Accounting for Leasehold Improvements for Discretely Presented Component Units

The Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2023-01, Leases (Topic 842), Common Control Arrangements, requires leasehold improvements related to a lease agreement between entities under common control to be amortized over the useful life of the leasehold improvement. Before this rule, leasehold improvements were to be amortized over the shorter of the remaining lease term or its useful life. The relationship between a primary government and its discretely presented component units is similar to the relationship among companies within common control, therefore the new accounting rule for amortizing leasehold improvements could be applicable to leases between a primary government and its discretely presented component units. The Governmental Accounting Standards Board (GASB) has yet to clarify the issue.

FASB Guidance on Leases

Topic 842, Leases, generally requires leasehold improvements to be amortized over the shorter of the remaining lease term or the useful life of the improvements, which is an approach that is largely consistent with legacy guidance. Lessees recognize leasehold improvements when they are the accounting owner of those improvements.

The FASB received comments regarding amortizing leasehold improvements associated with arrangements between entities under common control over a period shorter than the expected useful life of the leasehold improvements. Some felt this could result in financial reporting that does not faithfully represent the economics of the leasehold improvements:

• The lessee will continue to control the use of the lease asset after the initial lease term, either by extending the existing lease or entering into a new lease. Unlike transactions involving entities that are not under common control, the decision for that continued use often is controlled by a single party in the control group.
• Leasehold improvements will benefit another part within the common control group after the lessee ceases using the leased asset.

In response to the stakeholders’ concerns and to reduce the potential for diversity in practice, the FASB issued ASU 2023-01. The new accounting requirements for leasehold improvements associated with common control leases are as follows:

• The leasehold improvement should be amortized by the lessee over the useful life of the leasehold improvements to the common control group (regardless of the lease term), as long as the lessee controls the use of the underlying asset (the leased asset) through a lease. However, if the lessor obtained the right to control the use of the underlying asset through a lease with another entity not within the same common control group, the amortization period may not exceed the amortization period of the common control group.
• A transfer between entities under common control should be accounted for through an adjustment to equity (or net assets for not-for-profits) if, and when, the lessee no longer controls the use of the underlying asset.

Entities adopting this ASU are required to apply the amendments using the following methods:

• Prospectively to all new leasehold improvements recognized on or after the date that the entity first applies the amendments in this ASU.
• Prospectively to all new and existing leasehold improvements recognized on or after the date that the entity first applies the ASU’s amendments, with any remaining unamortized balance of existing leasehold improvements amortized over their remaining useful life to the common control group determined at that date.
• Retrospectively to the beginning of the period in which the entity first applied ASU 2023-01, with any leasehold improvements that otherwise would not have been amortized or impaired recognized through a cumulative-effect adjustment to the opening balance of retained earnings (or net assets of a not-for-profit entity) at the beginning of the earliest period presented in accordance with ASU 2023-01.

Conclusion

FASB’s new ASU is applicable only to lease agreements between companies under common control. However, for state and local governments, a component unit is determined based on several criteria established by GASB Statement No. 14, The Financial Reporting Entity. GASB Statement No. 14 defines a component unit as a legally separate organization for which the elected officials of the primary government are financially accountable. A primary government is financially accountable if it appoints a voting majority of a legally separate organization and it can impose its will on that organization or there is a potential for the organization to provide specific financial benefits to, or impose specific financial burdens on, the primary government. 

GASB Statement No. 87, Leases, states that lease arrangements between the primary government and discretely presented component units (or between discretely presented component units) should be treated in the same manner as any other lease arrangement with a legally separated entity. However, related receivables and payables should not be combined with other amounts due to, or due from, discretely presented component units or with lease receivables and payables with organizations outside the reporting entity.

GASB did not provide any guidelines on the accounting and amortization issues related to leasehold improvements that were developed by a component unit within the primary government’s reporting entity. GASB just mentioned the leasehold improvement in a discussion of whether a leasehold improvement paid by the lessor should be considered a lease incentive. GASB concluded that leasehold improvement paid by the lessor on behalf of the lessee is an example of lease incentive, as it provides additional assets to the lessee without additional cost.

A lease agreement between a primary government and its component unit is treated like any lease agreement with a third party. A primary government would not approve leasehold improvement to be invested by the component unit unless the economic benefits of these improvements are achievable by the component unit over the useful life of the leasehold improvement. Most likely, both the primary government and the component unit will work together to ensure the lease contract exceeds or equals the useful life of the leasehold improvement. The economic and rational factors of the decision-making process for government operations would guide government officials to extend the lease term to allow a component unit to use the leasehold improvement all the way until the end of its useful life. Based on a cost-benefit analysis, if the leasehold improvement was to amortize over the shorter of remaining lease term or its useful life, there is a reasonable possibility that the component unit will not get the full benefit of the costs invested in developing the leasehold improvement.

Thus, leasehold improvements in a lease agreement between a primary government and its discretely presented component unit should be amortized over its useful life, regardless of the lease term. The structure and financial relationships among companies under common control are similar to the relationships between a primary government and its component units. Therefore, the new accounting treatment introduced by the FASB for lease agreements between companies under common control could be applied to leasehold improvement in leases between a primary government and its discretely presented component units.

Governmental accountants are looking to the GASB to provide guidelines on the amortization of leasehold improvements, especially those related to lease agreements between a primary government and discretely presented component units.