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Leasing real estate? What lessees need to know · PwC's accounting podcast

0:00
SPEAKER_00: Thought Leadership from PWC's National Office.
0:06
SPEAKER_03: Welcome to PWC's Accounting Podcast.
0:10
SPEAKER_03: I'm Heather Horn.
0:11
SPEAKER_03: Got real estate?
0:13
SPEAKER_03: Most companies do.
0:14
SPEAKER_03: In this episode of our lease accounting miniseries, we cover what you need to know about real estate leases.
0:20
SPEAKER_03: As they're one of the most common types of leases, there should be something in this episode for everyone.
0:26
SPEAKER_03: No two pieces of real estate are the same.
0:29
SPEAKER_03: So, for the most part, no two real estate leases are the same either.
0:34
SPEAKER_03: They bring with them certain complexities, which we're going to hone in on today.
0:38
SPEAKER_01: So, for example, if you're moving into new real estate, you're typically going to have to do some renovations to the space or customize the space in some manner to meet your own needs and objectives.
0:49
SPEAKER_01: And you might negotiate with the Lesour to receive some lease incentives.
0:52
SPEAKER_01: Again, you can get lease incentives and equipment leases too, but they're more common in real estate leases.
0:58
SPEAKER_01: So we get a lot of questions about just leasehold improvements.
1:02
SPEAKER_01: How do I determine whether the improvement that I'm making that I can't take out when the lease ends, is that really my asset or is that really the Lesour's asset?
1:15
SPEAKER_03: That was Mark Jerusalem, who's joined by Suzanne Stefani, both stars of this April miniseries and both National Office specialists in lease transactions.
1:24
SPEAKER_03: Let's listen in on this conversation as they bring their wealth of knowledge and experience.
1:30
SPEAKER_03: Suzanne, Mark, welcome back to the podcast for our third episode in our month of leasing.
1:35
SPEAKER_03: And for those of our listeners who caught the first two podcasts this month, we already covered some of the key points for day one lease accounting.
1:42
SPEAKER_03: So classification, lease term, lease payments, discount rate.
1:47
SPEAKER_03: And then last week we talked about day two lease accounting and specifically modifications, terminations, and maybe a light touch on impairments, some sub-leases in there too.
1:57
SPEAKER_03: So hopefully some of the basics, obviously, you can check out uh the lease guide as well.
2:01
SPEAKER_03: But in today's podcast, I'm very excited because I think this is the first time we've really focused in on some of the nuances related to real estate leases.
2:10
SPEAKER_03: And I guess, Mark, from your point of view, why do you think that this is important?
2:14
SPEAKER_01: Well, for one, for for many companies, if not for most companies, their real estate leases are going to be their most expensive leases, right?
2:22
SPEAKER_01: It's gonna be the of all their leases, these are the ones they're gonna have the largest lease liabilities and rights of use assets for, right?
2:28
SPEAKER_01: And whenever we get into real estate leases, we have certain characteristics of real estate leases that you may not have with um equipment leases.
2:37
SPEAKER_01: So, for example, if you're moving into new real estate, you're typically gonna have to do some renovations to the space or customize the space in some manner to meet your own needs and objectives.
2:48
SPEAKER_01: And you might negotiate with the Lessor to receive some lease incentives.
2:51
SPEAKER_01: Again, you can get lease incentives and equipment leases too, but they're more common in real estate leases.
2:57
SPEAKER_01: So we get a lot of questions about just leasehold improvements.
3:01
SPEAKER_01: How do I determine whether the improvement that I'm making that I can't take out when the lease ends, is that really my asset or is that really the lesor's asset?
3:09
SPEAKER_01: When do I get into the dreaded build-to-suit guidance, right?
3:12
SPEAKER_01: So we figured it would make sense just to spend a day on you're moving into new real estate and what types of things do you have to think about.
3:19
SPEAKER_01: They're not necessarily unique to only real estate, but they come up commonly in real estate.
3:23
SPEAKER_03: All right, that's definitely helpful.
3:25
SPEAKER_03: So, Mark, one of the things you mentioned that we haven't previously talked about or we didn't talk about on last week's podcast specifically was lease incentives.
3:32
SPEAKER_03: And that would be when the lessor is actually making a payment to the lessee, which obviously is not the normal order of things.
3:40
SPEAKER_03: Um and that happens quite frequently in real estate lease is much less likely to see like the copy machine or something like that.
3:46
SPEAKER_03: So, Suzanne, maybe starting there, how do those lease incentives factor in when we're thinking about lease accounting?
3:53
SPEAKER_02: Yeah, so I the accounting depends really on the timing of when the lessee gets the payment from the lessor.
4:00
SPEAKER_02: So if the incentive is received before the lease commencement date, it's treated as an adjustment to the right of use asset and you know, when the lease is recognized on the balance sheet.
4:10
SPEAKER_02: And then in turn, it's gonna reduce the lease expense going forward, right?
4:13
SPEAKER_02: The lessee has less payments now in as such, right?
4:16
SPEAKER_02: Because it's like a negative payment.
4:18
SPEAKER_02: Um, if it's received after lease commencement, that's where we get some questions.
4:23
SPEAKER_02: And I want to actually illustrate it if I can with just a common example that we see quite a bit.
