Chapter 11 — Control of the Underlying Asset Before Commencement

11.3 Lessee’s Involvement in Construction Before Lease Commencement (Build-to-Suit Arrangements)

Build-to-suit arrangements can broadly be defined as arrangements in which a lessee is involved in construction of an asset it will eventually lease, including projects undertaken from the ground up and construction of major structural improvements related to existing assets.

Changing Lanes

Accounting for Build-to-Suit Arrangements

Under ASC 840, an entity considered whether it had taken on substantially all of the risks of construction and therefore whether it had to be considered, from an accounting perspective, the deemed owner during construction. Under this guidance, a lessee that was the deemed owner was required to record the entire cost of the asset and a corresponding financing obligation (for the portion of the cost funded by the lessor) on its balance sheet for amounts not directly funded during the construction period. Further, upon completion of construction, the lessee was required to apply sale-and-leaseback accounting to determine whether it could derecognize the project. Many entities were unable to derecognize the project after construction because of various forms of continuing involvement that precluded sale treatment. This was a particularly pervasive outcome for build-to-suit arrangements that involved real estate. Overall, the build-to-suit rules in ASC 840 were widely considered to be overly complex to apply and to result in overly punitive accounting outcomes.

ASC 842 removes the risk principle governing the determination of the deemed owner and replaces it with a model in which a lessee will be considered to own an asset during construction only if the lessee has “control” of the asset during the construction period.

11.3.1 Costs Related to the Construction or Design of an Underlying Asset

ASC 842-40

55-3 An entity may negotiate a lease before the underlying asset is available for use by the lessee. For some leases, the underlying asset may need to be constructed or redesigned for use by the lessee. Depending on the terms and conditions of the contract, a lessee may be required to make payments relating to the construction or design of the asset.

55-4 If a lessee incurs costs relating to the construction or design of an underlying asset before the commencement date, the lessee should account for those costs in accordance with other Topics, for example, Topic 330 on inventory or Topic 360 on property, plant, and equipment. Costs relating to the construction or design of an underlying asset do not include payments made by the lessee for the right to use the underlying asset. Payments for the right to use the underlying asset are lease payments, regardless of the timing of those payments or the form of those payments (for example, a lessee might contribute construction materials for the asset under construction).

A lessee may be required to make payments related to the underlying asset before the commencement date of the lease. In such cases, the lessee and the lessor should first assess whether the lessee controls the underlying asset before commencement (see Section 11.3.2). If the lessee controls the underlying asset before commencement, the lessee should account for the asset in accordance with Section 11.4 as if it were the deemed owner. If the lessee does not control the underlying asset before commencement, the lessee should do the following in accordance with ASC 842-40-55-3 and 55-4:

Determine whether those payments are for (1) costs related to the construction or design of the underlying asset to be leased or (2) the right to use the underlying asset.
If the payments are for costs related to the asset’s construction or design, they should be accounted for in accordance with other applicable GAAP (e.g., ASC 330, ASC 360).
If the payments are for the right to use the asset, they are lease payments, as discussed in Chapter 6.

Changing Lanes

Costs Incurred by Lessee Are No Longer Determinative of Whether Lessee Is the Deemed Owner of Construction

Under ASC 840-40, the lessee’s payment of “hard costs” before inception (e.g., payments for site preparation, construction costs, or equipment that is related to components to be used in a construction project) generally resulted in a sale-and-leaseback transaction, since the lessee was considered the deemed owner of the construction project before entering into the lease agreement. ASC 840-40 generally required the same outcome when the lessee paid for “soft costs” before inception (e.g., payments for architectural fees, survey costs, or zoning fees that are related to components to be used in the construction of a project) and the soft costs represented more than a minor amount of the expected fair value of the asset under construction.

However, under ASC 842-40, payments made for costs related to the asset’s construction or design are not indicative of whether the lessee is the deemed owner of the asset under construction. Provided that the lessee does not control the asset under construction before lease commencement (see Section 11.3.2), costs related to the asset’s construction or design should be accounted for in accordance with other applicable GAAP, as indicated in ASC 842-40-55-4, regardless of whether those costs are considered hard costs or soft costs. Effectively, under ASC 842-40, the concepts of hard costs and soft costs no longer exist.

