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Lease classification

Question 3-1

How should leases between related parties be classified?

PwC response
Leases between related parties should be classified like all other leases as discussed in ASC 842-10-55-
12. The classification should be based on the terms of the contract, without adjustment for provisions
that may have been impacted by the related party relationship.

ASC 842-10-55-12

Leases between related parties should be classified in accordance with the lease classification criteria
applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease.
In the separate financial statements of the related parties, the classification and accounting for the
leases should be the same as for leases between unrelated parties.

Related party leases are often embedded within other arrangements, e.g., a managed service
arrangement, rather than documented by a formal lease agreement. Due to the relationship between
the two parties, the legal lease provisions may be uneconomic. For example, within office space leased
from a related party under a nonrenewable, one-year managed service arrangement, a lessee may
install leasehold improvements with an economic life of five years. This may indicate that the lessee
expects to use the space longer than one year. Furthermore, that may be a reasonable expectation
given that management of the lessee and lessor often include the same decision makers.

Nevertheless, with respect to accounting for leases under ASC 842, we believe the lessee and lessor
should look only to legally enforceable rights. While we acknowledge that, in some cases, there may be
legally enforceable rights beyond those documented in the written contract, we believe the contract
executed between the two parties typically defines the legally enforceable rights related to the lease.
When the written terms governing the lease are uneconomic, it may be useful to involve legal counsel.

3.2.1 Lease commencement

ASC 840 required classification to be determined at lease inception. ASC 842 only requires the
determination of whether an arrangement contains a lease at lease inception. Classification and initial
measurement of right-of-use assets and lease liabilities are determined at the lease commencement
date, which is defined in the ASC 842 Glossary.

Definition from ASC 842 Glossary

Commencement Date of the Lease (Commencement Date): The date on which a lessor makes an
underlying asset available for use by a lessee. See paragraphs 842-10-55-19 through 55-21 for
implementation guidance on the commencement date.

The FASB believes that recognition of right-of-use assets and lease liabilities at lease commencement
is appropriate because prior to that date, the lessor has not yet performed under the arrangement. To
illustrate, assume a lessee and lessor enter into a lease arrangement on January 1, but the lessor does
not make the underlying asset available for use by the lessee until April 1 of the same year. At lease

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