4:28
SPEAKER_02: So say we have a lessee and they're leasing um some space, like office space, and they want to kind of renovate it, customize it to get it ready for them to move in.
4:37
SPEAKER_02: So common thing, the lesser is gonna agree to reimburse the lessee up to some amount, let's say 100,000 for leasehold improvements.
4:45
SPEAKER_02: And the lessee is gonna be putting in lessee assets like carpeting, painting, maybe like those divider walls for cubicles, things like that.
4:53
SPEAKER_02: So usually the way it works is the lessee's gonna pay for their leasehold improvements up front and then submit the receipts to the lessor to get paid.
5:01
SPEAKER_02: Usually there'll be some sort of time limit there that they the lessie has to incur those expenses.
5:07
SPEAKER_02: Let's just say it's a year here.
5:09
SPEAKER_02: They have a year to submit the receipts to the lessor to get paid.
5:12
SPEAKER_02: Um, that's a common example we see.
5:14
SPEAKER_03: All right.
5:15
SPEAKER_03: So then, Suzanne, in that scenario, I can think of a few different possible ways that you might want to think about that.
5:21
SPEAKER_03: But what is the accounting?
5:23
SPEAKER_03: How does it impact the initial measurement of the lease?
5:26
SPEAKER_03: Is it a separate receivable?
5:27
SPEAKER_03: Like how do you think about it?
5:28
SPEAKER_02: Yeah.
5:29
SPEAKER_02: So generally it's not a separate receivable from the lessor.
5:32
SPEAKER_02: And that is something some companies um tend to think it should be.
5:35
SPEAKER_02: And it's also not of generally not of considered a variable lease payment.
5:40
SPEAKER_02: So we think that the best way to do it is it impacts the initial measurement of the lease liability.
5:46
SPEAKER_02: Because, you know, think about it, most of this, most of this type of incentive is thought about as an in-substance fixed payment at least commencement.
5:54
SPEAKER_02: The lessee, in my example, just negotiated$100,000 for their own assets for leasehold improvements.
6:00
SPEAKER_02: It's not very likely that the lessee will just spend 90K and stop.
6:04
SPEAKER_02: They're entitled to get$100,000.
6:06
SPEAKER_02: They're gonna spend it, right?
6:07
SPEAKER_02: It's it's highly probable that they're gonna use the full$100,000.
6:11
SPEAKER_02: So usually it's looked at as an in-substance fixed payment.
6:15
SPEAKER_02: And um the lease liability is the present value of all the fixed lease payments.
6:20
SPEAKER_02: And if you look at the definition of lease payments in the standard, it includes lease incentives.
6:25
SPEAKER_02: So that's why we think it's best to include it actually as like a negative lease payment in the initial measurement of the lease liability.
6:32
SPEAKER_02: So you'll take the full 100,000, my example, assuming it's you know it's probable that the lessee is going to receive all that and record it as a cash inflow in the lease liability amortization schedule.
6:42
SPEAKER_02: So like a negative lease payment.
6:44
SPEAKER_03: Okay.
6:45
SPEAKER_03: So then the first thing I immediately thought of, Suzanne, when you said that is that uh at least in the example that you set up, we don't really know the exact timing of the payment.
6:54
SPEAKER_02: Yeah.
6:54
SPEAKER_03: Um, so how does that get factored into your calculation?
6:58
SPEAKER_02: Yeah.
6:58
SPEAKER_02: So it's gonna be an estimate.
6:59
SPEAKER_02: So at least commencement, the lesie is gonna think, okay, I'm gonna put in these leasehold improvements.
7:05
SPEAKER_02: How long do I think it's going to take me?
7:08
SPEAKER_02: And when do I expect to get the reimbursement from the lessor?
7:11
SPEAKER_02: So let's say, like I said in that example, you get 100,000 over the first year, but the lessee thinks most likely they're gonna get that full amount in six months, just based on their schedule for kind of updating the space.
7:24
SPEAKER_02: Then when they're doing the lease liability schedule, they're gonna put it in as a negative payment in six months from the commencement date.
7:30
SPEAKER_03: Okay.
7:31
SPEAKER_03: So obviously, Suzanne, I would assume in many, many, many cases, it's not exactly at the six months.
7:37
SPEAKER_03: It's either gonna be a little earlier or a little later.
7:39
SPEAKER_03: So then how do I handle it?
7:40
SPEAKER_02: Yeah, so we have to adjust for that if the change in timing has a material impact, right?
7:45
SPEAKER_02: So we'll sort of analogize to the remeasurement guidance that we talked about in our day two podcast, but not a full remeasurement or anything.
7:53
SPEAKER_02: We're just gonna remeasure the lease liability for the change in the timing.
7:57
SPEAKER_02: So from like when the act you get the actual timing from the estimate and remeasure it, but you don't update the discount rate or anything.
8:05
SPEAKER_02: It's really just for the change in the timing of the payments.
8:08
SPEAKER_02: And we have to do that because if you don't do it, if you left it like you thought it was six months, you got in three months, and you just left it alone.
8:14
SPEAKER_02: When you got to the end of the lease term, it wouldn't work out to zero, the liability.
8:19
SPEAKER_03: So you have to make that adjustment if it's material.
