Chapter 11 — Control of the Underlying Asset Before Commencement
Chapter 11 — Control of the Underlying Asset Before Lease Commencement
11.1 Overview
Transactions in which a lessee controls an underlying asset before the commencement date of the lease (in a manner discussed below) are within the scope of the sale-and-leaseback guidance in ASC 842-40. That is, if a lessee controls an underlying asset in the manner discussed in ASC 842-40-55 before the commencement date, the lessee must determine whether derecognition is appropriate as a sale-and-leaseback transaction. Sections 10.2.2 and 10.3 discuss control transfer in accordance with the sale-and-leaseback guidance in ASC 842-40.
The guidance in ASC 842-40-55 effectively categorizes these transactions into two groups:
- ASC 842-40-55-1 and 55-2 cover transactions in which the lessee is involved with an asset before that asset is transferred to the lessor. See Section 11.2 for more information.
- ASC 842-40-55-3 through 55-6 address transactions in which the lessee is involved with a construction project (i.e., the underlying asset that will be subject to the lease is in the process of being constructed). See Section 11.3 for more information.
In addition, see Section 11.4 for a discussion of the lessee’s accounting for an underlying asset it controls before lease commencement (i.e., accounting by the “deemed owner” of the asset).
Changing Lanes
Scope of Accounting Guidance for a Future Lessor in Transactions in
Which a Future Lessee (Potentially a Seller-Lessee) Controls the
Underlying Asset Before Lease Commencement
As stated above, the sale-and-leaseback guidance in ASC
842-40 addresses transactions in which a lessee controls the underlying
asset before lease commencement. The scope of ASC 842-40 applies to both the
future lessee and the future lessor in these types of transactions. Thus,
the scope of sale-and-leaseback accounting in ASC 842-40 differs from that
in ASC 840-40, which applied only to the future lessee (i.e., the
seller-lessee). ASC 842 therefore results in a significant change for
lessors engaged in these transactions, since they must now also assess
whether the counterparty in the arrangement (the lessee) has control of the
underlying asset before the commencement date of the lease (i.e., they must
determine whether the seller-lessee has obtained control of the underlying
asset before control is transferred to the buyer-lessor and the asset is
leased back to the seller-lessee).
Entities (both parties) involved in arrangements in which a
construction period is followed by a lease should carefully consider the
lessee’s involvement in the construction project to determine whether the
arrangement is within the scope of the guidance on sale-and-leaseback
accounting in ASC 842-40 as a result of such involvement. The implementation
guidance in ASC 842-40-55 addresses specific situations (not all-inclusive)
that would indicate that an arrangement is within the scope of the
sale-and-leaseback guidance in ASC 842-40. See Section 11.3.2 for additional
information.
11.2 Lessee’s Involvement With an Asset Before Lease Commencement
ASC 842-40
55-1 A lessee may obtain legal title to the underlying asset before that legal title is transferred to the lessor and the asset is leased to the lessee. If the lessee controls the underlying asset (that is, it can direct its use and obtain substantially all of its remaining benefits) before the asset is transferred to the lessor, the transaction is a sale and leaseback transaction that is accounted for in accordance with this Subtopic.
55-2 If the lessee obtains legal title, but does not obtain control of the underlying asset before the asset is transferred to the lessor, the transaction is not a sale and leaseback transaction. For example, this may be the case if a manufacturer, a lessor, and a lessee negotiate a transaction for the purchase of an asset from the manufacturer by the lessor, which in turn is leased to the lessee. For tax or other reasons, the lessee might obtain legal title to the underlying asset momentarily before legal title transfers to the lessor. In this case, if the lessee obtains legal title to the asset but does not control the asset before it is transferred to the lessor, the transaction is accounted for as a purchase of the asset by the lessor and a lease between the lessor and the lessee.
ASC 842-40-55-1 and 55-2 clarify that the notion of control is used to determine
whether a transaction is within the scope of the sale-and-leaseback guidance — if
the lessee controls the underlying asset before transferring it to the lessor (and
is thus the deemed owner), the transaction is accounted for in accordance with ASC
842-40. Section
10.2.2.1 includes an example illustrating such a scenario.
When the lessee obtains legal title to the underlying asset before transferring title to the lessor (i.e., the lessee obtains “flash title”) and the lessee does not control the underlying asset before transferring the asset to the lessor, the transaction is not accounted for in accordance with ASC 842-40. ASC 842-40-55-2 provides an example of such a situation, in which an entity often obtains financing or a certain tax treatment.
These same concepts apply to the transfer of an asset under construction, as discussed in Section 11.3.
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:
- Both the land and the property improvements (for example, a building) that are under construction
- 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
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 lessee designed the building to
its specifications and is contracted by the lessor to be
the general contractor during the construction project.
Assume that none of the criteria in ASC 842-40-55-5 are
met.
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
1
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.”
2
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.
11.4 Accounting by the Deemed Owner of an Asset
When a lessee is the deemed owner of an asset, the lessee must recognize the
asset in accordance with other applicable GAAP (e.g., ASC 360). Therefore, when the
lessee is the deemed owner of an asset under construction (see Section 11.3.2), the lessee
must recognize CIP in accordance with ASC 360 as it would for any other owned asset
under construction. That is, when the lessee determines that it is the deemed owner
of the CIP, it must account for the asset during the construction period as if it is
the party responsible for the construction costs, with a deemed loan from the
lessor, as construction progresses. Accordingly, the lessee must recognize on the
balance sheet (1) the costs incurred by the lessee to construct the asset, (2) the
costs incurred by the lessor to construct the asset, and (3) an offsetting financing
obligation for the amount funded by the lessor.
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.
11.5 Lessor Accounting
In the scenario described above in which a lessee controls and is deemed the
accounting owner of an underlying asset that is under construction before the lease
commencement date, the lessor should account for the arrangement as a
sale-and-leaseback transaction (in a manner consistent with the requirement for the
lessee to account for the arrangement as a sale-and-leaseback transaction). In other
words, the lessor’s cost of constructing the asset that it does not own for
accounting purposes is accounted for as a financing arrangement (i.e., a loan to the
lessee). Once construction is completed, the lessor applies the sale-and-leaseback
guidance to determine when to recognize the underlying asset (which would be
consistent with when the seller-lessee would also derecognize the underlying asset).
See Chapter 10 for further details related to
sale-and-leaseback accounting.