November 12, 2016
Build-To-Suit Lease Accounting – Part 2 – Am I the owner of the construction project?
Build To Suit – Determining the owner of the project
In Part 1, we discussed how to determine whether or not we “have a construction project to begin with”. If you haven’t read this post, I recommend reading that first. Click hear to be redirected to Part 1. Part 2 will focus on determining who the owner of the construction project will be.
First, let me tell you that I will break up this extremely important topic into multiple posts in order for the information to be in a format that is easier to digest. However, let me intro the topic with a high level reminder of where we are in the guidance.
Step 1 – Do we have a construction project? If so, move to step 2. (This really isn’t what I would consider “Build to suit” guidance).
Step 2 – Determine who the owner of the construction project is. If you, the lessee, are considered the owner, then now you are under build to suit guidance.
Step 3 – Accounting during construction (as if you are the owner)
Step 4 – Accounting for the “sale” and subsequent “leaseback” of “your” construction project
So clearly here, we have a ways to go.
Keep in mind, that this post is meant to give you a high level overview of the build to suit guidance, and in sufficient detail so that most of you can take it and directly apply it to your situation. However, this is by no means an all encompassing explanation of everything “build to suit” as the meat of the guidance would be lost in the details. However, please feel free to ask your particular questions, and if I get enough of them, I will revise this post as necessary. I would always recommend running your specific situation by your auditors before making an accounting conclusion. This advice is meant to be general in nature, and not CPA advice on your specific situation.
Involved vs Owner
Many people will use these terms synonymously. For the most part, this is fine as there is no meaningful distinction in practice. In theory, however, there is a big difference as you can be “involved” with construction, and not deemed the “owner” of the project. Being considered the “owner” is the only thing that matters for all intents and purposes.
First a couple words of warning. Just because you have not signed a lease, does not mean that anything that happens before it is signed is fair game. For example, PwC finds that certain payments made on behalf of the lessee by the developer or lessor should be evaluated under ASC 840-40-55-44 (which should be familiar to you if you read Part 1 of this series). Essentially it is PwC’s position, at least back in 2013, that these costs should be considered the lessee’s costs (and thus be evaluated to see if a construction project has begun and will be included in the maximum guarantee test to be discussed below). Deloitte’s 840-40-55 (Q&A 01) states that costs that the lessee incurs prior to a lease are absolutely fair game to trigger build to suit recognition and the subsequent lease arrangement would fall within the scope of ASC 840-40-15-9 (Sale Leaseback guidance). I won’t reproduce their Q&A here without their permission, but if you are their audit client, you can ask them to provide this to you. The point of this paragraph is to bring to your attention that just because pen has not hit paper on your lease agreement, does not mean you are safe from the effects of the build to suit guidance.
There are two main ways that a Company will be considered the owner of a construction project.
- Maximum Guarantee Test
- Automatic Indicators of ownership
Maximum Guarantee Test
I don’t want to skip over this test in its entirety, but for now I’m going to due to the fact that in the 30+ build to suit cases I’ve seen, 100% of the time where the lessee (Company) was surprised or shocked by this guidance, it was because the auditor clung onto one of the automatic indicators of ownership. Rarely will there be a situation where a Company will not assume that they are the owner of a building, yet the auditor will raise a huge stink about built to suit accounting on behalf that the Company fails this test. I will expand on this test in Part 3 of the build to suit series.
Automatic Indicators of Ownership
In my experience, these are the bad boys you have to watch out for. Perhaps it’s because the 90% test (which I know hasn’t been fully explored as of the writing of this) is judgemental, or perhaps because when there’s something black and white like an automatic indicator of ownership it’s harder for an audit firm to go along with anything but build to suit accounting (Think risk, plausible deniability, reasonable assurance). So without further ado (not adieu for all you who would make Shakespeare rollover in his grave), I give you ASC 840-40-55-15.