8:21
SPEAKER_03: All right.
8:21
SPEAKER_03: So definitely important to keep an eye on that.
8:23
SPEAKER_03: And then Suzanne, I also noticed when you set up this example, you made a very specific point that the lease incentive was for lessee assets.
8:32
SPEAKER_03: And so why is that such an important distinction?
8:35
SPEAKER_02: Yeah, so that's super important.
8:37
SPEAKER_02: The assumption was that it was for a lessee asset because that's a true lease incentive, right?
8:42
SPEAKER_02: If the lessor is giving the lessee money to buy or build their own assets, that's an incentive, right?
8:48
SPEAKER_02: You'd consider it a reduction in the rent.
8:50
SPEAKER_02: Now, on the other hand, if the lessee is actually spending money to buy or build a lessor asset, and then the lessor turns around and reimburses them, that's not an incentive, right?
9:01
SPEAKER_02: That's just the lessor reimbursing the lessee for the assets they bought on their behalf.
9:06
SPEAKER_02: So it's an important distinction there to determine lessee and less or assets.
9:10
SPEAKER_03: Okay, so important distinction, but I also would think there could sometimes be sort of a fine line between whether it's a lessee or a lessor asset.
9:18
SPEAKER_03: So, Mark, how do I think about that?
9:21
SPEAKER_01: Well, it may come as a surprise, but there's actually no direct accounting guidance on how to evaluate whether an improvement should be accounted for as a lessee-owned asset or as a lessor-owned asset.
9:32
SPEAKER_01: And we're talking typically here about assets that cannot be removed once they're installed or cannot be, you know, economically removed.
9:39
SPEAKER_01: So because there's no direct guidance, there is some diversity in practice, and this does require companies to develop like a consistent model as to how to think about these things.
9:49
SPEAKER_01: We we do have a model that we like that we think reflects well the economics of the underlying transaction.
9:55
SPEAKER_01: And in applying that model, we ask a couple of questions.
9:58
SPEAKER_01: The first question that we ask is Does the lease agreement specifically require the lessee to make the improvement?
10:06
SPEAKER_01: Or maybe to ask that same question in a different way.
10:09
SPEAKER_01: If the lessee a month later decides not to make that improvement, would they actually be in default of the lease agreement because it was required to do so?
10:17
SPEAKER_01: If the lease agreement does not require that the lessee make that improvement, then we don't think it's a lessor asset.
10:24
SPEAKER_01: We think that's a lessee asset because the lessor obviously doesn't care whether the improvement is made or not.
10:28
SPEAKER_01: So that's not indicative that it's his asset.
10:30
SPEAKER_01: On the other hand, if the lease does require the lessee to make the improvement, there's still an evaluation to do.
10:37
SPEAKER_01: It may or may not be a lessor asset.
10:40
SPEAKER_01: So again, we're talking about situations here typically where the lessee is going out and purchasing this asset, right?
10:47
SPEAKER_01: So the things that we would look to is how unique is that asset to the lessee's business, to the lessee's purposes, the more unique it is to the lessee, the less likely it is to be a lessor asset.
10:58
SPEAKER_01: He's just buying his own asset.
11:00
SPEAKER_01: On the other hand, if this is um the type of improvement that is more generic or that it would last longer than the lease term, right?
11:10
SPEAKER_01: Or that would be a value to the lesseur when the lessee moves out.
11:14
SPEAKER_01: Say the lessee, for example, puts in marble flooring, you know, throughout the lobby of the building.
11:20
SPEAKER_01: That marble flooring may last 15, 20 years, you know.
11:24
SPEAKER_01: So that would be more likely to be a lessor asset if it's required by the lease.
11:28
SPEAKER_03: All right.
11:28
SPEAKER_03: And obviously the reason we care whether it's a lessee or lesseur is that that is going to impact our accounting.
11:35
SPEAKER_03: So, Suzanne, what are the scenarios then?
11:38
SPEAKER_03: Let's start with maybe when it's a lessee asset.
11:40
SPEAKER_02: Okay, yeah, I'll kind of go through it.
11:42
SPEAKER_02: I'm gonna try to do debits and credits.
11:43
SPEAKER_02: So see if you guys have this guy.
11:47
SPEAKER_02: So for a lessee asset, okay, when the lessee buys the asset, they go out and get their own assets.
11:53
SPEAKER_02: Um, we'll keep with my initial example that I was talking about earlier.
11:56
SPEAKER_02: So the lessee is moving into office space and they're customizing that space.
12:00
SPEAKER_02: So they spend$100,000 on Lessee assets, carpeting, painting, et cetera, and they'll get reimbursed at a later date from the lesser.
12:08
SPEAKER_02: So when the lessee first pays for its own assets, they're just gonna debit leasehold improvements.
12:13
SPEAKER_02: So it's just like kind of like PPE and credit cash, just like any other PPE purchase.
12:19
SPEAKER_02: And when they do that on the cash flow statement, they're gonna have an investing outflow, just like you would if you bought your own, your own stuff.
12:26
SPEAKER_02: So then let's turn to the lease liability.
12:29
SPEAKER_02: So at least commencement, the lessee, like we talked about earlier, will record a lease liability for the lease payments and a corresponding ROU asset.
