On March 27, 2023, the Financial Accounting Standards Board (FASB) published narrowly drawn amendments to the lease accounting rules. The updated guidance clarifies issues that are relevant to rental agreements between businesses that have the same owner.

Written vs. verbal leases

Accounting Standards Update (ASU) No. 2023-01, Leases (Topic 842) Common Control Arrangements, explains how related business entities that are controlled by the same owner determine whether a lease exists. Specifically, it provides an optional practical expedient to private companies and not-for-profit organizations that aren’t conduit bond obligors. (A practical expedient is an accounting workaround that allows a company to use a simpler route to get to the same outcome.) The guidance settles questions about how to approach verbal common control leases and whether legal counsel is required to determine the terms and conditions of a lease.
The practical expedient is applicable only for written leases. Under the updated guidance, a private company electing the practical expedient must use the written terms and conditions of a common control arrangement to determine whether a lease exists and, if so, how to account for it. In the case of a lease agreement that’s verbal — as is often the case between private entities under common control — the company must document the existing unwritten terms before applying the lease accounting rules.

The lessee isn’t required to determine whether written terms and conditions are enforceable when applying the practical expedient. In addition, companies are allowed to apply the practical expedient on an arrangement-by-arrangement basis.

Leasehold improvements

The accounting rules related to certain leasehold improvements have also changed for both public and private organizations under ASU 2023-01. Examples of leasehold improvements include installing carpet, painting and building out the space for the lessee’s needs. For example, a salon might install sinks and plumbing fixtures, a chemical manufacturer might need ventilation for its production process and an eco-friendly restaurant might design a rooftop garden to attract patrons.
The amendments require lessees to amortize leasehold improvements over the improvements’ useful lives to the common control group — regardless of the lease term. When the lessee no longer controls that underlying asset, the transfer of those improvements must be accounted for through equity or net asset. The improvements remain subject to the impairment requirements of Accounting Standards Codification (ASC) Topic 360, Property, Plant and Equipment.

Implementation guidance

ASU No. 2023-01 is an amendment to ASC Topic 842, Leases, which was issued in 2016. This standard requires the full effect of entities’ long-term lease obligations to be reported on the balance sheet. It went into effect for public entities in 2019 and for private entities in 2022.

The new-and-improved rules will be effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted for both interim and annual financial statements that haven’t yet been made available for issuance. If a company adopts the amendments in an interim period, the company must adopt them as of the beginning of the fiscal year that includes that interim period.

If your company decides to adopt ASU 2023-01 concurrently with the adoption of Topic 842, you should use the same transition approach as that standard. If your company adopts the rules in a subsequent period, you can do so either retrospectively or prospectively.

For more information

Does your company rent property from a related party? We can help you report these arrangements in accordance with the updated guidance. Our accounting pros understand how to determine whether a common control lease exists and how to report leasehold improvements and other fixes that have been made to rented property. Contact Us!

© 2023

What do you do with your financial statements after your CPA delivers them? If you’re like most business owners and managers, you breathe a sigh of relief that they’re finished, file them away, and go back to running the business. But financial statements can be a useful tool to help improve business operations in the future.

 

Eye on profitability

The income statement is a good starting point for using your financials to analyze performance and remedy inefficiencies and anomalies. Here are four ratios you can compute from income statement data:

1. Gross profit. This is profit after cost of goods sold divided by revenue. It’s a good ratio to compare to industry statistics because it tends to be calculated on a consistent basis.

2. Net profit margin. This is calculated by dividing net income by revenue. If the margin is rising, the company must be doing something right. Often, this ratio is computed on a pretax basis to accommodate for differences in tax rates.

3. Return on assets. This is calculated by dividing net income by the company’s total assets. The return shows how efficiently management is using its assets.

4. Return on equity. This is calculated by dividing net profits by shareholders’ equity. The resulting figure tells how well the shareholders’ investment is performing compared to competing investment vehicles.