Automatic Indicators of Ownership
a. The lessee or any party related to the lessee that is involved with construction on behalf of the owner-lessor makes or is required to make an equity investment in the owner-lessor that is considered in substance an investment in real estate (see paragraph 976-10-15-4 for examples of equity investments that are in substance real estate). In accordance with paragraph 840-40-55-45, the fair value of an option to acquire real property transferred by the lessee to the lessor would be considered a soft cost incurred by the lessee before entering into a lease agreement. In addition, loans made by the lessee during the construction period that in substance represent an investment in the real estate project, such as those loans discussed in the Acquisition, Development, and Construction Arrangements Subsections of Subtopic 310-10, would indicate that the lessee was the owner of the real estate project during the construction period and therefore would be required to apply this Subtopic.
b. The lessee is responsible for paying directly (in contrast to paying those costs through rent payments under a lease) any cost of the project other than as follows:
- Pursuant to a contractual arrangement that includes a right of reimbursement (regardless of the frequency of reimbursement)
- Payment of an environmental cost as described in (c)
- Normal tenant improvements. For this purpose, normal tenant improvements exclude costs of structural elements of the project, even though unique to the lessee’s purpose, and equipment that would be a necessary improvement for any lessee (for example, the cost of elevators, air conditioning systems, or electrical wiring). A requirement that the lessee pay more of the cost of tenant improvements than originally budgeted for if construction overruns occur could, in effect, obligate the lessee to pay for 90 percent or more of the total project costs. Therefore, normal tenant improvements also exclude any amounts included in the original project budget that the owner-lessor agrees to pay on the date the contract terms are negotiated regardless of the nature of such costs.
c. The lessee indemnifies the owner-lessor or its lenders for preexisting environmental risks and the risk of loss is more than remote. The lessee should follow the guidance in paragraphs 840-10-25-12 through 25-13 for any indemnification of environmental risks.
d. Except as permitted by (c), the lessee provides indemnities or guarantees to any party other than the owner-lessor or agrees to indemnify the owner-lessor with respect to costs arising from third-party damage claims other than those third-party claims caused by or resulting from the lessee’s own actions or failures to act while in possession or control of the construction project (as is noted in paragraph 840-40-55-9(d) any indemnification of [or guarantee to] the owner-lessor against third-party claims relating to construction completion shall be included in the maximum guarantee test). For example, a lessee may not provide indemnities or guarantees for acts outside or beyond the lessee’s control, such as indemnities or guarantees for condemnation proceedings or casualties. If the lessee is acting in the capacity of a general contractor, its own actions or failure to act would include the actions or failure to act of its subcontractors. See the following paragraph for an analysis of the indemnity-guarantee guidance in this Subtopic.
e. The lessee takes title to the real estate at any time during the construction period or provides supplies or other components used in constructing the project other than materials purchased after lease inception (or the date of the applicable construction agreement, if earlier) for which the lessee is entitled to reimbursement (regardless of the frequency of reimbursement). The costs of any such lessee-provided materials would be considered hard costs (see the guidance beginning in paragraph 840-40-55-42).
f. The lessee either owns the land and does not lease it or leases the land and does not sublease it (or provide an equivalent interest in the land, for example, a long-term easement) to the owner-lessor before construction commences. If the transaction involves the sale of the land by the lessee to the owner-lessor, that sale would have to occur before construction commences. If the land is sold to the owner-lessor and subsequently leased back with the improvements, the sale of the land would be subject to the requirements of this Subtopic even if the lease of the improvements was not considered to be within the scope of this Subtopic pursuant to this guidance.
In 99% of all build to suit cases, it is one of these automatic indicators of ownership that prompted that conversation with your auditor and resulted in you scurrying to Google where you finally landed on this post. Of that 99%, 90% of those times is because of subparagraph b. 3. above. The firms are VERY strict on this point. PwC specifically stated in guidance given to multiple of my clients that even $1 spent on “non-normal tenant improvements” directly to the contractor will automatically cause the lessee to be considered the owner of the entire construction project. We haven’t discussed the definition of “non-normal tenant improvements” as of yet, however, I want you to contemplate the potential impact. You, as the lessee, agree to pay the contractor directly to buttress the load bearing capacity of a particular room on the second floor that you know you want to put a heavy generator in. The costs to you for this structural amendment is 20k, but the total building in this downtown location is worth $200M. Congratulations, you just became the proud “owner” of a $200M asset (and financed obligation by the way).
