When a prospective lessee is involved in the construction or design of an underlying asset prior to lease commencement (commonly referred to as a “build-to-suit” lease), the lessee should evaluate whether it controls the asset during the construction period. Generally, the evaluation of whether a lessee controls an asset under construction is similar to the evaluation in the revenue recognition standard to determine whether a performance obligation is satisfied over time.
lists several examples that demonstrate when a lessee has obtained control during the construction period.
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:
a. 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).
b. 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.
c. 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.
d. 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
) 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.
e. 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.
There have been questions raised as to the meaning of "at any point during the construction period". Those questions focus on whether the provision requires the lessee to have the right to obtain the asset either (1) at all times during the construction period (which could include contingent events that are only triggered upon events within the lessee's control) or (2) only based on some contingency or stated event. We believe a lessee would be considered the owner of the asset during the construction period if the lessee has the right to obtain the partially-constructed asset at some point during the construction period (i.e., a call/purchase option). If the lessee does not have the right at all times, ownership of the asset would be imputed at the point in time that the lessee has the right to obtain the partially-constructed asset (e.g., when a purchase option becomes exercisable).
We believe a lessee's call option that becomes exercisable solely due to the passage of time would cause the lessee to have control of the partially-constructed asset immediately. If the option is contingent upon any other event, and that event is within the lessor's control or based on the occurrence of an external event, control does not pass to the lessee until the contingency is resolved.
There may be circumstances in which the purchase option becomes exercisable only upon contingent events occurring, such as when the lessee or the lessor is in default. In these cases, the lessee would generally be considered to have the right to obtain the partially-constructed asset if the contingent event were within the control of the lessee. All facts and circumstances should be considered carefully. For example, a lease that provides a lessee the right to acquire the partially-constructed asset if the lessee is in default may be considered within the control of the lessee. However, a lessee default under the lease contract may result in economic consequences to the lessee, such as triggering cross defaults in the lessee's other arrangements. The right to acquire the partially-constructed asset in this circumstance may not be considered substantive.
The existence of a lessee-provided indemnification for preexisting environmental contamination does not, in isolation, result in the lessee obtaining control of the underlying asset prior to lease commencement regardless of the likelihood of loss as a result of the indemnity.
The list of circumstances provided by ASC 842-40-55-5
is not all inclusive; there may be other circumstances that individually or in combination demonstrate that a lessee controls an underlying asset under construction before the lease commencement date. As additional circumstances have not yet substantially developed in practice, entities will be required to carefully evaluate the facts and circumstances of each arrangement. For example, we believe if a lessee is required to make lease payments regardless of whether the lessor completes construction of the asset (i.e., a date-certain lease) and the lease is expected to be classified as a finance lease, the lessee has obtained control of the asset from lease inception, rather than the lease commencement date. Additionally, we believe a lessee that is required to fund substantially all (i.e., 90% or more) of the costs of construction that are probable of being incurred during the construction period may have obtained control. However, we do not believe this example is similar to the prescriptive rules in ASC 840
. For example, we do not believe a lessee has obtained control of the asset under construction solely because it is required to pay the first costs of construction or is responsible for cost overruns that are unlimited when such cost overruns are not probable of representing substantially all of the costs of construction.
We believe a put option held by the lessor to put the asset under construction to the lessee should be assessed to determine whether the lessor has a significant economic incentive to exercise its put right consistent with the guidance regarding repurchase agreements in the new revenue standard. If an incentive exists, the lessee would be assumed to control the construction in process and would be considered the owner of the asset during the construction period. For further guidance, refer to RR 8.7
Example LG 6-4 and Example LG 6-5 illustrate the assessment of whether a lessee has obtained control of the underlying asset under construction prior to lease commencement. See ASC 842-40-55-39
through ASC 842-40-55-44
for additional examples.
EXAMPLE LG 6-4
Sale and leaseback transaction – lessee obtains control of construction in progress
University would like to construct a new library on a parcel of land next to its campus. University acquires the parcel of land and enters into an agreement with Developer Corp, an independent third party, under which Developer Corp will lease the parcel of land from University, construct the library, and lease the completed library to University. Both the ground lease to Developer Corp and the library lease to University have 20-year lease terms. Rental rates on both leases are consistent with prevailing market rents for similar leased assets. The economic life of the library is 40 years.
Does University control the underlying asset during the construction period?
University controls the underlying asset during the construction period because the ground lease to Developer Corp is for a term that is less than substantially all of the economic life of the property improvements (20-year ground lease/40-year economic life = 50%). Accordingly, University should account for the underlying asset during the construction period similar to any other owned asset under construction (i.e., under ASC 360
, Property, Plant, and Equipment
). Additionally, any construction costs paid for by Developer Corp should be recorded by University as a financial liability.
In symmetry with University's accounting, Developer Corp should not recognize the asset under construction. Rather, Developer Corp should account for any payments it makes during the construction period as a collateralized loan to the lessee in accordance with ASC 310
EXAMPLE LG 6-5
Sale and leaseback transaction – lessee does not obtain control of construction in process (real estate)
Law Firm enters into an arrangement with Developer Corp to lease an office building for 10 years contingent upon Developer Corp completing construction of the asset in accordance with the construction plan. The construction plan includes Law Firm-specific improvements necessary for Law Firm to begin operations at the lease commencement date. The budgeted cost of construction is $10 million. The useful life of the asset is 40 years. Law Firm is obligated to reimburse Developer Corp for increases in the cost of steel from the inception date of the arrangement to the completion date of the construction project up to a maximum of $250,000. During the construction period, Law Firm has access to the building in order to inspect the progress of the construction and to make discretionary improvements.
During the construction period, Law Firm reimburses Developer Corp for $200,000 due to increases in the cost of steel during the construction period. In addition, Law Firm incurred $100,000 of additional construction costs related to discretionary tenant improvements, including branding elements.
Does Law Firm control the underlying asset during the construction period?
Law Firm did not obtain control of the underlying asset during the construction period, therefore it should account for the transaction as a lease arrangement with Developer Corp. Although Law Firm had access to the asset, incurred costs related to both structural and normal tenant improvements, and had financial risks related to the construction of the asset, Law Firm did not obtain control of the asset under construction before the lease commencement date (i.e., the construction completion date). Except for the payment for increases in the cost of steel, Developer Corp does not have an enforceable right to payment unless and until construction is completed. Law Firm’s exposure to steel costs is insignificant relative to the overall construction budget. In addition, none of the other indicators of control in ASC 842-40-55-5