Example 11-1

Company X enters into a build-to-suit transaction to construct a building (i.e., X will be involved in the construction of the building before its lease of the building commences). Company X acts as construction agent. Before lease inception, X graded the land to prepare the site for construction of the building.

Under ASC 840, since the hard cost incurred involved construction of the asset (site preparation), X was considered the owner of the construction project and the transaction was treated as a sale-and-leaseback transaction. Under ASC 842, provided that either (1) the lease commenced before the effective date of ASC 842 (see Section 16.8) or (2) the lease has not commenced but X does not control the asset under construction before lease commencement (see Section 11.3.2), X would not be considered the deemed owner during construction and would account for the costs of preparing the site for construction under ASC 842-40-55-3 and 55-4.

In determining whether payments made by the lessee before the commencement date of the lease should be considered lease payments for the future right to use the underlying asset or whether the payments should be accounted for as costs related to the asset’s construction or design that are within the scope of other applicable GAAP (e.g., ASC 330, ASC 360), the lessee should consider the nature and substance of the payments made. Factors to consider include, but are not limited to, the nature of the construction costs or activities paid for by the lessee and whether the cash lease payments negotiated with the lessor that are due after lease commencement appear to be at market rates (e.g., the cash lease payments that would have otherwise been due in the absence of lease prepayments may be decreased below market rates as a result of those prepayments). Costs incurred by the lessee for leasehold improvements for the benefit of the lessee are generally accounted for in accordance with ASC 360. Payments made by the lessee before lease commencement for the lessee’s right to use the lessor’s asset, rather than for leasehold improvements, are generally accounted for as lease payments. An entity should use judgment in determining the appropriate guidance to apply to payments made before lease commencement.

Example 11-2

Company Y enters into a build-to-suit transaction to construct a building. Company Y enters into a lease agreement with the lessor before the start of construction. The lease commencement date will be 30 days after the building is fully constructed. Company Y does not control the asset under construction and therefore is not considered the deemed owner. During the construction period, Y purchases slabs of granite that it expects to use throughout the leased floors of the building. The granite purchased by Y can be seen as a leasehold improvement since it will be used by the lessee and is not related to the right to use the lessor’s asset. Therefore, Y would account for the cost incurred in accordance with ASC 360.

Example 11-3

Company Y enters into a build-to-suit transaction to construct a building. Company Y enters into a lease agreement with the lessor before the start of construction. The lease commencement date will be 30 days after the building is fully constructed. Company Y does not control the asset under construction and therefore is not considered the deemed owner. During the construction period, Y purchases various construction materials specified under the terms of the lease agreement with the lessor. The construction materials purchased by Y can be viewed as consideration paid to the lessor for the right to use the lessor’s asset, which reduces the amount of future cash lease payments required after lease commencement. Therefore, Y would account for the cost incurred for construction materials as a prepayment of rent in accordance with ASC 842.

11.3.2 Control of the Underlying Asset During Construction

ASC 842-40

55-5 If the lessee controls the underlying asset being constructed before the commencement date, the transaction is accounted for in accordance with this Subtopic. Any one (or more) of the following would demonstrate that the lessee controls an underlying asset that is under construction before the commencement date:

The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period (for example, by making a payment to the lessor).
The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use (see paragraph 842-10-55-7) to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased.
The lessee legally owns either:
1. Both the land and the property improvements (for example, a building) that are under construction
2. The non-real-estate asset (for example, a ship or an airplane) that is under construction.
The lessee controls the land that property improvements will be constructed upon (this includes where the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale in accordance with paragraphs 842-40-25-1 through 25-3) and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements.
The lessee is leasing the land that property improvements will be constructed upon, the term of which, together with lessee renewal options, is for substantially all of the economic life of the property improvements, and does not enter into a sublease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to sublease the land for substantially all of the economic life of the property improvements.