12:38
SPEAKER_02: The lessee is gonna consider the cash receipt, the$100,000 that it expects to get from the lessor and put it as a negative payment in the lease liability.
12:47
SPEAKER_02: So when the lessor reimburses the$100,000 to the lessee, that negative amount, it's already in the lease liability, right?
12:54
SPEAKER_02: So you're gonna debit cash and credit the lease liability.
12:58
SPEAKER_02: And just a reminder, and maybe I should have said this earlier, but it's not appropriate like to reduce, you know, you like I said, you're putting that leasehold improvement on at the full value.
13:08
SPEAKER_02: You should not reduce the cost of the leasehold improvement for the incentive received.
13:12
SPEAKER_02: It's two separate units of account, right?
13:14
SPEAKER_02: That lease incentive, it's just impacting the lease liability.
13:17
SPEAKER_02: And then when the payment is received from the lessor, the lease, it's classified just like any other lease payment on the statement of cash flow.
13:26
SPEAKER_02: So if we have an operating lease, when we get the money in from the lessor, it's an operating cash inflow.
13:32
SPEAKER_03: All right.
13:32
SPEAKER_03: And so then back to that leasehold improvement that we are not reducing, Suzanne.
13:36
SPEAKER_03: Yeah.
13:36
SPEAKER_03: So then we would just be amortizing or depreciating that leasehold improvement as though any other PPE.
13:42
SPEAKER_02: Yeah.
13:42
SPEAKER_02: So you're gonna amortize it over the shorter of its useful life or the lease term that you're using for accounting purposes.
13:49
SPEAKER_02: Excellent.
13:49
SPEAKER_02: That's helpful.
13:50
SPEAKER_03: And then now let's go through a scenario where the payment is actually reimbursing for a lessor asset.
13:56
SPEAKER_03: So the lessee did something for the lessor.
13:59
SPEAKER_02: Yep.
13:59
SPEAKER_02: So that usually happens before lease commencement.
14:02
SPEAKER_02: So I'm gonna stick with that.
14:03
SPEAKER_02: So that when the lessee pays for a lessor asset, they're not debiting, you know, PPE, leasehold improvements.
14:11
SPEAKER_02: It's not their asset, right?
14:12
SPEAKER_02: So they're going to debit prepaid rent, which will eventually go into the right of use asset when we have commencement, and credit cash.
14:20
SPEAKER_02: When the lessor pays the lessee, if they do that before lease commencement, just a reduction of prepaid rent, right?
14:27
SPEAKER_02: It's not factoring into um lease expense.
14:30
SPEAKER_02: The only time it would is like if a lessee was not fully reimbursed for what they put out.
14:36
SPEAKER_02: They put out$100,000 for a lessor asset, but the lessor only reimbursed them$90,000, right?
14:42
SPEAKER_02: That 10 difference.
14:44
SPEAKER_02: Um, it stays in prepaid rent.
14:46
SPEAKER_02: And then when we have lease commencement, it rolls into the right-of-use asset.
14:50
SPEAKER_02: So effectively, it becomes part of the lease expense, that additional$10.
14:54
SPEAKER_02: Because you think about it, you paid$100,000 for the lessors asset and they only gave you$90 back.
14:59
SPEAKER_02: So$10 has to be lease expense.
15:01
SPEAKER_02: So let's talk about the statement of cash flow classification as well for the cash out outflow when the lessee buys the lessor asset and the inflow when the lessor reimburses the lessee for that payment.
15:15
SPEAKER_02: So this it depends on the lease classification, if known.
15:19
SPEAKER_02: Now you might not always know because, like I said, a lot of this happens before lease commencement.
15:23
SPEAKER_02: So if there's clear evidence that the lease will be a finance lease, then the payment, you know, to buy the asset and when you receive would generally be investing, because it's like a payment to acquire a productive right-of-use asset.
15:37
SPEAKER_02: And there's no lease liability on the books yet, because you don't have lease commencement.
15:41
SPEAKER_02: Um, but alternatively, we we could um see that also being classified as financing as well, similar to a principal payment on a finance lease.
15:50
SPEAKER_02: So we've got a policy choice there.
15:52
SPEAKER_02: But if you're in a situation where you don't know if it's gonna be a financing lease or you know it's gonna be an operating lease, then all the cash flows should be operating, the ins and the outs.
16:03
SPEAKER_03: All right.
16:03
SPEAKER_03: So definitely need to understand what type of asset it is and then what type of lease it is is important.
16:09
SPEAKER_03: But Suzanne, this whole scenario, we were talking about sort of all of this happened before lease commencement.
16:16
SPEAKER_03: But what if we have the scenario then that the lessee is required to make this improvement, but it's either not completed or they don't get paid by the date of the lease commencement?
16:26
SPEAKER_02: Yeah.
16:27
SPEAKER_02: So if the lessee has not received reimbursement yet before lease commencement for all of the money it put out for less or assets, you know, they might still be required to do some sort of improvement or something, you know, after lease commencement.
16:42
SPEAKER_02: Then what they're gonna do when they have lease commencement, they have to make an estimate of the cost to construct that asset, the lessor asset, net of any funding that's expected to be provided by the lessor, that amount should be included for purposes of classification and measurement.
