Related Party Leases

Click here and check out the Sikich Lessee Ledger tool

Leasing transactions with related parties are common among privately held companies for various reasons – including tax, estate planning and legal liability. So much so that the FASB provides a GAAP alternative for applying Variable Interest Entity (VIE) guidance to common control leasing arrangements under ASC Topic 810. The alternative, available since 2014, allows private companies to avoid applying the VIE guidance to lessor entities under certain conditions. Private companies may wonder then if a similar alternative is available for lease accounting under the new ASC Topic 842. The answer, unfortunately, is no.

Background

ASC 842-10-55-12 states:

“Leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. In the separate financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties.”

Ultimately, this means that leases with related parties are handled no differently than leases with unrelated parties.

In the Basis for Conclusions in ASU 2016-02 (which created ASC Topic 842), the FASB acknowledges that some related party leases are not documented, and the terms and conditions may not be at arm’s length. Entities were previously required to account for leases with related parties based on the economic substance of the arrangement under ASC Topic 840. However, this is difficult to carry out under ASC Topic 842, as there may not be specifically stated legally enforceable terms or conditions – such as with month-to-month leases or leasing arrangements with payments dependent on cash availability.

As such, the FASB noted that it might not only be difficult and costly to apply the recognition and measurement guidance under ASC Topic 842 in these situations, but that the resulting information often is not useful to users of financial statements in these situations.

While the FASB expects related party lessees and lessors to apply the guidance in ASC Topic 842 to all leases, it acknowledges there are circumstances when this will not be the case, due to the lack of legally enforceable terms and conditions. Entities, however, must still comply with the disclosure requirements under ASC Topic 850, Related Party Disclosures. These disclosures provide information necessary to understand the nature of those related party leasing arrangements that are not recognized and measured on the balance sheet.

How to determine if there are legally enforceable terms and conditions

For related party arrangements, this may be more difficult. Lease contracts can be made verbally, and lease terms may be explicit or implicit outside of a formal lease contract. It would not be appropriate to ignore facts and circumstances simply because the terms are not formally enumerated in a lease contract, since unwritten terms can create enforceable rights and obligations. Additionally, other agreements between related parties, such as management or operating agreements, may create enforceable rights and obligations related to leases without specifically contemplating those leases. Some situations might require consultation with an entity’s legal counsel to make this determination.

Amortization of leasehold improvements

The existence of leasehold improvements in related party leasing arrangements may provide an indication of legally enforceable rights and obligations, absent a formal contract. For entities under common control, decisions about leasing and leasehold improvements often involve owner(s) and manager(s) of both entities, possibly indicating an agreement to continue the leasing arrangement until the cost of the leasehold improvement has been recovered (e.g. fully amortized). Companies will need to consider the amortization period for leasehold improvements in relation to the lease term. 

The amortization period for leasehold improvements depends on whether ownership of the leased asset transfers to the lessee at the end of the lease term or the lessee is reasonably certain to exercise an option to purchase the leased asset. If either of those conditions is met, the leasehold improvement should be amortized over its useful life. In other lease arrangements, a leasehold improvement should be amortized over the shorter of its useful life or the remaining lease term. It may be inconsistent (or worse, misleading) to conclude the amortization period for a leasehold improvement exceeds the related lease term for application of the guidance under ASC Topic 842.

Be Prepared

Companies need to recognize and measure related party leases based on legally enforceable terms and conditions. Related parties do not need to infer terms and conditions based on economic substance. However, it is important to consider all facts and circumstances that may create legally enforceable rights and obligations, such as the existence of leasehold improvements. Legal counsel may need to be consulted on these assessments.

For more information or if you have questions about related party leases, please contact our team.

Abbreviations to note:

Financial Accounting Standards Board (FASB)

Accounting Standards Codification (ASC)

Generally Accepted Accounting Principles (GAAP)

Accounting Standards Update (ASU)

FIND MORE RESOURCES ON LEASES HERE