The list of circumstances above in which a lessee controls an underlying asset that is under construction before the commencement date is not all inclusive. There may be other circumstances that individually or in combination demonstrate that a lessee controls an underlying asset that is under construction before the commencement date.

Even if a lessee determines that it does not meet any of the criteria in ASC 842-40-55-5, it may still “control an underlying asset” during construction on the basis of the concept of control in ASC 606.1 The first three criteria in ASC 842-40-55-5 are grounded in principles of ASC 606, which indicate that the lessee has control of the asset during construction if (1) the lessee holds a call option, (2) the lessor has an enforceable right to payment for performance to date and the asset does not have an alternative use, or (3) the lessee has title to the asset under construction. The concept in the last two criteria is not in ASC 606 but, in our view, is based on an assumption that the lessor should be able to legally use the underlying land (e.g., cannot be forced to vacate the property) during substantially all of the economic life of the property improvement that is being constructed on the land.

We do not believe that the concept of controlling an asset under construction should be based on the definition of a lease in ASC 842, which includes guidance on whether a contract conveys the right to control the use of an identified asset. Although the concepts sound similar, the FASB explicitly excluded from the scope of ASC 842 leases of assets under construction, partially because it is difficult to apply the lease definition before an asset is placed in service (e.g., it is difficult to assess the economic benefits associated with an asset that is not yet operational).

When the above principles are applied, it would not be appropriate to conclude that a lessee controls the asset under construction solely because of its involvement in designing the asset or acting as the general contractor during the construction project. This involvement is typical of many “build-to-suit” arrangements. In these cases, the lessee would typically not control the asset during construction because the lessee does not (1) take title to the asset, (2) provide the lessor with an enforceable right to payment, or (3) prevent the lessor from using the underlying land for substantially all of the economic life of the property improvements.

Example 11-4

The lessee would not control the asset during construction because its role as general contractor and designer of an asset is not an indicator of control under the criteria in ASC 842-40-55-5 or the principles of control in ASC 606. Likewise, the lessee’s exposure to overrun risk (since the lessor will pay only up to $50 million of the construction costs) does not affect the control analysis; before the adoption of ASC 842, however, the lessee would have been considered the deemed accounting owner because of its exposure to construction risk.

Connecting the Dots

Control of Asset Under Construction Is Similar to Control in ASC 606

ASU 2016-02’s Background Information and Basis for Conclusions notes that (1) a lessee can be, and thus should assess whether it is, the owner of an asset under construction before lease commencement and (2) the assessment should be based on control (i.e., when the lessee controls the asset under construction). This is a departure from the requirements under ASC 840-40, which focused on construction risk assumed by a lessee, and is another example of the Board’s effort to align the guidance on leases and revenue when appropriate. Two of the indicators of a lessee’s control of an underlying asset that is under construction closely mirror those used by suppliers under ASC 606 to determine whether customers gain control of their work as they perform (i.e., as construction progresses). Under ASC 606, when a supplier’s “performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced,” the supplier is satisfying its performance obligation over time. A lessee that controls an asset as it is created or enhanced by the supplier’s performance owns the asset throughout the work in process and should therefore apply the sale-and-leaseback accounting guidance in ASC 842-40 upon lease commencement. ASC 842-40 also provides indicators of legal ownership of the asset under construction as well as control, through lease or ownership, of the underlying land.

However, it is important to differentiate control of an asset during construction from control of the right to use an asset during construction. The latter reflects the lease of an asset under construction, an arrangement that is outside the scope of ASC 842 (see Chapter 3).

11.3.2.1 Lessee Has the Right to Obtain the Partially Constructed Underlying Asset at Any Point During the Construction Period

ASC 842-40-55-5(a), which provides one criterion under which the lessee would control the underlying asset during construction before the lease commences, states that the “lessee has the right to obtain the partially constructed underlying asset at any point during the construction period (for example, by making a payment to the lessor).”

In other words, if a call option is exercisable by the lessee at any point during construction, the lessee controls the underlying asset and should recognize the CIP. Importantly, “at any point” does not mean at all points; therefore, entities must also consider options that arise (or become exercisable) during the construction period regardless of whether they are based on the passage of time or a substantive contingency. In the case of a substantive contingency, an entity would be deemed to control the asset under construction once it has the current ability to exercise the option. On the other hand, we believe that if the only barrier preventing exercise is the passage of time, an entity would be deemed to control the asset under construction from the beginning of the construction period.