Profitability ratios can be used to compare your company’s performance over time and against industry norms.

 

Connecting the dots

If your company’s profitability ratios have deteriorated compared to last year or industry norms, it’s important to find the cause. If the whole industry is suffering, the decline is likely part of a macroeconomic trend. If the industry is healthy, yet your company’s margins are falling, it’s time to determine the cause and then take corrective measures.

Depending on the source of the problem, you might need to cut costs, lay off unproductive workers, automate certain business functions, eliminate unprofitable segments or product lines, raise prices — or possibly even investigate for fraud. For instance, a hypothetical manufacturer might discover that the reason its gross margin has fallen is rising materials costs because its procurement manager is colluding with a supplier in a kickback scam.

 

Contact us

Today’s uncertain, inflationary markets are putting the squeeze on profits in many sectors. But don’t accept that excuse without first investigating further. Your income statement provides critical clues into what’s happening at your company.

Examine the main components — gross revenue, cost of sales, and selling and administrative costs — to assess if specific line items have fallen due to company-specific or industrywide trends. Also, monitor comparable public companies, trade publications, and the internet for information. We can help you determine possible causes and brainstorm ways to unplug your profit drains.

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Deferred taxes are a confusing topic — and the accounting rules for reporting these items often seem to defy the logic of real-world economics. Here’s a brief overview to help clarify matters.

 

What are deferred taxes?

Companies pay income tax on IRS-defined taxable income. On their Generally Accepted Accounting Principles (GAAP) financial statements, however, companies record income tax expense based on accounting “pretax net income.” In a given year, taxable income (for federal income tax purposes) and pretax income (as reported on your GAAP income statement) may substantially differ. A common reason for this temporary difference is depreciation expense.

For income taxes, the IRS allows companies to use accelerated depreciation methods to lower the taxes paid in the early years of an asset’s useful life. Some companies also may elect to claim Section 179 deductions and bonus depreciation in the year an asset is placed in service. Alternatively, for GAAP reporting purposes, companies frequently use straight-line depreciation. Early in an asset’s useful life, this divergent treatment usually causes taxable income to be significantly lower than GAAP pretax income. However, as the asset ages, the temporary difference in depreciation expense reverses itself.

The use of different depreciation methods for book and tax purposes causes a company to report deferred tax liabilities. That is, by claiming higher depreciation expense for tax purposes than for accounting purposes, the company has temporarily lowered its tax bill — but it will make up the difference in future tax years. Deferred tax assets may come from other sources, such as capital loss carryforwards, operating loss carryforwards, and tax credit carryforwards.

 

How are deferred taxes reported on the financials?

If a company’s pretax income and its taxable income differ, it must record deferred taxes on its balance sheet. The company records a deferred tax asset for the future benefit it will receive if it pays the IRS more tax than an income statement reflects. If the opposite is true, the company records a deferred tax liability for the additional future amount it will owe.

Like other assets and liabilities, deferred taxes are classified as either current or long-term. Regardless of their classification, deferred taxes are recorded at their cash value (that is, no consideration of the time value of money). Deferred taxes are also based on current income tax rates. If tax rates change, the company may revise its balance sheet, and the change flows through to the income statement.

While deferred tax liabilities are recorded at their full amount, deferred tax assets are offset by a valuation allowance that reflects the possibility the asset will expire before the company can use it. Deciding how much-deferred tax valuation allowance to book is highly subjective and left to management’s discretion. Any changes to the allowance flow through to the company’s income statement.

 

Now or later?

Financial statement users can’t afford to lose sight of deferred taxes. All else being equal, a company with significant deferred tax assets may be able to lower its future tax bill and preserve its cash on hand by claiming deferred tax breaks. Conversely, a company with significant deferred tax liabilities has already tapped into tax breaks and may need additional cash on hand to pay Uncle Sam in future tax years. Contact us for more information.

© 2023