16:59
SPEAKER_02: So again, like a think about they're gonna spend 100,000 on less or assets, but they're only getting 90 back for some reason.
17:06
SPEAKER_02: 10 would go into that, would be considered a lease payment for classification and measurement.
17:12
SPEAKER_02: And then if there's some sort of difference there, like the estimate doesn't turn out the same as actual, that'd be a treat it as a variable lease payment.
17:20
SPEAKER_03: All right.
17:20
SPEAKER_03: So definitely makes a difference also when you're getting that payment.
17:25
SPEAKER_03: And Mark, because it makes a difference if the payment is before or after lease commencement, can you just remind the listeners of what we mean when we say lease commencement date or how you determine that date?
17:37
SPEAKER_01: Sure.
17:37
SPEAKER_01: And it's a reminder because we have talked about it on previous podcasts, but the lease commencement date is the date that the lessor makes the underlying asset available for use by the lessee.
17:47
SPEAKER_01: And just to mention a couple of things that the lease commencement date is not, right?
17:52
SPEAKER_01: It's typically not the date specified in a lease contract, right?
17:56
SPEAKER_01: And I mentioned this again because real estate leases frequently have lease commencement dates as sort of a bolded thing in the lease agreement.
18:04
SPEAKER_01: And that's usually not the accounting lease commencement date.
18:07
SPEAKER_01: It's not the date that's specified in the contract.
18:09
SPEAKER_01: It's typically not the date that the first lease payment is due, right?
18:13
SPEAKER_01: So, for example, if the first lease payment is due April 1st and the lessee um does not yet control how and when and whether they can go into the space, then the lease has simply not commenced yet.
18:24
SPEAKER_01: Another example that we sometimes see is that both the lesseur and the lessee are sort of doing improvements in the property at the same time.
18:32
SPEAKER_01: And the lesseur is allowing the lessee early access to the property to install these hold improvements, right?
18:38
SPEAKER_01: That lease has also not commenced yet because the lesseur has not yet transferred control of the asset to the lessee.
18:45
SPEAKER_01: So the lease commencement is the date that the lessee sort of gets the proverbial key to the space, or in this case, the actual key to the space, right?
18:53
SPEAKER_01: And they have the right to decide whether and when people can enter the space.
18:58
SPEAKER_01: If the lessee can't yet go and come as he pleases without asking the lesse or permission, the lease has probably not commenced.
19:05
SPEAKER_03: All right.
19:06
SPEAKER_03: And then, Mark, I know a question that we get often is what if a lessee is leasing multiples?
19:12
SPEAKER_03: So the question in my industry would be like two units in a power plant, but probably the more common example would be like multiple floors in a building.
19:19
SPEAKER_03: So can you have different lease commencement dates even if all those floors are covered in the same lease?
19:25
SPEAKER_01: Not just can you, but you often do.
19:28
SPEAKER_01: And if you just think about, you know, let's first of all talk about the unit of account.
19:31
SPEAKER_01: So the unit of account is any portion of a building that you could use separately from a different portion of the building.
19:38
SPEAKER_01: So certainly floors in an office building is the most common example.
19:41
SPEAKER_01: Everyone knows you can use the second floor before the first floor or vice versa, right?
19:45
SPEAKER_01: So sometimes a lessee will get control of one floor before the work is complete on another floor.
19:51
SPEAKER_01: And in that case, there's just two units of account.
19:55
SPEAKER_01: And the lease of one floor will start earlier, and the lease of the second floor will be for a shorter period of time.
20:00
SPEAKER_01: That obviously affects the timing of the lease expense, and if material, they'd have to account for this as two leases.
20:06
SPEAKER_01: The other thing I want to mention is that, you know, we've talked about this before, all the payments would have to be allocated amongst the two floors, right?
20:13
SPEAKER_01: So let's consider the fact pattern where there's an incentive, right?
20:17
SPEAKER_01: That incentive, as as Suzanne has just talked about, that incentive is just part of the consideration of the lease, and it would have to be allocated between the two units of account.
20:25
SPEAKER_01: So let me give an extreme example.
20:27
SPEAKER_01: This may not be the most common thing, but let's just to illustrate the point.
20:30
SPEAKER_01: Say that I put in all hundred thousand dollars of the improvements Suzanne was discussing on the second floor of the building, and none of them on the first floor of the building.
20:41
SPEAKER_01: Okay?
20:41
SPEAKER_01: And let's also assume, just to make it more complicated, that the Lassor doesn't give us the keys to the second floor until a later date.
20:48
SPEAKER_01: Right?
20:48
SPEAKER_01: So as we've talked about, we have two units of account.
20:51
SPEAKER_01: The first floor lease started sooner than the second floor lease, but I can't just say that all the$100,000 of lease incentive was only for the second floor because that's where I put in the improvements.
21:02
SPEAKER_01: Instead, that$100,000 negative payment, or the thing I'm gonna receive, is just part of my consideration.
21:09
SPEAKER_01: And all the consideration is gonna have to be allocated between the first floor and the second floor.
21:13
SPEAKER_01: And the odd thing here is that since the first floor lease started earlier, it's a longer lease than the second floor lease, which started later.
21:21
SPEAKER_01: So as a result, more of that$100,000 is actually gonna be allocated to the first floor than it would be to the second floor.
