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 (http://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).
840-40-55-44
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 (http://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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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.
Overview
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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Build To Suit – 90% Maximum Guarantee Test
We’ve already discussed the six automatic indicators of ownership in Part 2. I recommend reading this in case you haven’t yet.
The six automatic indicators of ownership are not the only way that you can be considered the “owner” of a construction project. The other main method is that you fail the 90% Maximum Guarantee Test. Per ASC 840-40-55-10:
Beginning with the earlier of the date of lease inception or the date that the terms of the construction arrangement are agreed to, if the documents governing the construction project could require, under any circumstance, that the lessee pay 90 percent or more of the total project costs (excluding land acquisition costs) as of any point in time during the construction period, then the lessee-agent should be deemed to have substantially all of the construction period risks and should be considered to be the owner of the real estate project during the construction period.
There are many intricacies when it comes to identifying the costs to include, which costs to exclude, how to accrete prior costs and discount future costs; however, I want to start with the most relevant information that will apply to most first. As the “under any circumstances” suggests in the codification above, this test is a “worst case scenario” type of test. Essentially, what this means is that if you have an unlimited exposure to cost overruns, then you will automatically fail this test.
Ernst & Young (EY) regularly publish their “Financial Reporting Developments – Lease Accounting” guide online for the public. I pulled the following from this publication (revised August 2015), and you can find E&Y’s latest publications here:
Cost overruns
An obligation to fund construction cost overruns would be included in the maximum guarantee test. A lessee’s unlimited obligation to cover costs over a certain amount (for example, an obligation arising from the lessee-general contractor’s entering into a fixed-price contract) would result in the lessee’s maximum guarantee being in excess of 90% of the total project costs. Therefore, the lessee would be considered the owner of the project during the construction period. Any payments that the lessee could be required to make as a result of cost overruns or change orders should be considered carefully. Payments made by the lessee during the construction period for tenant improvements also should be carefully considered. Payments for normal tenant improvements would not impact either the maximum guarantee or the lease classification tests. Payments for any other tenant improvements (for example, those originally included in amounts to be paid by the lessor) should be treated the same as other cost overruns.
Note the sentence regarding “normal tenant improvements”. Normal tenant improvements (see Part 2 for discussion) do NOT impact this test. In other words, your “construction project” should exclude these types of costs. This is important as you’ll see in later parts.
What to include in the maximum guarantee test
So this section, admittedly, will not help most people as most people never need to get as far as actually calculating out a % for this as they generally are 100% liable for overruns or their costs are limited to a number that does not require a mathematical computation as it is extremely low as compared to the total project. Therefore, I am going to list the relevant codification guidance here, as well as some of the firm guidance. As always, please feel free to submit a question if you have any questions at all.
Implementation Guidance and Illustrations
840-40-55-8
Except as indicated in the following paragraph and paragraph 840-40-55-15, the maximum guarantee should include, but not be limited to, the following:
- Lease payments that must be made regardless of when or whether the project is complete (a date-certain lease)
- Guarantees of the construction financing (however, such guarantees can only be made to the owner-lessor as specified in paragraph 840-40-55-15(d))
- Equity investments made (or an obligation to make equity investments) in the owner-lessor or any party related to the owner-lessor
- Loans or advances made (or an obligation to make loans or advances) to the owner-lessor or any party related to the owner-lessor
- Payments made by the lessee in the capacity of a developer, a general contractor, or a construction manager-agent that are reimbursed less frequently than is normal or customary for the real estate construction industry in transactions in which the developer, general contractor, or construction manager-agent are not involved in the project in any other capacity
- Primary or secondary obligations to pay project costs under construction contracts
- Obligations that could arise from being the developer or general contractor
- An obligation to purchase the real estate project under any circumstances
- An obligation to fund construction cost overruns
- Rent or fees of any kind, such as transaction costs, to be paid to or on behalf of the lessor by the lessee during the construction period
- Payments that might be made with respect to providing indemnities or guarantees to the owner-lessor.