An entity should carefully analyze a call option that becomes exercisable upon the occurrence of a contingent event to determine whether the lessee can unilaterally cause the call option to become exercisable. For example, some construction and lease agreements stipulate that if the lessee defaults on its obligation to perform under the agreement, the lessee would be obligated to purchase the CIP. Under this provision, the lessee would control the underlying asset because it could unilaterally default under the agreement and thereby become able to obtain the underlying asset. In contrast, if the obligation or option to purchase the CIP was outside the control of the lessee (e.g., bankruptcy or third-party events), the lessee would not have control over the CIP until the contingent event occurred. Once the lessee is deemed to control the CIP, it must apply sale-and-leaseback accounting rules to determine whether it can derecognize the project, typically upon the completion of construction or at lease commencement. Scenarios in which the lessee must apply sale-and-leaseback accounting rules to make such a determination include those in which the lessee maintains control up to completion of construction, as well as those in which the option that conveyed control expires unexercised during the construction period.

Example 11-5

A lessee enters into a construction and lease agreement with a lessor to build a new corporate headquarters. The lessor will retain title to the building throughout the construction period and agrees to pay up to $50 million toward construction. The construction is expected to be completed in 18 months. At any point during the construction, the lessee has the right (but not the obligation) to purchase the CIP at the lessor’s cost plus a profit margin. If the call option is not exercised and construction is completed, the lessee will lease the asset from the lessor for a lease term of 15 years with an option to purchase the building at the end of the lease term at a fixed price.

The lessee would control the asset during construction and recognize the CIP. At the end of construction, the lessee must consider the sale-and-leaseback guidance in ASC 842-40-25-1 through 25-3. In this case, the lessee would not qualify for sale accounting because of the call option that exists at the end of the lease period (see Section 10.3.3.1).

Connecting the Dots

Lessor Put Options

Lessor put options should also be considered in scenarios involving construction of an asset to be leased. In a manner consistent with the guidance on put options in ASC 606, an entity should assess a put option held by the lessor to determine whether the lessor has a significant economic incentive to exercise the option.

If such an incentive exists, it would be assumed that the lessee controls the CIP.

11.3.2.2 Lessor Has Enforceable Right to Payment for Its Performance to Date and the Asset Does Not Have an Alternative Use

ASC 842-40-55-5(b), which provides one criterion under which the lessee would control the underlying asset during construction before the lease commences, states the following:

The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use (see paragraph 842-10-55-7) to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased.

The criterion in ASC 842-40-55-5(b) would apply only when (1) the lessor has an enforceable right to payment for all of its performance to date (i.e., throughout the development or construction of the asset) and (2) the asset has no alternative use to the owner-lessor. This criterion is derived from the guidance in ASC 606 on recognizing revenue as control is transferred to a customer over time (e.g., when the transfer of control results in the customer’s ownership of a partially completed asset during the asset’s development or construction).

We expect the circumstances listed above to be uncommon for an asset under construction because a lessee is not typically required to pay for all of the performance to date throughout construction. Rather, the lessor will be paid, at least in part, through lease payments over the period of the lease term after construction has ended. A significant amount of required prepaid rent would not meet the criterion in ASC 842-40-55-5(b) unless the lease provided for the nonrefundable right to payment for all the costs incurred by the lessor plus a reasonable profit margin. That is, for the future lessee to control the asset and, therefore, to be the deemed owner of the asset during construction under this condition, the required payments must compensate the developer for all construction efforts throughout the asset’s construction.2

Further, many build-to-suit arrangements may require the lessee to pay the lessor upon the occurrence of certain contingent events outside the lessor’s control (e.g., default by the lessee). This requirement alone would not meet the criterion in ASC 842-40-55-5(b) because the lessor cannot force the lessee to pay in the absence of a default under the lease agreement.