21:27
SPEAKER_03: All right.
21:27
SPEAKER_03: And Mark, from that point of view as well, it doesn't matter if we go back to those improvements.
21:32
SPEAKER_03: It doesn't matter if they're less C asset or less SOR asset, you'd still just allocate it.
21:37
SPEAKER_01: All the consideration in the contract would be allocated.
21:40
SPEAKER_03: All right.
21:40
SPEAKER_03: Yet another place where I think people need to make sure they really understand the rules and that they are following them correctly, because I think instinctively people may sometimes want to do something different than that.
21:51
SPEAKER_03: So we've let's kind of switch things now a little bit.
21:54
SPEAKER_03: So we've mostly been talking about situations where the lessee is putting in some um like less old employees.
22:00
SPEAKER_03: Improvements and as Suzanne's described them, painting, cubicles, those types of things.
22:04
SPEAKER_03: It's probably not heavy construction, but I know that we have situations where the leftees actually involved in construction of the asset itself.
22:12
SPEAKER_03: So build to suit, whether it's a factory or a building or a power plant or something else.
22:18
SPEAKER_03: So, and many people would have um scars from dealing with this under the old lease accounting.
22:24
SPEAKER_03: I know it's changed under 842, but there's still some things to think about.
22:29
SPEAKER_03: So, Mark, uh, what should uh lessee be thinking about when they are involved in a build-to-suit arrangement?
22:36
SPEAKER_01: So I should just preface this by saying that this is just to generate some awareness in build-to-suit accounting.
22:41
SPEAKER_01: Um we'll go through sort of a very high level, but if you are involved in a build-to-suit, it probably makes sense to talk to your accountants about it.
22:48
SPEAKER_01: So build-to-suit guidance should be considered whenever the lessee executes a lease, they sign a lease agreement before the underlying asset is completed.
22:57
SPEAKER_01: So, for example, it has not yet been built or it's it's still being in the middle of being constructed.
23:03
SPEAKER_01: And um, Heather, as you mentioned, the build-to-suit guidance under 840 back in the olden days, we know was very strict.
23:09
SPEAKER_01: It was very much a risk-based model, and the lessee was often deemed to be the owner during construction if they had risks of construction.
23:17
SPEAKER_01: Thankfully, today there are fewer situations where the lessee was deemed to be the owner of the yet-to-be constructed asset under 842.
23:24
SPEAKER_01: And that's because now it's really a control-based model as opposed to a risk-based model.
23:28
SPEAKER_01: So we're not seeing as many situations where the lessee is deemed the owner of dirt during the construction, but it still behooves us to at least be aware of what those things are.
23:38
SPEAKER_01: Now, the guidance itself lists five factors to consider, but it specifically says that this list is not all inclusive, right?
23:47
SPEAKER_01: So there are other situations which we'll talk about that the profession is kind of settled on as these are indicators that you actually should be deemed the owner of the building as opposed to just the lessee.
23:57
SPEAKER_01: So we're not going to go over all the criteria.
23:59
SPEAKER_01: I really want to focus on some of the ones that are the more frequent flyers that we see, right?
24:04
SPEAKER_01: But one that is actually not that frequent, but it is so basic to the model that I just want to kind of get it out of the way.
24:10
SPEAKER_01: And that is that the lassour has to have the legal right to use the land upon which the building's going to be built on, right?
24:18
SPEAKER_01: Or whatever is underlying the asset that they're building, they have to have the legal right to control that land from the very beginning of construction and continue throughout the entire economic life of the building being constructed on that land.
24:31
SPEAKER_01: Because if not, how could the lesseur ever really control the asset that's being built on the land, right?
24:37
SPEAKER_01: So if the lessee is the owner of the land, which is not always the case, obviously, but if the lessee is the owner of the land, or they're leasing the land in from a third party, they would have to lease out the land or or sublease the land to the lesseur before the construction begins and for a long enough period of time that the lesseur can recover the value of the building.
24:56
SPEAKER_01: And the bottom line is that the reason we don't see that that often is because of course les sours are going to demand the same thing.
25:02
SPEAKER_01: Exactly.
25:03
SPEAKER_03: Exactly.
25:04
SPEAKER_03: And I was trying to figure out a scenario where this wouldn't be the case.
25:07
SPEAKER_03: But and also it's obviously easy enough to structure your arrangements so you have the space in place.
25:12
SPEAKER_01: But remember, sometimes lessours are just financial institutions.
25:15
SPEAKER_01: So there's a fine line between having an owned asset and just giving a mortgage.
25:20
SPEAKER_03: Yes.
25:20
SPEAKER_01: And that's really what this guidance is trying to straddle, that line.
25:23
SPEAKER_01: Okay.
25:24
SPEAKER_01: So now let's talk about the one that we do see a lot of.
25:28
SPEAKER_01: Okay.
25:30
SPEAKER_01: And one of the things we're always cautious of is when the lessee has a right, not an obligation, but a right to obtain the partially constructed underlying asset during the construction period, i.e., it's still incomplete, and that right is contingent only upon the passage of time.
25:47
SPEAKER_03: All right.
25:47
SPEAKER_03: So um, can you give us I can think of a few examples, but what are some examples that you commonly see of this?
