It is common practice for manufacturers and other companies to have related party leases, oftentimes leasing facilities from separate lessor entities with common ownership. As your organization continues to work through the implementation of the new lease standard, ASC 842, it is important to understand the areas which have caused some confusion with regard to the impact this new guidance has on related party leases. On the one hand, when related party leases are included within consolidated financial statements, ASC 842 essentially has no impact on the balance sheet as the right of use asset and lease liability are eliminated. On the other hand, thanks to ASU 2014-07, there are many such arrangements that do not get consolidated into one set of financial statements. In those cases, misclassifying a related party transaction as a lease when it does not fit the new definition of a lease or using the wrong lease term in your implementation of ASC 842 may result in a material misstatement on your financial statements.
The FASB has acknowledged that they intended to simplify the accounting for related party leases through the new lease standard, ASC 842. There seems to be a general consensus that they fell short of this goal, since, as the AICPA’s Center for Plain English Accounting so aptly put it: “in essence regarding related party leases, one form of complexity (economic substance) has been exchanged for another form of complexity (implied or unwritten legally enforceable terms and conditions).”
Economic Substance vs. Legally Enforceable Terms and Conditions
The former standard on when a lease existed was based on whether or not there was “economic substance.” Essentially if you were paying for the use of the asset then there was at least an implicit lease regardless of whether or not there was a formal lease agreement in place or there were any legal implications in the transaction. Or put another way, ASC 840’s determination of whether a lease existed was driven by substance over form.
The new standard changed this significantly, resulting in the potential for some related party transactions which qualified as leases under ASC 840 to no longer be leases under ASC 842. Under ASC 842, related party leases should be accounted for based on “legally enforceable terms and conditions.” While the standard is clear that this threshold can be met through implied or unwritten legally enforceable terms and conditions, the best solution is to have your related party lease formalized in a contract with an enforceable lease term and termination options.
As you draft lease agreements with your related parties, keep in mind that the mere existence of a contract does not necessarily mean there are legally enforceable terms and conditions under the guidance of ASC 842. A lease contract is not considered enforceable if both the lessee and the lessor can terminate the lease without permission from the other party with no more than an insignificant penalty.
Similar to other lease agreements, your related party lease may include renewal options which is relevant as you determine the value of your right of use asset to put on your organization’s balance sheet. The longer the term of your lease, the larger the right of use asset and lease liability. The threshold as defined in ASC 842 for determining your lease term when renewal options exist is whether the renewal term is “reasonably certain to be exercised.” There are a few things to consider when trying to make this determination:
- What is management’s intent with regard to renewing the lease for one or more terms?
- Do you have a history of exercising renewal terms in lease contracts?
- Do your forecasts and estimates include the assumption that you will renew the lease?
- Is there economic incentive to exercise the renewal?
Quick example – Let’s say you have a lease agreement with a related party to lease a facility for 3 years, at which point you have the option to renew for 2-year increments. Additionally, you made significant leasehold improvements to the facility which you’re determining have useful lives of 7 years. In this scenario, you likely have economic incentive to exercise the renewal since you invested a significant amount of money in leasehold improvements which after the initial 3 year term are not even halfway into their useful lives. If that’s the case, you would determine your right of use asset and lease liability based on a lease term of at least 7 years, more than doubling the impact to your balance sheet than if you assumed no renewals.
If you have questions about the new lease standard or any of the information outlined above, McKonly & Asbury’s experienced professionals are here to help. Please contact us or visit our website to watch our webinar titled “ASC 842 Leases: Moving Forward and Implementation.”