840-40-55-9
The following guidance relates to the application of the maximum guarantee test:
- If, in connection with the project, the lessee or any party related to the lessee makes or is required to make an investment in the lessor, or any party related to the lessor, other than investments considered to be in substance real estate as discussed in paragraph 840-40-55-15, the cost of that investment is to be included in the maximum guarantee test. Likewise, if, in connection with the project, the lessee or any party related to the lessee makes or is required to make loans or advances (including making time deposits) to the lessor or any party related to the lessor, other than loans that in substance represent an investment in the real estate project, those loans or advances are to be included in the maximum guarantee test.
- If the lessee, in the capacity of a developer, a general contractor, or a construction manager-agent pays or can be required to pay costs relating to the project that are reimbursed less frequently than is normal or customary, those payments are to be included in the maximum guarantee test. Thus, if the lessee can be required to make payments at a time when the owner-lessor of the project does not have the funds or a committed line of credit available to make the required reimbursements, the maximum payment amount that the lessee could be required to make is included in the maximum guarantee test. For this purpose, a line of credit would not be considered committed if there is a possibility that the reimbursement would not occur because the lender, as a result of a provision in the loan agreement, agency agreement, or other documents pertaining to the transaction, can withhold funds for any reason other than misappropriation of funds or willful misconduct of the owner-lessor or its agent.
- Any guarantee or commitment made to the owner-lessor by a party related to the lessee should be included in the maximum guarantee test as if that guarantee were made by the lessee unless the owner-lessor, guarantor, and lessee all are under common control, in which circumstance the guarantee or commitment may be excluded from the maximum guarantee test. Thus, situations in which a private entity (lessee) is controlled by a shareholder that also controls the lessor are not required to consider such guarantees or commitments in performing the maximum guarantee test.
- Any indemnification or guarantee of the owner-lessor against third-party claims relating to construction completion must be included, at its maximum amount, in the maximum guarantee test without regard to the probability of its occurrence.
- Total project costs include the amount capitalized in the project by the owner-lessor in accordance with generally accepted accounting principles (GAAP) plus other costs related to the project paid to third parties other than lenders or owners. For example, cancellation fees that would be payable to subcontractors if the project were to be cancelled before completion would be included in total project costs. Transaction costs that would not be capitalized by the lessor as construction costs in accordance with GAAP, such as a facility fee (that is, a fee paid to establish a master lease facility), are specifically excluded from the definition of total project costs. Consequently, if the lessee were to pay any transaction costs to or on behalf of the lessor at the time the construction arrangement is entered into, the lessee would be considered the owner of the construction project because that payment by definition would exceed the total project costs incurred to date at that time. Likewise, imputed yield on equity in the project is specifically excluded from the definition of total project costs.
- Land acquisition costs should be excluded from project costs for purposes of applying the maximum guarantee test regardless of the land value relative to the overall project value. Land carrying costs, such as interest or ground rentals incurred during the construction period, are considered to be part of total project costs.
- A lessee’s unlimited obligation to cover costs over a certain amount (for example, an obligation arising from the lessee-general contractor’s entering into a fixed-price contract) would result in the lessee’s maximum guarantee being in excess of 90 percent of the total project costs. Therefore, the lessee would be considered the owner of the project during the construction period.
- Any payments that the lessee could be required to make as a result of cost overruns or change orders should be considered carefully. Payments by the lessee for project costs that are not reimbursed by the owner-lessor will cause the lessee to be considered the owner of the project during the construction period. However, lease payments made during the construction period do not automatically cause the lessee to be considered the owner of the project, although those payments would need to be considered in both the maximum guarantee test and the lease classification test. Payments made by the lessee during the construction period for tenant improvements should be carefully considered. Payments for normal tenant improvements, as described in paragraph 840-40-55-15(b), would not affect either the maximum guarantee or the lease classification tests. Payments for any other tenant improvements (for example, those originally included in amounts to be paid by the lessor) should be treated the same as other cost overruns.
