Chapter 16 — Effective Date and Transition

16.8 Build-to-Suit Transition

ASC 842-10

65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .

u. A lessee shall apply a modified retrospective transition approach for leases accounted for as build-to-suit arrangements under Topic 840 that are existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements (if an entity elects the transition method in (c)(1)) or that are existing at the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph (if an entity elects the transition method in (c)(2)) as follows:

1. If an entity has recognized assets and liabilities solely as a result of a transaction’s build-to-suit designation in accordance with Topic 840, the entity shall do the following:

i. If an entity elects the transition method in (c)(1), the entity shall derecognize those assets and liabilities at the later of the beginning of the earliest comparative period presented in the financial statements and the date that the lessee is determined to be the accounting owner of the asset in accordance with Topic 840.

ii. If an entity elects the transition method in (c)(2), the entity shall derecognize those assets and liabilities at the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph.

iii. Any difference in (i) or (ii) shall be recorded as an adjustment to equity at the date that those assets and liabilities were derecognized in accordance with (u)(1)(i) or (ii).

iv. The lessee shall apply the lessee transition requirements in (k) through (t) to the lease.

2. If the construction period of the build-to-suit lease concluded before the beginning of the earliest comparative period presented in the financial statements (if the entity elects the transition method in (c)(1)) or if it concluded before the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph (if the entity elects the transition method in (c)(2)), and the transaction qualified as a sale and leaseback transaction in accordance with Subtopic 840-40 before that date, the entity shall follow the general lessee transition requirements for the lease. . . .

Under ASC 840, a lessee may have capitalized the construction cost of an asset under construction with an offsetting liability on the basis of an assessment of the involvement during construction, which is primarily based on the risks to which the lessee was exposed. In addition, if a lessee is deemed the owner of the construction project, it is required to assess whether a sale and leaseback is achieved, which often results in a failed sale and leaseback because of continuing involvement. ASC 842 significantly changes the assessment of whether a lessee is the accounting owner of the asset during construction, which is an assessment of control (see Chapter 11 for a general overview of these arrangements). As a result, it will be common for a lessee to be the deemed owner of the asset under ASC 840; however, the lessee may not be the deemed owner of an asset under ASC 842 because it does not meet ASC 842’s concept of control. The general transition provisions indicate that a lessee that recognized an asset solely because it was the deemed owner under the ASC 840 build-to-suit guidance would derecognize the related assets and liabilities as of the later of the date of initial application or the date the lessee was determined to be the deemed owner.

Although the transition guidance indicates that the difference between the asset and liability should be recognized as an adjustment to equity as of that later-of date, we think that a lessee should carefully consider the impact of such adjustments as follows:

If a lease has not commenced as of the date of initial application, the asset and liability will generally be equal, because the lessee’s accounting as the deemed owner before placing the asset into service is a gross-up of the asset with an offsetting financing obligation. Therefore, the adjustments in transition to ASC 842 generally will not affect equity for leases that commenced after the date of initial application.
A lessee should reverse any of the accounting entries that were recognized during the comparative periods for the respective line items (e.g., depreciation expense, interest expense) rather than as an adjustment to equity. That is, it would not be appropriate to reverse the accounting after placing the asset into service through equity if those comparative periods are shown in accordance with ASC 842.
If a lease commenced before the date of initial application and the lessee continued to recognize the asset and liability as a failed sale and leaseback under ASC 840, there typically will be a difference between the asset and liability that should be recognized in equity as of the date of initial application.
Although the transition guidance related to build-to-suit arrangements does not specifically address situations in which the lessee is the deemed owner of an asset under construction in accordance with ASC 842, we have provided our interpretive guidance on such scenarios in the Q&A below.

Q&A 16-12 Derecognition of Existing Build-to-Suit Assets and Liabilities in Transition

The build-to-suit transition guidance specifies that any build-to-suit assets and liabilities recognized under ASC 840 should be derecognized in transition. However, the transition guidance does not explicitly address whether ASC 842’s principles related to controlling an asset under construction should be applied during the comparative periods under ASC 842, if applicable.

