May 25, 2020

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Build-To-Suit Lease Accounting – Part 4 – Accounting when deemed the owner

Accounting when deemed the owner of a construction project

Welcome to Part 4 of my Build To Suit series. Parts 1-3 we discussed how to identify if a construction project exists, and whether or not the lessee should be deemed the owner of the construction project either through one of the 6 automatic indicators of ownership (Part 2) or through failing the Maximum Guarantee test (Part 3). At this point, I will assume that we’ve concluded that the Lessee (presumably you) need to be considered the owner of the construction project.

Per ASC 840-40-55-2:

This implementation guidance addresses the application of paragraph 840-40-15-5, which requires that a lessee be considered the owner of an asset during the construction period, and thus subject to this Subtopic, if the lessee has substantially all of the construction period risks. An evaluation of whether the lessee has substantially all of the construction period risks should be based on a maximum guarantee test that is similar to the 90 percent recovery test in the minimum-lease-payments criterion in paragraph 840-10-25-1(d).

So the first thing to do while in construction, is to record the asset for the full construction project. However, remember what we said earlier regarding the fact that I have not normally seen “normal tenant improvements” be considered part of a construction project. E&Y and PwC both state unequivocally that normal tenant improvements do not affect the 90% Maximum Guarantee Test, which supports what I’ve seen in practice (in later Parts of this series, you’ll see what this doesn’t actually matter all that much from a P&L perspective). If your organization has directly paid some of these costs (see automatic indicators of ownership in Part 2), then this portion of the “construction project” will already be recorded on your books in some capacity, as these payments would have followed your normal purchase-to-payables process. For the fair value of the construction project that you need to bring on your books (i.e., landlord paid costs, whether existing or part of the current project), this is done by making the following entry.

Dr. Financed Asset…………………….FV of Landlord Paid Portion
Cr. Financed Obligation……………………………………FV of Landlord Paid Portion

Perhaps an example will make this more clear. Let’s say that ABC Inc. enters into a lease with with Lessor Co.. As part of the lease agreement, ABC and Lessor both agree that Lessor will make some renovations to move an elevator shaft as part of ABC’s plans to retrofit the space as their new headquarters. Lessor will approve all construction plans, make all decisions regarding selection/hiring/firing of general contractors, be legal party to all construction contracts, etc.. The total budget for the entire retrofitting plans is $10M. The $10M can be subdivided between normal tenant improvements (painting, carpet, blinds, demising wall creation, signage, etc.) of $6M, and $4M of non-normal tenant improvements (perhaps building additional space onto the building, moving the elevator shafts, etc.). The building is worth $80 before any construction activities begin. None of the automatic indicators of ownership are triggered (as ABC is not paying any of these costs directly, nor for any other reason), but Lessor Co. did specifically agree to pay for $10M of the costs, and any overruns would be required to be paid by ABC Co.. As such, the 90% test has failed, and ABC shall be deemed the owner of the construction project.

Per PwC ARM 4650.253 (Copyright 2013, all rights reserved by PriceWaterhouseCoopers LLP, published May 10, 2013):

Sometimes a lessee is involved in asset construction when it will lease only a portion of the building
constructed. In these situations, if the lessee is deemed to be the owner of the construction project, a
question arises as to the unit of account (i.e., the identity of the construction project that the lessee must
capitalize during the construction period). We believe that it is acceptable for a lessee that is considered
to be the owner of the asset being constructed to make the determination that the “construction project” to
be capitalized is the larger of:
– The portion of the building space to be leased by the lessee, or
– The portion of the construction project for which the lessee is responsible.
In other words, if the lessee is involved with constructing only the portion of the building that it will lease
(e.g., the lessee is not the general contractor for the construction of the entire building; the lessee does
not guarantee the lessor’s debt; the lessee is not subject to paying for cost overruns relating to the entire
building but only those relating to the construction of the space that it will lease), then it would be
acceptable for the lessee to capitalize only the cost associated with the space that it will lease.

This is how I have seen all of my clients record build to suit leases. Essentially what this means is that you bring on the total fair value of the entire leased space once a company is deemed the owner. In our situation above, this would mean that we Dr. Financed Assets and Cr. Financed Obligations in the amount of $80M. Further, as the landlord spends money on the construction project, the cash spend would follow the same Dr. Financed Asset, and Cr. Financed Obligation. This does bring an interesting issue where a company may not KNOW when and how much a landlord is spending on a construction project in real time. My clients have always used total projected construction costs per the budget, and then estimated the timing of those payments based on either their history with similar projects, or by discussing it with general contractors.