- If the lessee is obligated to make payments in either of the following circumstances, those payments should be included in both the maximum guarantee test and the lease classification computation:
- The lessee is obligated to make a payment under the lease regardless of whether the construction project is completed (as would be the circumstance in a date-certain lease).
- The lessee is required to prepay rent, those payments should be included in both the maximum guarantee test and the lease classification computation.
With respect to the lease classification computation, any lease payments made during the construction period should be accounted for in accordance with the guidance in paragraph 840-10-25-6(d).
- The following contingent obligations assumed by the lessee are the only contingent obligations that are to be excluded from the maximum guarantee test:
- Permitted environmental indemnities as discussed in paragraph 840-40-55-15(c)
- Indemnifying the owner-lessor for permitted third-party damage claims as discussed in paragraph 840-40-55-15(d), other than claims arising directly or indirectly out of the lessee’s failure to complete construction or to cause construction to be completed by a specified date (for example, claims brought by lenders to accelerate payment of construction financing)
- Claims brought by the owner-lessor relating to fraud, misapplication of funds, illegal acts, or willful misconduct on the part of the lessee
- A bankruptcy of the lessee.
All other contingent obligations, including contingent obligations resulting directly or indirectly from the lessee’s failure to complete construction (for example, default obligations under the related lease agreement if failure to complete construction is an event of default under the lease), must be included in the maximum guarantee test at their maximum amount without regard to the probability of their occurrence. Lessee obligations that result from the lessee’s bankruptcy are to be excluded from the maximum guarantee test only if it is reasonable to assume, based on the facts and circumstances that exist on the date the construction agreements are entered into, that a bankruptcy will not occur during the expected period of construction.
- In performing the maximum guarantee test, the lessee must consider each alternative course of action available to the owner-lessor in the event of a lessee default under any applicable construction period agreement. For example, if the owner-lessor can cause the uncompleted project to be sold and trigger the lessee’s maximum guarantee payment, or alternatively, activate the lease and enforce its rights thereunder, the lessee must perform the maximum guarantee test assuming that the lessor will select the alternative with the highest cost (as a percentage of total project costs) to the lessee.
I’ll actually plug E&Y one more time here. Their leasing guide (link reposted here) has detailed information on the inclusions and exclusions in the maximum guarantee test.
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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:
- the implicit rate, if known,
- 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
- 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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Sale Leaseback accounting for real estate
The point of this post is not to go through every iteration of sale leaseback accounting, but to focus on how sale leaseback accounting will most likely affect your build to suit lease. First a few important notes that will help you make sense of the guidance.
The guidance (ASC 840-40) refers to “Sale Leaseback Accounting”, and is synonymous with how most people refer to either “normal sale leaseback accounting” or “non-failed sale leaseback accounting.” Essentially the guidance is laid out so that you do normal leaseback accounting unless you fail it, so when it says “sale leaseback accounting” it is not the accounting that typically results from build to suit leases.
The second thing to point out is that ASC 840-40-15 (Scope) specifies that the “Real Estate” subsections of ASC 840-40 apply to the following
The guidance in the Real Estate Subsections applies to the following transactions:
- Sale-leaseback transactions that qualify for sales recognition under the guidance in paragraphs 360-20-40-57 through 40-59
- Sale-leaseback transactions involving real estate with equipment or equipment integral to real estate
- Sale-leaseback transactions involving only real estate
- Sale-leaseback transactions involving real estate with equipment in which the equipment and the real estate are sold and leased back as a package, irrespective of the relative value of the equipment and the real estate
- Sale-leaseback transactions in which the seller-lessee sells property improvements or integral equipment to a buyer-lessor and leases them back while retaining the underlying land
- Sale-leaseback transactions involving real estate with equipment that include separate sale and leaseback agreements that meet both of the following conditions:
- They are with the same entity or related parties.
- They are consummated at or near the same time, suggesting that they were negotiated as a package.
Essentially this means that when looking through the codification, and if the sale leaseback transaction includes any real estate, you need to focus on the “Real Estate” subsections.