Question 1

Must ASC 842’s principles related to controlling an asset during construction be applied when construction was completed and the lease commenced before ASC 842’s effective date?

Answer

No. An entity is not required to assess ASC 842’s principles of control (regardless of whether the lessee was the deemed owner under ASC 840) as long as construction is complete and the lease commenced before the ASU’s effective date. The FASB staff agreed with this application of transition for build-to-suit arrangements. This answer is applicable regardless of whether an entity elects the Comparatives Under 840 Option.

Therefore, in such circumstances, the transition derecognition guidance in ASC 842-10-65-1(u) should be applied. ASC 842-10-65-1(u) states:

A lessee shall apply a modified retrospective transition approach for leases accounted for as build-to-suit arrangements under Topic 840 that are existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements (if an entity elects the transition method in (c)(1)) or that are existing at the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph (if an entity elects the transition method in (c)(2)) as follows:

If an entity has recognized assets and liabilities solely as a result of a transaction’s build-to-suit designation in accordance with Topic 840, the entity shall do the following:
1. If an entity elects the transition method in (c)(1), the entity shall derecognize those assets and liabilities at the later of the beginning of the earliest comparative period presented in the financial statements and the date that the lessee is determined to be the accounting owner of the asset in accordance with Topic 840.
2. If an entity elects the transition method in (c)(2), the entity shall derecognize those assets and liabilities at the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph.
3. Any difference in (i) or (ii) shall be recorded as an adjustment to equity at the date that those assets and liabilities were derecognized in accordance with (u)(1)(i) or (ii).
4. The lessee shall apply the lessee transition requirements in (k) through (t) to the lease.
If the construction period of the build-to-suit lease concluded before the beginning of the earliest comparative period presented in the financial statements (if the entity elects the transition method in (c)(1)) or if it concluded before the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph (if the entity elects the transition method in (c)(2)), and the transaction qualified as a sale and leaseback transaction in accordance with Subtopic 840-40 before that date, the entity shall follow the general lessee transition requirements for the lease. [Emphasis added]

Accordingly, the lessee should (1) derecognize any build-to-suit assets and liabilities that were recognized solely as a result of the lessee’s being the deemed accounting owner and (2) recognize the difference, if any, in equity. However, lessee-paid costs that were included in the build-to-suit asset may not have been capitalized solely as a result of the build-to-suit designation. For example, the deemed accounting owner may have funded part of the construction costs and such costs may be considered prepaid lease payments or payments for lessee-owned improvements when the arrangement is accounted for as a lease. Accordingly, in transition, these costs would be carried over and retained at their currently recognized amount (i.e., the amortized or depreciated balance). That is, these costs would have been recognized in the absence of the build-to-suit designation and therefore should not be derecognized through equity upon transition.

Example

Company C, a calendar-year public entity that has elected the option not to recast the comparative periods presented when transitioning to ASC 842 (the Comparatives Under 840 Option), entered into an agreement with Developer D to lease a newly constructed corporate headquarters.30 Developer D began building the corporate headquarters on August 1, 2016, and construction is expected to be complete on November 12, 2018, at which time the lease will commence. Company C funded $6 million of the construction costs during the construction period, and the total project costs are expected to be $40 million. Therefore, D will fund $34 million of the construction costs. In addition, C incurred $1 million for furniture and fixtures (the “improvements”). Assume that C was considered the accounting owner of the corporate headquarters during construction and that sale-and-leaseback accounting would not be achieved upon lease commencement under ASC 840. The various journal entries to account for the construction project resulted in the following account balances as of November 12, 2018:

Upon transition to ASC 842, C is required to derecognize the amounts related to the build-to-suit accounting because construction of the corporate headquarters was completed, and the lease commenced, before January 1, 2019 (the effective date of ASC 842). Therefore, on its adoption date (January 1, 2019), C would derecognize the entire financing obligation because it was recognized solely as a result of the build-to-suit designation. Company C would retain a portion of its PP&E balance related to the amount it paid before lease commencement less adjustments for subsequent measurement (i.e., depreciation), even though this amount was included in the carrying amount of the build-to-suit asset. As a result, the unamortized portion of the $6 million construction funding payment should be carried forward into the ROU asset because it represents a prepaid lease payment. Similarly, the unamortized balance of the $1 million for improvements paid by the lessee should be carried forward in transition and not written off as an equity adjustment. The remaining build-to-suit asset would be derecognized. The offset between the resulting build-to-suit asset balance and the financing obligation, if any, would be recognized in equity.

