Short-term leases, component expedients and common control arrangements under ASU 2023-01

• Apply the short-term lease definition and the 842-20-25-2 exemption
• Explain the election to combine lease and nonlease components by asset class
• Apply the ASU 2023-01 written terms practical expedient to a common control lease
• Determine the amortization period for leasehold improvements in a common control lease

Short-term leases

A short-term lease is a lease that, at commencement, has a lease term of 12 months or less and does not include an option to purchase the asset that the lessee is reasonably certain to exercise. Under 842-20-25-2 a lessee may elect, by class of underlying asset, not to recognize an ROU asset and liability for short-term leases. Instead it recognizes payments on a straight-line basis over the term and variable payments when incurred.

The test uses the lease term, not the stated contract period. A 12-month equipment rental with a renewal option the lessee is reasonably certain to exercise has a lease term over 12 months and is not short-term. If the term or purchase option assessment later changes so that the remaining term extends more than 12 months beyond the previously determined end, the lease stops qualifying and is accounted for as if the change date were commencement (842-20-25-3).

Short-term lease cost is a required disclosure, excluding leases of one month or less (842-20-50-4).

Combining lease and nonlease components

Many contracts include services: common area maintenance in a building lease, or maintenance in an equipment lease. The default is to separate nonlease components and account for them under other Topics. Under 842-10-15-37 a lessee may elect, by class of underlying asset, not to separate them and instead account for the lease component and its associated nonlease components as one lease component. The election increases the liability when the service payments are fixed, because they join the lease payments. It is simpler for real estate.

Payments that reimburse the lessor's own costs as owner of the asset are not components at all, because they do not transfer a good or service separate from the right of use (842-10-15-30). Administrative tasks to set up the contract are not components either.

Common control arrangements: ASU 2023-01

Private companies often lease a building from an entity owned by the same shareholder. Topic 842 requires the lease to be classified and accounted for on the basis of legally enforceable terms, which for a handshake or loosely followed agreement can be hard to determine.

ASU 2023-01 Issue 1 gives a practical expedient to any entity that is not a public business entity, not a not-for-profit conduit bond obligor with securities traded on an exchange or over the counter, and not an employee benefit plan that files or furnishes statements with the SEC. An eligible entity may use the written terms and conditions of a common control arrangement to determine whether a lease exists and, if so, its classification and accounting (842-10-15-3A). The expedient is applied arrangement by arrangement. If no written terms exist, the entity cannot use it and must determine the enforceable terms.

ASU 2023-01 Issue 2 applies to all entities. Leasehold improvements in a common control lease are amortized by the lessee over their useful life to the common control group, regardless of the lease term, as long as the lessee controls the use of the asset through a lease. When the lessee stops controlling the asset, the remaining improvements are accounted for as a transfer between entities under common control through an adjustment to equity.

Both issues are effective for fiscal years beginning after December 15, 2023.

Audit points

• Confirm the short-term and combining elections by class, and check that each is disclosed.
• For short-term leases, test a sample for renewal options that make the lease term exceed 12 months.
• For related party leases, read the written agreement, compare it to how the parties actually behave, and evaluate disclosure under ASC 850. The related party questionnaire helps find unrecorded arrangements.

A shareholder-owned warehouse at Pinecrest Supply, Inc.