms and conditions (ASC 842-10-55-12), the lack of documentation common with related-party leases can be problematic.
This article provides some insight into the requirements of a lease arrangement and examples of a few common arrangements along with the related scoping considerations. This represents a practical approach and reflects FASB’s desire to make it more practical, less complicated, and more meaningful to financial statement users.
Determining a Lease
With the emphasis on legally enforceable terms and conditions in ASC 842, there is the potential that some related-party transactions that previously qualified as leasing arrangements under ASC 840 will no longer be leases under ASC 842.
Also, having documentation is not necessarily going to be enough — especially when considering the legally enforceable terms and conditions component of this standard. Therefore, just because you have a signed contact between all parties does not mean that you have legally enforceable terms and conditions.
For instance, a lease contract is not considered enforceable if both the lessee and lessor can terminate the lease without permission from the other party with no more than an insignificant penalty.
As a reminder, a lease exists when a contract, or part of a contract, conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Additionally, a period of time is described by FASB as the total period of time that an asset is used to fulfill a contract with a customer. Disclosure requirements for related-party transactions, including leases, are to be in accordance with paragraphs 1-6 of ASC 850-10-50.
Entities must determine at contract inception whether a contract is or contains a lease by assessing whether, throughout the period of use, the lessee has the right to direct an asset’s use and substantially obtain all the economic benefits from directing its use.
Month-to-Month Leasing Arrangements & Renewal Options
It’s common in related party transactions for the lease terms to be month to month. Unfortunately, month-to-month leasing arrangements between entities and related parties are not scoped out of ASC 842 and will still require entities to analyze or evaluate the legally enforceable terms and conditions.
Generally, month-to-month lease terms that are implied or specifically stated in the contract are not factored into the considerations of a related-party lease, as it would be reasonably certain that the lease would be renewed or extended. The following are some other considerations when evaluating extensions or renewal options:
- What are the entities’ intentions with regard to renewing the lease for one or more terms?
- What are the entities’ histories of exercising renewal terms in lease contracts?
- Do the entities’ forecasts and estimates include the assumption that the lease will renew?
- Is there economic incentive to exercise the renewal?
Let’s look at some potential scenarios to determine if a lease arrangement exists under the new guidance.