So this part is fairly straightforward, but PwC has this to say as well. Again, from PwC ARM 4650.253:

.253 Accounting when the lessee is considered the owner of a construction project

When a lessee is deemed the accounting owner of a construction project, ASC 840-40-55 requires the lessee to ignore the legal form of the arrangement and account for construction as if it were the legal owner of the construction project. As such, the lessee will record an asset for construction-in-process for all incurred construction costs, and a liability for those costs that are not funded by the lessee. The amounts recorded will increase as construction progresses, and should be recognized in accordance with the lessee’s policies for construction of its owned assets.
Interest cost should be capitalized into the construction project on construction costs funded by the lessee in accordance with ASC 835-20. Interest will also be calculated and capitalized for construction costs funded by the lessor. While the application of ASC 835-20 to the costs funded by the lessee is straightforward, the rate to be used to capitalize costs funded by the lessor is not straightforward. According to ASC 835-20-30-3, “….the capitalization rates used in the accounting period shall be based on the rates applicable to borrowings outstanding during the period.” Therefore, the rate used for capitalization of interest on the portion of the construction costs financed by the lessor should be determined using the following hierarchy:

  1. the implicit rate, if known,
  2. the rate on the lessor’s construction debt — provided that the construction debt rate is based on the lease and not on the credit of the lessor, or
  3. the rate the lessee used to capitalize interest on the construction costs that it funded.

However, per ASC 840-20-25-10 and 25-11:

25-10: In some lease arrangements, an entity (lessee) may take possession or be given control of leased property before it commences operations or makes rental payments under the terms of the lease. During this period, the lessee has the right to use the leased property and does so for the purpose of constructing a lessee asset (for example, leasehold improvements). After construction is completed, the lessee commences operations and is required to make rental payments under the terms of the lease. Alternatively, some lease arrangements require the lessee to make rental payments when the lessee takes possession or is given control of the leased property.

25-11: Rental costs associated with building and ground operating leases incurred during and after a construction period are for the right to control the use of a leased asset during and after construction of a lessee asset. There is no distinction between the right to use a leased asset during the construction period and the right to use that asset after the construction period. Therefore, rental costs associated with ground or building operating leases that are incurred during a construction period shall be recognized by the lessee as rental expense. A lessee shall follow the guidance in paragraphs 840-20-25-1 through 25-2 in determining how to allocate rental costs over the lease term. This guidance does not change the application of the maximum guarantee test discussed in paragraph 840-40-55-2. This guidance does not address whether a lessee that accounts for the sale or rental of real estate projects under Topic 970 should capitalize rental costs associated with ground and building operating leases.

Therefore, ground rents should still be imputed during the construction period. In order to calculate land rents, ASC 840-10-25-38(b)(2) dictates that,”…The minimum lease payments after deducting executory costs, including any profit thereon, applicable to the land and the building shall be separated by the lessee by determining the fair value of the land and applying the lessee’s incremental borrowing 1321 rate to it to determine the annual minimum lease payments applicable to the land element; the remaining minimum lease payments shall be attributed to the building element.” This is a common method that the codification uses very consistently, and if, after being deemed the owner of the construction project, and failing normal sale/leaseback criteria, this is something that you’ll have to do to bifurcate payments as well. During the construction period, you are required to expense the portion of any payment attributable to land-rent.

Obviously, one of the major issues that Companies will have to work through when they are deemed the owner of the construction project is the question of fair value. Of course that would be too expansive of a topic to tackle in this post, however, most of my clients will either a) use a sale price if it was within the last year or so, and possibly adjust the price to account for potential changes since the sale, or b) they hire an accounting firm to perform a valuation (generally costs anywhere from $5k to $15k in my experience). Based on the previous paragraph, it is important that the fair value of any buildings/improvements are provided separately from the fair value of the land.

During the construction phase, remember one golden rule, you have been deemed the owner, and therefore you account for it exactly if you are the LEGAL OWNER. Most people are very familiar with these general concepts, so if you follow your instinct on that front, you should be fine. Next up, I’ll briefly go through the main points that kick people out of “normal sale leaseback”, and then in Part 6 (the final part), I’ll walk through the complicated part of accounting for build to suit leases post construction period.

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  • jamieb105


    If the lease in question is for an entire building (for a retail store) – and the lessee is deemed the owner during construction due to spend non normal improvements, should the FMV of the building and the land be recognized on the lessee’s balance sheet during construction or just the FMV of the building?


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