The subsequent accounting for the improvements should be consistent with that for other leasehold improvements. That is, the amortization period would be limited to the lease term in accordance with ASC 842-20-35-12.

The journal entries in transition are shown below. Note that, for simplicity, there are no adjustments for subsequent measurement between November 12, 2018, and the effective date of ASC 842 (i.e., depreciation of the building, amortization of the $6 million in prepaid rent, or payments on the financing obligation). These subsequent-measurement adjustments would most likely result in an adjustment to equity, which is not depicted below.

Company C would also recognize any remaining lease payments as a lease liability, along with an offsetting ROU asset, in accordance with the lessee transition requirements in ASC 842-10-65-1(k)–(t).

Question 2

How should a lessee approach the transition for a build-to-suit arrangement when construction was not completed, and the lease had not commenced, as of the effective date of ASC 842?

Answer

The table below summarizes the transition approach an entity should use in those circumstances.

ASC 840 Determination	ASC 842 Determination	Transition Approach
Lessee was the deemed owner	Lessee has control during construction	No change in accounting; asset and financing obligation remain on the balance sheet during the comparative periods and as of the effective date.
Lessee was the deemed owner	Lessee does not have control during construction	If the lessee was determined to be the deemed accounting owner under ASC 840 before the date of initial application, derecognize the asset and financing obligation recognized solely as a result of the build-to-suit designation and reflect the difference, if any, in equity. If the lessee was determined to be the accounting owner of the asset during the comparative periods (i.e., construction commenced during the comparative periods), and the Comparatives Under 840 Option was not elected, the lessee should reverse the impact of the accounting for the appropriate line items and not reverse the impact through equity.
Lessee was not the deemed owner	Lessee has control during construction	Recognize the asset and financing obligation as of the later of the date of initial application or the date as of which the lessee is determined to be the accounting owner of the asset in accordance with ASC 842. If a lessee elects the Comparatives Under 840 Option, the asset and financing obligation will be recognized as of the effective date of ASC 842. See the example below.

Example

Company A, a calendar-year-end public entity that has not elected the Comparatives Under 840 Option, has entered into an agreement with Company B to lease a newly constructed television studio. Company B began building the television studio on June 8, 2017, and construction is expected to be complete on November 5, 2019. The lease will commence once construction is complete. During the construction period, A can acquire the television studio in process of construction and therefore is deemed to control the construction project under ASC 842. Assume that A was not determined to be the deemed owner in accordance with ASC 840. When A initially applies ASC 842, because A is deemed to control the construction project under ASC 842 as of the effective date, it must recognize the cost of the in-process asset (and an offsetting financing obligation) during the comparative periods beginning June 8, 2017.

If A had elected the Comparatives Under 840 Option, A would first recognize the asset and financing obligation as of January 1, 2019 (the ASC 842 effective date).

Connecting the Dots

Lease Classification Assessment for Derecognized Build-to-Suit Arrangements in Transition

If a previous build-to-suit arrangement (for which construction was completed and the lease commenced before the effective date of ASC 842) was capitalized under ASC 840 and reversed upon the adoption of ASC 842, we generally believe that the appropriate framework for determining lease classification will depend on multiple factors as follows:

If the practical expedient package is not elected, lease classification should be determined under ASC 842, as follows:
- If the lease commenced before the date of initial application, lease classification would generally be determined as of the later of the (1) lease commencement date or (2) date the lease was last modified. If a lease was renewed or extended before the date of initial application, the renewal or extension date would be considered the lease commencement date for this purpose unless the renewal was assumed to be reasonably certain as of the initial lease commencement date.
- If the lease commenced after the date of initial application, the initial lease classification would generally be determined as of the lease commencement date.
The transition guidance is not clear on situations in which the practical expedient package is elected and the lessee has accounted for the transaction as a failed sale and leaseback through the effective date of ASC 842. We believe that, notwithstanding the election of the practical expedient package, it would be acceptable to determine lease classification in accordance with ASC 842 (i.e., as of the later of the (1) lease commencement date or (2) date the lease was last modified — see bullet above), because the lease (for accounting purposes) was never recognized or assessed under ASC 840 (i.e., the lease classification is assessed for the first time upon adopting ASC 842). However, we understand that others believe, because of the lack of clear guidance, that it would also be acceptable to determine lease classification as of lease inception under ASC 840. We think that either approach would be acceptable as an accounting policy that must be applied consistently.