Some quick notes about the automatic indicators of ownership.
a) This one I have never seen used, but it seems fairly straightforward to me.
b) This is by far and large the MOST common. If you are paying for the costs directly for any non-normal tenant improvements, you are on VERY shaky ground.
c) Rare, but I have heard of this in the oil industries, but in the tech industry (my industry) the only time this has come up is in the datacenter space whereby underground diesel tanks have been known to leak from time to time. However, even then the situation is rare whereby the lessee would agree to indemnify AND the risk of loss is more than remote.
d) To get to the economics of this one, what it’s trying to get at is if you are essentially taking on risk of ownership. If you own a building, it’s an inherent risk that it may be vandalized, or an earthquake may strike, or a fire breathing dragon may burn it to the ground (in which case I think the insurance companies would consider this an act of God, but that’s for another post). If you indemnify the owner or even a third party against these types of risks (those beyond your control), then you are assuming risk of ownership, and THAT in and of itself would indicate your ownership interest in the project. It’s very verbose and wordy language, but that is the essence.
e) Straight forward, rarely happens. If it does, generally you are already on board with the whole “I have to account for this as if I own it” concept because you will own it afterall if you are receiving title. Personally, I have not seen a situation where a company contributes its own materials that it has already had on hand, but you can see how this is economically equivalent to paying directly for costs (similar to b. 3).
f) You can’t be in control of the land before you have someone else start building on it. Basically that simple. If you are, make sure to take a hard look at this one, but this won’t be applicable to most of you.
I’m going to focus the rest of this post on the most pertinent question, “What is a normal tenant improvement?”
Clearly based on the guidance above, we know that a normal tenant improvements are NOT “costs of structural elements of the project, even though unique to the lessee’s purpose, and equipment that would be a necessary improvement for any lessee (for example, the cost of elevators, air conditioning systems, or electrical wiring). ” However, I will be the first person to tell you that there is no hard and fast answer on this, and each firm, and potentially even different teams within each firm, may have different opinions on this. The answer to this question can SIGNIFICANTLY impact your build to suit accounting implications.
For example, Deloitte has a series of questions that the propose when considering this question (ask them about ASC 840-40-55 Q&A 27). Their questions mostly center around whether the construction modification / project in question will modify any significantly the structure of the building. So Deloitte brings in a little bit of judgement here. Juxtapose this with PwC’s view that there is no materiality threshold when it comes to the automatic indicators of ownership so even $1 could trigger build to suit accounting (Ask them about ARM 4650.252). Deloitte will also consider other things such as whether or not the functionality or value is being impacted significantly, as well as whether or not the timing of such lessee involvement would be close to the original construction of the asset in question.
So with that being said, the good news here is that there is room to argue. I will give you my own personal experiences when it comes to build to suit accounting. Firstly, demising walls do not count as structural. This is very very well established (at least in the Silicon Valley). Also, even though the definition above specifically calls out air conditioning systems and electrical wiring, most firms will agree that this is when the building is bare, and the initial installation of AC systems or electrical wiring throughout the building needs to be completed. This does not mean you want an electrical plus in a demising wall, or reroute an AC duct into a newly created conference room. The electrical wiring / air conditioning work needs to be extensive in order to be considered non-normal. If you need to connect your building to the main power grid, this is typically considered structural in nature. If anything load bearing is being moved or supplemented, this is typically structural. Therefore, elevator shafts and additional stair cases most likely will trigger build to suit accounting. If is includes concrete, this is a warning sign that something structural is going on. Although PwC doesn’t recognize materiality when it comes to automatic indicators of ownership, they do recognize that not everything is structural. Materiality certainly has come into question when having this discussion, however. (The argument being something like, “We’re spending $10k, clearly a structural change would cost more than this.” or the auditor’s remark may be something like, “You’re telling me you’re going to spend $10M and none of this is structural? I’m going to need to see the detailed construction budget.”) This leads me to my last point, you need your construction managers to be informed of the accounting implications of build to suit accounting. They are the ones that your auditors are going to reach out to, they are the ones that you should be reaching out to in order to truly understand the types of construction activities being performed. Lastly, the argument with your auditors should never be about how bad you fail one of the automatic indicators of ownership, but instead whether or not you fail at all, which generally means that you are arguing over the nature of the works being performed, versus the materiality.
Stay tuned as I still need to walk through the maximum guarantee test, assessment for sale/leaseback, and the actual accounting (the good stuff) for what it looks like if you find yourself in a position where you are being asked to bring an asset that you legally don’t have title to onto your books.
Please remember that this information should not be solely relied upon, and that you should consult with your hired professional.
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