It's prevalent for construction firms to have common control leases, which refer to any leases between two entities under common control. Now that ASC 842 is in full effect for private companies, it's an excellent time to review the accounting rules regarding common control leases.
Under the prior lease accounting standard ASC 840, the existence of a lease was based on "economic substance;" if you paid to use an asset, you had an implicit lease, regardless of whether there was a formal agreement in place or legal implications in the transaction. The new standard, ASC 842, requires lessees to account for common control leases based on the lease's "legally enforceable terms and conditions," which has created problems for private companies whose common control leases lack formal documentation or legally enforceable terms and conditions.
ASU 2023-01: Amendments to Common Control Lease Accounting Provisions Under ASC 842
To help ease the adoption of the new lease accounting standard ASC 842, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update 2023– 01 ("ASU 2023-01"), Leases (Topic 842): Common Control Arrangements
in March of 2023, which amends some provisions of ASC 842 that apply to common control leases. The update offers private companies and nonprofits (that are not conduit debt obligors) a practical expedient allowing them to use the written terms and conditions of a common control arrangement to determine if a lease exists and its accounting treatment without considering the legal enforceability of the written terms and conditions. In instances where the terms of the arrangement are not in writing, companies may not use the practical expedient under ASU 2023-01. Instead, they'd apply the existing guidance to determine the arrangement's legally enforceable terms and conditions.
Note that written agreements are not always legal documents; they could be as simple as writing the terms and conditions on a napkin. The amendments in ASU 2023-01 related to transition indicate that entities may document any existing unwritten conditions and terms of a common control arrangement before the entity’s first annual (or interim, if applicable) financial statements are available to be issued. This option is only available in relation to transition and can not be used in periods after transition. The practical expedient ASU 2023-01 only applies to common control leases and can be used on a case-by-case basis.
Defining Common Control
While the FASB does not have an official definition of "common control," longstanding guidance from the Securities and Exchange Commission ("SEC") describes three situations where common control can be demonstrated:
- An individual or enterprise holds more than 50% of the voting ownership interest of each entity.
- Immediate family members hold more than 50% of the voting ownership interest of each entity (with no evidence that those family members will vote their shares in any way other than in concert). Immediate family members include a married couple and their children.
- A group of shareholders holds more than 50% of the voting ownership interest of each entity, and contemporaneous written evidence of an agreement to vote a majority of the entities' shares in concert exists. (Definition of "Common Control" in Relation to FASB Statement No. 141).
Accounting for Common Control Leases in the Construction Industry
Suppose a lessee has a written agreement to rent a crane on a month-to-month basis from a common control entity to construct a building expected to take two years to complete. The lessee decides to use the practical expedient under ASU 2023-01 and determines that a lease exists because the written terms and conditions of the agreement convey the practical right to control the use of the crane for a period of time. The lessee should account for and classify the lease based on the written terms and conditions, which state the lease is month-to-month, so the lease for the crane would not need to be included on the balance sheet as a right-of-use asset or lease liability.
If the lessee did not have this written agreement in place and they had to consider the legal enforceability of the written terms and conditions, it may be determined that the crane's lease term is not really month-to-month, but for the period of time the equipment will be used (in this case, two years). It would then need to be recognized as a right-of-use asset or lease liability on the lessee's balance sheet.
Misclassifying a common control arrangement under ASC 842
could result in a material misstatement on a company's financial statements, so it's critical to understand the accounting rules regarding common control leases. It can be concerning for construction firms to put additional liabilities on their balance sheets under the new lease accounting standard, so it's also crucial to have conversations with your bankers and bonding agents to discuss the effects of ASC 842 on your financial statements.