25:53
SPEAKER_01: Yeah, so let's say that a lessee wants to build a corporate headquarters or a very important building like a flagship store, as an example.
26:00
SPEAKER_01: Well, they would often give the lesseur a deadline.
26:03
SPEAKER_01: And they say if the building isn't complete by such and such date, by a certain date, then the lessee has the right, again, not the obligation, but they have the right to purchase the project and hire someone else to complete it.
26:15
SPEAKER_01: And since the only contingency there is the passage of time, that would be viewed as an option to purchase the asset during construction.
26:23
SPEAKER_01: And that would typically make the lessee be deemed the owner of the asset while it is being constructed.
26:29
SPEAKER_03: All right.
26:29
SPEAKER_03: So then what if the option is not based on time, but there's some other contingency involved?
26:35
SPEAKER_01: Yeah, if the option is based on some contingency that's outside of the lessee's control, then the lessee would not be deemed the owner of the asset until the contingency actually occurs.
26:44
SPEAKER_03: All right.
26:44
SPEAKER_03: Again, something to look out for.
26:46
SPEAKER_03: So that's one of these examples that you said is typically sort of a trigger for being the owner of the property during construction.
26:52
SPEAKER_03: But what other circumstances do we need to be thinking about?
26:56
SPEAKER_01: The other thing that we always ask about is is the lease a date certain lease?
27:00
SPEAKER_01: And that's not a defined term.
27:02
SPEAKER_01: That's just a lay term.
27:03
SPEAKER_01: So when we say a date certain lease, what we really mean is that all the rights and obligations of the lease agreement, right, will begin at a certain date, regardless of whether the asset is complete.
27:15
SPEAKER_01: Okay.
27:16
SPEAKER_01: And one of the reasons we're concerned about that is because normal leases often have purchase options, right?
27:23
SPEAKER_01: So if you have a date certain lease where the lease obligations could kick in, despite the fact that the building's not finished, and that lease has a purchase option in it, I'm back to the same problem where I now have a purchase option that the only thing preventing me from exercising it is the passage of time.
27:39
SPEAKER_01: And we would say that you're the owner of the asset.
27:42
SPEAKER_01: And just to explain a little bit as to why this is the case, right?
27:46
SPEAKER_01: If I compared this to, you know, uh, let's say perhaps this is a silly example.
27:50
SPEAKER_01: Say I ordered a truck from a dealer, right?
27:53
SPEAKER_01: And I told the dealer, hey, if it's not done by July 1st, I have the right to buy the incomplete car, and I'm going to take it to the body shop around the corner and have them finish it for me.
28:03
SPEAKER_01: We would all think that's ridiculous.
28:05
SPEAKER_03: And not recommend this.
28:06
SPEAKER_03: Yes.
28:06
SPEAKER_03: Yeah.
28:06
SPEAKER_01: And that would be, let's face it, you're that's because you're the owner of the car.
28:10
SPEAKER_01: So it's the same kind of concept, right?
28:12
SPEAKER_01: You shouldn't have the right.
28:14
SPEAKER_01: If you're just a lessee, the lesseur should at least be obligated to finish the asset before the lease begins.
28:20
SPEAKER_01: One other problem with dates certain leases is that um sometimes the lease is expected to be classified as a finance lease.
28:27
SPEAKER_01: Now, as we've mentioned before, we really can't determine lease classification with certainty until the lease commencement date, because you need all the numbers as of that date.
28:36
SPEAKER_01: But frequently, if something is a finance lease, you know it.
28:40
SPEAKER_01: Okay.
28:40
SPEAKER_01: You might have a, for example, you might have a bargain purchase option.
28:43
SPEAKER_01: That would be a finance lease.
28:44
SPEAKER_01: You would know that, right?
28:45
SPEAKER_01: If we have a date certain lease and the lease is expected to be a finance lease, and it's date certain lease means it's going to start on a certain date, regardless of whether the building's complete, we would deem the lessee to be the owner of the asset.
28:57
SPEAKER_01: And then finally, one more is where the lessee has to participate in the funding of the construction and they're paying for substantially all the construction, i.e., 90% or more during the construction period, then we would say, okay, that you're you're should be the owner of that asset.
29:12
SPEAKER_03: All right.
29:12
SPEAKER_03: So those all seem relatively logical.
29:15
SPEAKER_03: Any other ones that you would focus on?
29:17
SPEAKER_01: Um one other that I just want to mention is that um just as we've talked about the fact that the lessee can't have a call option, a purchase option on the asset during construction, sometimes these arrangements have a put option whereby the lessor could put the asset to the lessee.
29:34
SPEAKER_01: And the reason that lesseurs do that is because often in the build-to-suit, they hire the lessee to act as the construction manager.
29:41
SPEAKER_01: So they say, hey, basically, if the building's not done, it must be your fault, lessee.
29:44
SPEAKER_01: So I have the right to sell it to you.
29:46
SPEAKER_01: Now, whenever we have a put option, put options just generically are in the control of the lesseur.
29:52
SPEAKER_01: He can decide whether to exercise the put.
29:53
SPEAKER_01: So it's not an automatic problem, but the thing that we would look to is does he have an incentive to exercise that put and put it back to us?