With that said, instead of going through the guidance word by word, let’s try to focus on the concept underlying sale leaseback transactions. The entire point of this part of the codification is to prevent companies from disguising loans as “sales” and then subsequent “leases”. For one, this would not portray the economics of many transactions, and two, this may allow for companies to manage their earnings. For example, let’s say that I want to $10,000, however, I already have a debt outstanding with a financial covenant that requires a certain current asset to liability ratio that I’m VERY close to. In this scenario, let’s assume that we’ve concluded that $10,000 would essentially cause us to violate our financial covenant and put us in default. However, save for the covenant in questions, the bank would have allowed us to borrow the $10k at our incremental borrowing rate (10%) with a repayment period of 5 years. So we devise a plan where we take a company vehicle and “sell” it to a bank, and then subsequently “lease” it back for 5 years. The sales price is $10k. We agree to pay $2,640 each year (which is approximately what payments would be if compounded annually on a similar $10k loan). In this way, the company will be able to put a loan on their books, and potentially avoid any balance sheet recognition all together of the financing arrangement, if papered in a way that the lease would have been classified as an operating lease. To my second point, if the other counterparty is viewing this transaction as a loan (and their interest rate is commensurate with the risk as if it were an uncollateralized loan), then they may not have a strong opinion on the “sale price”, and therefore the sale price may not accurately reflect a fair market value of the underlying asset. In the previous example, if the bank was comfortable loaning $100,000 instead of $10,000, then this most likely would have resulted in a large gain on the date of sale. In this way, without special rules in place, sale leaseback arrangements present significant risk that Management can both manage earnings and misrepresent financial arrangements.
Let me stop here and say that these situations above are not these far fetched ideas that only rarely happen. In fact, sale leasebacks are very common ways to paper loans and have them be collateralized. If the seller/lessee doesn’t pay their “rents”/”debt payments” then the buyer/lessor can take the underlying assets back. In practice, I have seen this many times where a company will sell and then leaseback its personal property such as desks, chairs, laptops, etc.. Often, at the end of these “leases” the buyer/lessor will not even care enough to come and pick up the assets, and will just leave them there, which is further evidence that the transaction was not economically similar to an actual sale and then leaseback, but was, in essence, a financing arrangement.
However, there are times where you are legitimately trying to sell something, and for multiple reasons, you want to lease it back for just a portion of the time. For example, you sell a building because the buyer wanted to lock in future plans in terms of space, so that they effectively manage their business, but they don’t need to actually take possession of the space until later. Likewise, you want a short period of time to wrap things up and move out. These are often papered as a legitimate sale and a subsequent leaseback of the space. The purpose of me saying this is that the guidance focuses on distinguishing between these two scenarios. The way they distinguish between these scenarios, when involving real estate, is on three main factors per ASC 840-40-25-9: (Remember what I said earlier in that “Sale Leaseback accounting” essentially means a non-failed, which translates to you record the sale as a legitimate sale first, then a legitimate leaseback (mostly):
25-9 Sale-leaseback accounting shall be used by a seller-lessee only if a sale-leaseback transaction meets all of the following criteria:
- It meets the definition of a normal leaseback.
- The payment terms and provisions adequately demonstrate the buyer-lessor’s initial and continuing investment in the property as described in paragraphs 360-20-40-9 through 40-24.
- The payment terms and provisions transfer all of the other risks and rewards of ownership as demonstrated by the absence of any other continuing involvement by the seller-lessee described in paragraphs 360-20-40-37 through 40-64, 840-40-25-13 through 25-14, and 840-40-25-17.
The definition of normal leaseback can be found in the glossary section of ASC 840-40:
A lessee-lessor relationship that involves the active use of the property by the seller-lessee in consideration for payment of rent, including contingent rentals that are based on the future operations of the seller-lessee, and excludes other continuing involvement provisions or conditions described in paragraphs 840-40-25-14.
