We are often asked, “If I switch to a month-to-month lease with a related party, am I scoped out of FASB ASC Topic 842?”
Unfortunately, there is no easy answer to this question. Under FASC ASC Topic 842, a practical expedient exists whereby a lessee can elect not to record on the balance sheet a lease whose term is 12 months or less and does not include a purchase option that the lessee is reasonably certain to exercise. As such, we have received several inquiries about whether month-to-month leases with related parties would allow companies to exclude these related party leases from their balance sheet.
When determining whether the lease qualifies for the aforementioned practical expedient, the lessee would need to analyze the lease’s legally enforceable terms and conditions. Determining the legally enforceable terms and conditions may be difficult in a lease between related parties because of the nature of the arrangement, and the fact that many related party leases are unwritten. Generally speaking, the stated lease term of month-to-month would not be factored into the equation in a lease between related parties, as it would be “reasonably certain” that the lease would be renewed or extended.
The reasonably certain assessment requires significant judgment and per ASC 842-10-30-2 should be based on:
· The facts and circumstances at lease commencement
· The factors that create an economic incentive for the lessee (and not the lessee’s intentions or past practices)
As such, companies will be required to analyze the renewal terms and make a “reasonably certain” assessment when determining the length of the contract. Determining the contract term for a month-to-month lease is highly subjective and requires significant judgment in regard to how long the company will continue extending the lease.
When making this determination, consider some of the following:
· Did you recently spend significant money on improvements? If so, there may be an economic incentive to stay longer, in which case you may need to consider how long the company will benefit from the improvements when determining the term of the lease.
· Do you require zoning or business permits that might require significant time before operations could be shut down and moved? If so, the lease may be an essential asset for the business and difficult to replace, in which case you may need to consider how long the company will benefit from the permits when determining the term of the lease.
· Is there an associated mortgage on the leased property? If so, and if it is expected that the lessee will have lease payments through the mortgage term you may need to consider the mortgage term when determining the term of the lease.
· Is the lease for general office space and leasing a new facility would be uncomplicated and inexpensive? If so, you may be able to make a case for determining a shorter lease term.
After considering the above, if the lease term, including renewal periods, increases to more than 12 months, or it is reasonably certain the lessee will exercise a purchase option, the practical expedient would not apply and FASB ASC Topic 842 guidance would be required to be followed.
Finally, keep in mind that upon transition, an entity may elect to use hindsight to determine the lease term, and while the reasonably certain assessment is required to be performed using the facts and circumstances at least commencement, it would be difficult to justify a month-to-month lease already in place longer than 12 months as a short-term lease. If you have any questions regarding your specific situation, reach out to our experts today to further discuss.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.