Q&A 16-12A Accounting for a Previously Impaired Build-to-Suit Asset

Under ASC 840, a build-to-suit asset and financing obligation may be recognized on a lessee’s balance sheet as a result of a transaction’s build-to-suit designation, as described in Q&A 16-12. Thereafter, under ASC 360, a lessee could have determined that the asset group containing the build-to-suit asset was impaired, resulting in the measurement of an impairment loss, of which a portion was recognized against the build-to-suit asset.

The general transition provisions in ASC 842 indicate that a lessee that recognized an asset because it was the deemed owner under the ASC 840 build-to-suit guidance would, in accordance with ASC 842-10-65-1(u),31 (1) derecognize the asset and financing recognized solely as a result of the build-to-suit designation and (2) apply the general lessee transition requirements. Further, ASC 842-10-65-1(m)(2) and ASC 842-10-65-1(o), which apply to operating leases and finance leases, respectively, provide the following guidance on accounting for the ROU asset at transition when there is an existing ASC 420 liability:

m. For each lease classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3, a lessee shall initially measure the right-of-use asset at the initial measurement of the lease liability adjusted for both of the following: . . .

2. The carrying amount of any liability recognized in accordance with Topic 420 on exit or disposal cost obligations for the lease. . . .

o. For each lease classified as a finance lease in accordance with paragraph 842-10-25-2, a lessee shall measure the right-of-use asset as the applicable proportion of the lease liability at the commencement date, which can be imputed from the lease liability determined in accordance with (l). The applicable proportion is the remaining lease term at the application date as determined in (c) relative to the total lease term. A lessee shall adjust the right-of-use asset recognized by the carrying amount of any prepaid or accrued lease payments and the carrying amount of any liability recognized in accordance with Topic 420 for the lease.

On the basis of the above guidance, it is clear that the initial ROU asset is generally recorded net of any ASC 420 liability at transition. However, under a deemed ownership model, entities have historically looked to the impairment guidance in ASC 360 instead of the exit cost guidance in ASC 420. As a result, entities have questioned how previous impairment charges recognized on a build-to-suit asset should be treated in transition given that the asset to which the impairment is related will be derecognized upon adoption of ASC 842. In other words, entities have asked whether the historical ASC 360 impairment charge should or could affect the measurement of the ROU asset in transition.

Question

When a lessee previously recognized impairment for a build-to-suit asset subject to derecognition under ASC 842-10-65-1(u)(1), how should the lessee consider the historical impairment when recognizing and measuring the related ROU asset at transition?

Answer

We believe that a lessee should subject the newly recognized ROU asset to a full impairment test in accordance with ASC 360 as of the effective date of ASC 842 if an impairment indicator continues to exist as of this date. Accordingly, a lessee would determine a “new” impairment amount on the basis of the test conducted as of the effective date. In addition, we believe that it is acceptable to recognize the impairment loss, if any, determined as of the date of initial application of ASC 842 through an adjustment to equity, with a corresponding reduction to the carrying amount of the ROU asset. We think that recognition of the impairment loss in equity is appropriate since it reflects a unique circumstance in which the adjustment effectively results from an impairment indicator that arose before the date of initial application of ASC 842.

However, since ASC 842 does not provide clear guidance on this situation, there may be other acceptable approaches. We encourage stakeholders who are affected by this issue to consult with their accounting advisers and auditors to understand their views.

Footnotes

The outcome of this example would not be affected by whether the entity elected the Comparatives Under 840 Option.

See Q&A 16-12 for an excerpt of the transition guidance in ASC 842-10-65-1(u).

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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.