From a build to suit perspective, the issue becomes the concept of continuing involvement. From a theoretical perspective, the guidance is looking for anything that could indicate the “sale” is anything but normal in terms of transferring all of the risks/rewards of ownership as well as having the payment terms match the economics of a normal sale (and leaseback). I recommend looking through the enumerated list provided by the codification, and I will add this to the end of this post. I will point out the three main pieces of continuing involvement that will most likely affect you in your build to suit situation.
1. ASC 840-40-25-13b: The seller-lessee guarantees the buyer-lessor’s investment or a return on that investment for a limited or extended period of time.
I’ve seen this be used when the leaseback period is for a substantial amount of time, and therefore the lease is essentially guaranteeing the landlord a reasonable return on their investment (being the construction project).
2. ASC 840-40-25-14b: The seller-lessee provides nonrecourse financing to the buyer-lessor for any portion of the sales proceeds or provides recourse financing in which the only recourse is to the leased asset.
3. ASC 840-40-25-14d: The seller-lessee provides collateral on behalf of the buyer-lessor other than the property directly involved in the sale-leaseback transaction, the seller-lessee or a related party to the seller-lessee guarantees the buyer-lessor’s debt, or a related party to the seller-lessee guarantees a return of or on the buyer-lessor’s investment. FAS 098, paragraph 12 ][ Except as noted in paragraph 840-40-25-16, an uncollateralized, irrevocable letter of credit is not a form of continuing involvement that precludes sale-leaseback accounting under this Subtopic. The continuing involvement guidance in this Subtopic does not preclude a lessee from providing an independent third-party guarantee of the lease payments in a sale-leaseback transaction. However, all written contracts that exist between the seller-lessee in a sale-leaseback transaction and the issuer of a letter of credit must be considered. For example, a financial institution’s right of setoff of any amounts on deposit with that institution against any payments made under the letter of credit constitutes collateral and, therefore, is a form of continuing involvement that precludes sale-leaseback accounting under this Subtopic.
In order to explain #2 and #3 above, I need to move to firm guidance to explain how these are viewed in the eyes of the firms. The following is taken from PwC’s May 2013 ARM 4650.
The seller-lessee provides nonrecourse financing to the buyer-lessor for any portion of the sales proceeds or provides recourse financing in which the only recourse is to the leased asset (or to the lease itself, i.e., the lease payments). A concern arises whenever (i) the lease payments during the leaseback term are payable in a pattern that reflects substantial acceleration as compared to a straight-line payment pattern (e.g., prepaid rent) and (ii) the acceleration is not justified by estimated increases in the cost of using the leased property. We believe that such an accelerated payment pattern may be indicative of the seller-lessee indirectly providing collateral and/or nonrecourse financing to the buyer-lessor, which may represent continuing involvement sufficient to preclude sale-leaseback accounting. Because accelerated payments, including prepaid rent, are not, in form, either nonrecourse financing or collateral, the significance of the prepayment would be relevant to the determination as to whether it represents continuing involvement. We have seen cases in practice where a seller retains usage for a relatively short period and rents are free or at a nominal amount. Economically, these rents have been netted against the sales proceeds, and represent prepaid rent. Such prepayments generally constitute prohibited continuing involvement.
In determining the amount of accelerated rent paid, the lessee should include any amounts paid during the construction of a build-to-suit asset for which the lessee is considered to be the owner during construction pursuant to ASC 840-40-55. If a future lessee is considered the owner of an
asset under construction due to the fact that there is a cap on the amount of cost to be paid by the lessor, which effectively holds the lessee responsible for all cost in excess of the pre-determined project costs (i.e., including all cost overruns), such excess costs incurred by the lessee are considered to be prepaid rent regardless of the nature of such cost.
Based on the second paragraph above, any rents paid during the construction period (including overruns) as prepaid rent. Based on the first paragraph, this almost always is considered to be recourse financing and/or collateral, which constitute prohibited continuing involvement.
Honestly, it’s pretty safe to bet that if you’ve found yourself in a build-to-suit situation, you probably will fail sale leaseback accounting. Part 6 will walk through the accounting of failed sale leaseback with regarding to build to suit leases.
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