11.4 Accounting by the Deemed Owner of an Asset

After recognizing the asset, the lessee must apply sale-and-leaseback accounting as of the commencement date of the lease (which is typically the end of the construction period) to determine whether it can derecognize the asset (see Chapter 10 for more information about sale-and-leaseback transactions). If the lessee cannot derecognize the asset because the transaction fails to meet the criteria for sale-and-leaseback accounting, the lessee would continue to account for the asset as if it were the asset’s owner, as further discussed below.

In addition, the seller-lessee would continue to account for the financing obligation in the same manner as it would for any other failed sale-and-leaseback transaction. If the seller-lessee expects the balance of the financing obligation to be lower than the net carrying value of the underlying asset when control of the asset is transferred to the buyer-lessor (which is typically the end of the lease term), the interest rate on the financing obligation should be increased to avoid this “built-in loss.” This adjustment generally causes the balance of the financing obligation to be equal to the net carrying value of the underlying asset when control of the asset is transferred.

On the other hand, if the seller-lessee expects the balance of the financing obligation to be higher than the net carrying value of the underlying asset when control of the asset is transferred to the buyer-lessor, the interest rate on the financing obligation should not be adjusted (i.e., a “built-in gain” is not prohibited). See Section 10.4.2.1 for further discussion of the accounting for a financing obligation in a failed sale-and-leaseback transaction.

As discussed above, if a sale and leaseback of the asset fails to meet the sales recognition criteria in ASC 842-40, the seller-lessee would continue to account for the asset as it always has — as the owner. However, when the lessee is deemed the accounting owner of an asset during the construction period, the lessee would not have begun depreciating the asset because the asset would not yet have been placed in service. In other words, rather than account for the asset as it always has, the deemed owner must apply an appropriate depreciation method at the end of the construction period.

The fact that the deemed owner of an asset (e.g., a constructed building) is typically not the owner of the underlying land further complicates the adoption of a depreciation method because treatment of the asset would be akin to that of a leasehold improvement. If the lease meets either the transfer-of-ownership criterion in ASC 842-10-25-2(a) or the reasonably certain purchase option criterion in ASC 842-10-25-2(b), the asset should be depreciated in a manner consistent with the lessee’s normal depreciation policy for owned assets.

If the lease does not meet either criterion, the asset should be depreciated in a manner consistent with the lessee’s normal depreciation policy except that the depreciable life must not exceed the lease term. In a manner consistent with the depreciation of other owned assets, the asset should be depreciated to its expected residual value at the end of its depreciable life. As discussed above, the depreciable life of such assets is often restricted to the lease term, which may result in a significant expected residual value. In these circumstances, the residual value of the asset is effectively the final payment against the associated financing obligation. Importantly, as discussed above, ASC 842-40-30-6 precludes the expected balance of the financing obligation from being lower than the expected residual value of the asset when control of the asset is transferred. However, this guidance stipulates that, in those cases, an entity is required to adjust the interest rate on the financing obligation to avoid a “built-in loss” rather than adjusting the residual value of the asset.