November 12, 2016
Build-To-Suit Lease Accounting – Part 1 – What is a construction project?
Before getting too far into build to suit accounting, let me just say that this is one of the most surprising and frustrating pieces of the accounting guidance today. It often catches people off guard, and is completely foreign to even the most experienced accountants. I do want to provide some much needed information, but I highly suggest letting us walk you through this one on one, helping you develop your build-to-suit excel schedules, and write up a memo to help support your positions. Please navigate here (https://www.popularaccounting.com/consultant/) to inquire further as to how we can get the ball rolling helping you out on a one-on-one basis.
One of the most complicated areas of lease accounting is this crazy idea of “build-to-suit” (BTS) leases/accounting. (Note, it’s build not built, and it’s suit not suite). I always like to explain topics generally in a way where I can marry the logic that underlies the rules with the actual accounting guidance. However, with build-to-suit leases, I find it difficult at times to do this. The guidance itself can be very judgmental, cumbersome, and frankly a little complicated. Therefore, I have decided to start a journey to try to explain, if at nothing else, the basics, which will get you to a better understanding of what to look out for and how the accounting works. My guess is that many of you, if you’ve found this post via a Google search, are trying to figure out what the heck your auditor is talking about since they’ve just come back to you mentioning that you may have to bring the entire fair value of a building (that you don’t own, nor will own, by the way) onto your books. This did tend to catch people off guard, and frankly, there’s no real great guidance for build-to-suit accounting. Hence, I will try to build a skeleton for people to work off of, and my hope is that I can fill in some of the gaps as questions come in.
So first and foremost, let me tell you the high level steps that I will be walking through over the next few posts, and how the accounting guidance comes together to make what we know as “Build-To-Suit guidance”.
First and foremost, people think that this build-to-suit guidance is in and of itself, an actual complete thing. While this is partially true (there is some guidance in the form of implementation guidance and sporadically throughout the codification that does make the majority of what we refer to as build-to-suit guidance), it is not completely true. In order to understand the real accounting implications, one needs to consider sale leaseback accounting. Build-to-suit guidance covers everything from the point a company concludes that there is a construction project, to the point that the construction project has been completed. Once the construction project is complete, then from an accounting perspective, you no longer own the project and you simultaneously sell the project back to the landlord and begin to lease it. This portion of the transaction is then accounted for as a sale leaseback transaction and mostly falls under ASC 360-20 more than ASC 840. We’ll get more into this later, but just keep in mind that if you are looking for the guidance that prescribes the goals of a complicated build-to-suit excel schedule that someone has provided you, the guidance is sale leaseback guidance (most likely specifically FAILED sale leaseback where gains/losses from the sale are deferred), and will not be found in ASC 840.
I promised a high level overview, and here it is. These are the basic steps when trying to understand your leasing transaction, and whether or not build-to-suit / Sale Leaseback accounting needs to be considered, or if the more traditional operating vs capital lease tests should be your concern.
Step 1. Determine if there is actually a construction project (This post below will cover this)
Step 2. If there is a construction project, you have to determine who the deemed owner of the project is (I may break this up into multiple posts, as there are numerous ways to do this)
Step 3. If you (lessee) are deemed the owner, account for the construction project while under construction.
Step 4. Post construction, there is deemed to have been a sale and simultaneous leaseback of the construction project. This needs to be assessed for normal sale lease back in accordance with ASC 360-20 and ASC 840-40-25-9. (Typically these fail for a variety of reasons, and therefore accounting in accordance with non-normal/failed sale leaseback guidance is mostly appropriate).
Construction Project – Do I have one?
So I’m definitely starting off slow, as you can see. This should be a really straightforward question correct? Well, mostly yes, but there are one or two things to consider. The following is from the FASB codification (which btw I think I legally have to tell you is a copyright of FASB, which is garbage because the SEC has incorporated it into law, and therefore, I’m pretty sure it shouldn’t be protectable under copyright laws as it should meet the definition of “works of government”, but I digress).
Construction activities have commenced if the lessee has performed any of the following activities:
- Begun construction (broken ground)
- Incurred hard costs (no matter how insignificant the hard costs incurred may be in relation to the fair value of the property to be constructed)
- Incurred soft costs that represent more than a minor amount of the fair value of the leased property (that is, more than 10 percent of the expected fair value of the leased property).
I think points one and two above are pretty self explanatory. If you actually start constructing physically, or you spend even one penny on anything that is considered to be a “hard cost” (actual cost to construct vs planning to construct), then a construction project has been deemed to have begun. Nothing too crazy here, except that if you are still finalizing some final wording in a lease/contract, and someone goes and sticks a shovel in the ground, this could trigger build-to-suit accounting much earlier than you expected, so be careful.
The real point of emphasis here is #3. If you’ve incurred soft costs equal to more than 10% of the EXPECTED fair value of the leased property (meaning post construction), then you’re construction project has begun. The theory here is that if you’ve spent such a large amount of money on multiple rounds of fancy architectural mark ups, obtaining permits, etc., then it can be considered to be reasonably assured that this is a construction project that is well underway (clearly, if more than 10% of the total future value of the building has been spent on just soft costs, then those soft cost related activities were significant and should be considered at least as important as the first shovel in the ground). Of course, we can debate whether or not this makes sense, but this is the rule, so definitely watch out for it. Also, the other wrench this can throw at you is that the future value is judgmental, which introduces a whole other set of things to consider depending on your auditors (how much evidence is your auditor going to want to see to support your estimated future fair value? Are they going to want documented controls? As this is an estimate, many audit teams, especially if PCAOB reviewed in 2014, will most likely want to see documented key controls to support the data, methods, and assumptions used in arriving at fair value estimate of the completed property).
That pretty much is all you need to know on whether or not you technically have a construction project that needs to be assessed with ASC 840 or not. However, I would also caveat this with the fact that this should only be applied to construction projects whereby the landlord will be the owner of the final assets. i.e., if you lease a space, and install your own AC unit, or additional HVAC system that you plan on taking with you when you leave, then these are just assets to you and have nothing to do with the building itself (as the property will be returned in the same manner with which you rented it). Follow regular leasehold improvement guidance (of course, consider any lease incentives), but I have never seen regular tenant improvements be the sole catalyst to launch someone into build-to-suit accounting. However, from a theoretical point of view, if you do not take title to these tenant improvements, and the landlord is therefore involved with the construction, you will want to assess if there is some reason you should be considered the owner of the project. This can be possible before an entity has even reached lease inception (see lease inception post), although it would be rare, in my experience, that the assessment would lead you to be the owner in this fact pattern.
Please stay tuned for Part 2 – Determining who should be considered the owner of the construction project. Also, please feel free to submit questions and comments in the meantime.
I’ve been getting a lot of very specific questions regarding individuals’ situations. Again, I recommend that you check out how we can help you on an individualized basis, please navigate here (https://www.popularaccounting.com/consultant/) to reach out to us to so that we can help you through this very tricky accounting literature, including memo and schedule preparation.
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