Finally, in the rare circumstances in which the first part of this criterion is met, the asset under construction may have an alternative use to the lessor under ASC 842-10-55-7. This criterion is intended to be the same as that in ASC 606-10-25-27(c) and 25-28. See Section 8.4.5.1 of Deloitte’s Roadmap Revenue Recognition for a detailed discussion of this criterion.

11.3.2.3 Lessee Controls the Underlying Land

ASC 842-40-55-5(d), which provides one criterion under which the lessee would control the underlying asset during construction before the lease commences, states the following:

The lessee controls the land that property improvements will be constructed upon (this includes where the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale in accordance with paragraphs 842-40-25-1 through 25-3) and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements. [Emphasis added]

In this context, the lease term should take into account all renewal options, regardless of whether it is reasonably certain that the renewal options will be exercised. Note that the consideration of renewal options in accordance with this criterion differs from the consideration of renewal options in the determination of lease term under ASC 842-10-30-1. (See Section 5.2.2 for further discussion.) Examples of when the transfer of land may not qualify as a sale include circumstances in which the seller-lessee retains a call option on the land or the leaseback is determined to be a finance lease.

In our view, the concept in the criterion in ASC 842-40-55-5(d) is based on an assumption that the lessor of the property improvements should be able to use the underlying land during substantially all of the economic life of the property improvements that are being constructed on the land. When the lessor does not have appropriate rights to the land, the lessee would control the property improvements during construction if the following conditions are met:

The lessee of the property improvements controls the land — This condition is met if any of the following is true:
- The lessee holds title to the land.
- The lessee previously sold the land but did not qualify for sale accounting.
- The lessor of the property improvements has title to the land, but the lessee sold the land to the lessor in a failed sale and leaseback.
The lessee controls the constructed asset — Even if the first condition is met (i.e., the lessee controls the land), the lessee does not control the constructed asset if it has leased the land to the lessor for substantially all of the economic life of the to-be-constructed asset.

Read literally, the second condition can never be met in a financing of the land through a previous failed sale or sale and leaseback because the lessee cannot lease out the land that it has already legally sold to the lessor. However, we believe that the principle underlying the criterion in ASC 842-40-55-5(d) should be considered. That is, an entity should consider whether the lessor has the right to legally use the land for substantially all of the economic life of the property improvements. The entity must consider all facts and circumstances when making this determination.

Example 11-6

Company A sells land to Company B and contemporaneously enters into a construction and lease agreement for B to build a new corporate headquarters for A. Upon completing construction of the new headquarters building, B will lease the land and the building to A for a period of 40 years. At the end of 40 years, A will have the right to purchase the land and corporate headquarters at a fixed price. The corporate headquarters has an estimated economic life of 40 years. Company A must evaluate whether it meets the criteria in ASC 842-40-55-5(d). In this example, it is assumed that none of the other criteria in ASC 842-40-55-5 apply to the arrangement related to the to-be-constructed property improvements.

Company A determines, in accordance with ASC 842-40-25-3, that the call option precludes accounting for the transfer of the land as a sale. The first condition in ASC 842-40-55-5(d) is met since the failed sale-and-leaseback of the land indicates that the seller/lessee (A) still controls the land during construction.

However, even if the first condition is met, A must also evaluate the second condition related to whether it also controls the constructed asset. (Importantly, the right to use the constructed asset is not the same as controlling the constructed asset.) In assessing whether A controls the corporate headquarters, A notes that B has the legal right to use the land (as lessor of the corporate headquarters) for the entire 40-year economic life of the asset to be constructed. That is, the land purchase option is not exercisable until the property improvement has no remaining economic life. Therefore, on the basis of these facts and circumstances, A (as the seller/lessee) concludes that it does not control the corporate headquarters during construction since the second condition in ASC 842-40-55-5(d) is not met.

11.3.2.4 Codification Examples

Example 3, Cases A and B, reproduced below, illustrate applications of the guidance in ASC 842-40-55-5.

ASC 842-40

55-6 See Example 3 (paragraphs 842-40-55-39 through 55-44) for an illustration of the scope of this Subtopic.