30:01
SPEAKER_01: And that would often depend on how I'll use the word generic the property is versus how specialized it is.
30:07
SPEAKER_01: If he could just as easily or if he could find ready buyers for this uh construction project, then he may not have an incentive to put it specifically to the lessee.
30:16
SPEAKER_01: On the other hand, if it's very unique to the lessee, that may be his only way to recover his investment.
30:21
SPEAKER_01: So that's an evaluation that you'd have to look at.
30:23
SPEAKER_01: That's very judgmental.
30:24
SPEAKER_01: And we always have lots of conversations with um clients when they tell us that there is a put option in the arrangement.
30:31
SPEAKER_01: It's not necessarily problematic, but we have to, you know, think about it.
30:35
SPEAKER_03: All right.
30:35
SPEAKER_03: So definitely it's less prescriptive than the old rules for those who had dealt with it.
30:40
SPEAKER_03: But I do think even with that, we still do see some arrangements that wind up being accounted for this way.
30:45
SPEAKER_03: So what are some of the key accounting considerations if the lessee does control the asset during construction?
30:52
SPEAKER_01: Well, if the lessee is deemed to be the owner during the construction period, then they would account for the underlying asset during the construction period as if it was just an owned asset that they're constructing itself.
31:04
SPEAKER_01: So they would record all of the construction costs as they would in an owned asset, even the amounts that are being paid for directly by the lessor, they would account for that as if that was just a construction mortgage that they've received.
31:16
SPEAKER_01: Right.
31:17
SPEAKER_01: Um, and they would follow all the normal building your own asset guidance.
31:21
SPEAKER_01: That would include like capitalized interest as an example, right?
31:24
SPEAKER_01: They'd have to capitalize interest if it's a long-lived asset that they're constructing.
31:28
SPEAKER_01: Um, and then once the lessee has obtained control of the underlying asset under construction, they would generally not be able to derecognize that asset until the construction has been completed.
31:38
SPEAKER_03: All right.
31:39
SPEAKER_03: And then once the construction is complete, then how is the lessee going to get the asset off its books?
31:45
SPEAKER_01: Well, they don't just they don't just get to de-recognize the asset and the mortgage.
31:49
SPEAKER_01: Yeah.
31:50
SPEAKER_01: Um, instead, when the construction is complete and the quote unquote lease would begin, they would only be able to de-recognize the completed building and the associated mortgage if the transaction qualifies as a sold asset under the sale leaseback guidance.
32:04
SPEAKER_01: So now they'd have to apply sal leaseback guidance, which absent being deemed the owner, they wouldn't have had to apply, right?
32:10
SPEAKER_01: So the lessee must evaluate whether the transaction is a qualified sale under the sal leaseback guidance or not.
32:16
SPEAKER_01: If not, it's just a financing arrangement, it's just a mortgage.
32:19
SPEAKER_01: And if the transaction does meet the criteria to qualify for a sal lease back accounting, then the lessee would recognize the sale of the asset.
32:27
SPEAKER_01: They would de-recognize the asset, de-recognize the construction mortgage, and they would then recognize a new lease liability reflective of their future lease payments and a right of use asset.
32:37
SPEAKER_03: All right.
32:38
SPEAKER_03: So definitely a lot to think about there.
32:40
SPEAKER_03: And if you are dealing with even a potential uh build-to-suit arrangement, definitely recommend you check out chapter six, maybe call Mark, uh, see, you know, get some advice.
32:50
SPEAKER_03: So, Suzanne, Mark, definitely a lot to think about here.
32:53
SPEAKER_03: And I think again, as we mentioned at the very beginning, real estate leases are among the most common.
32:58
SPEAKER_03: So I didn't do this on every episode this series, but I would like to ask you guys just, you know, your words of wisdom for someone if they are thinking about a real estate lease, sort of the number one thing you would either tell them to start with or a number one piece of advice.
33:12
SPEAKER_03: So, Suzanne, I'll go to you first.
33:14
SPEAKER_02: Um, I think it's advice that we give for lots of transactions, but just really make sure you understand kind of what's in the contract, the rights and obligations, what you're required to do, what you're not required to do, because it's really going to drive the accounting.
33:28
SPEAKER_02: All right.
33:28
SPEAKER_03: Great advice, Sarah and Mark.
33:30
SPEAKER_01: Yeah, I would say one of the things we get a lot of questions on are lessee and less or assets when you're putting in improvements that cannot be removed and take back with you when you leave the property, and really pay attention to that guidance, which I believe is in chapter I'll go with chapter three of our lease's guide.
33:47
SPEAKER_03: Okay, all right.
33:48
SPEAKER_03: We'll we'll go with chapter three with that.
33:50
SPEAKER_03: But I think that's great advice because definitely even a topic we haven't even covered as much as some of these other topics on all of our various podcasts and webcasts.
33:58
SPEAKER_03: So, anyway, Mark and Suzanne, as always, such a pleasure to talk to you.
34:01
SPEAKER_03: Thank you so much for joining me today.
34:03
SPEAKER_03: Sure.
34:03
SPEAKER_01: Thank you.
34:05
SPEAKER_03: That's our show for today.
34:08
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34:28
SPEAKER_03: From Thought Leadership at PwC, I'm Heather Horn.
34:32
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