55-39 Example 3 illustrates the guidance on determining whether a lessee controls an underlying asset that is under construction before the commencement date.

Example 3 — Lessee Control Over an Asset Under Construction

55-40 Lessee and Lessor enter into a contract whereby Lessor will construct (whether itself or using subcontractors) a building to Lessee’s specifications and lease that building to Lessee for a period of 20 years once construction is completed for an annual lease payment of $1,000,000, increasing by 5 percent per year, plus a percentage of any overruns above the budgeted cost to construct the building. The building is expected to have an economic life of 50 years once it is constructed. Lessee does not legally own the building and does not have a right under the contract to obtain the building while it is under construction (for example, a right to purchase the construction in process from Lessor). In addition, while the building is being developed to Lessee’s specifications, those specifications are not so specialized that the asset does not have an alternative use to Lessor.

Case A — Lessee Does Not Control the Asset Under Construction

55-41 Assume Lessee controls (that is, Lessee is the owner for accounting purposes) the land upon which the building will be constructed and, as part of the contract, Lessee agrees to lease the underlying land to Lessor for an initial period of 25 years. Lessor also is granted a series of six 5-year renewal options for the land lease.

55-42 None of the circumstances in paragraph 842-40-55-5 exist. Even though Lessee owns the land (whether legally or for accounting purposes only) upon which the building will be constructed, Lessor legally owns the property improvements and has rights to use the underlying land for at least substantially all of the economic life of the building. Lessee does not own the building and does not have a right under the contract to obtain the building (for example, a right to purchase the building from Lessor). In addition, the building has an alternative use to Lessor. Therefore, Lessee does not control the building under construction. Consequently, the arrangement is not within the scope of this Subtopic. Lessee and Lessor will account for the lease of the building in accordance with Subtopics 842-20 and 842-30, respectively. If Lessee incurs costs related to the construction or design of the building (for example, architectural services in developing the specifications of the building), it will account for those costs as lease payments unless the costs are for goods or services provided to Lessee, in which case Lessee will account for those costs in accordance with other Topics.

Case B — Lessee Controls the Asset Under Construction

55-43 Assume Lessee leases, rather than owns, the land upon which the building will be constructed. Lessee has a 20-year lease of the underlying land and five 10-year renewal options. Therefore, Lessee’s lease of the underlying land, together with the renewal options, is for at least substantially all of the economic life of the building under construction. Lessee enters into a sublease with Lessor for the right to use the underlying land for 20 years that commences upon completion of the building. The sublease has a single 10-year renewal option available to Lessor.

55-44 Lessee controls the building during the construction period and, therefore, the arrangement is within the scope of this Subtopic. Lessee and Lessor will apply the guidance in this Subtopic to determine whether this arrangement qualifies as a sale and a leaseback or whether this arrangement is, instead, a financing arrangement. Lessee controls the building during the construction period because, in accordance with paragraph 842-40-55-5(e), Lessee controls the use of the land upon which the building will be constructed for a period that is at least substantially all of the economic life of the building and the sublease entered into with Lessor does not both (a) grant Lessor the right to use the land before the beginning of construction and (b) permit Lessor to use the land for substantially all the economic life of the building (that is, the sublease, including Lessor renewal options, only is for 30 years as compared with the 50-year economic life of the building).

Footnotes

Paragraph BC400(b) of ASU 2016-02 states, in part, that the FASB “observed that, in concept, the evaluation under Subtopic 842-40 on whether an entity controls an asset that is under construction is similar to the evaluation undertaken in the revenue recognition guidance in accordance with paragraph 606-10-25-27 to determine whether a performance obligation is satisfied over time.”

This example contemplates a scenario in which the lessee is able to instruct the lessor to stop construction and thus is liable for only cost plus a reasonable margin incurred through the date of ceased construction. However, the example does not contemplate a specific performance scenario in which, despite the lessee’s request to cease construction, the lessor could elect to complete construction and therefore require the lessee to pay the full consideration in the agreement (cost plus margin). The latter arrangement suggests that the lessee has control over the CIP in a manner consistent with the guidance in ASC 606-10-55-13.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.