ABC Inc. Case

ABC Inc. was founded in 2007 and is headquartered in San Francisco. Revenues and net income for 2010 are $500 million and $80 million, respectively. In September 2010, ABC Inc. (“ABC” or the “Company”) entered into an agreement with Landlord LLC (the “Landlord”) to lease approximately 268,000 square feet or 40% of a building located at 100 Smith Street, San Francisco. The building was originally configured to be used as office space. However, ABC wished to re-configure the interior layout and make certain improvements to the lease space to meet ABC’s design specifications. The tenant improvements (“TIs”) as specified in the lease agreement are for general purpose and not structural. The total estimated budget for tenant improvements is approximately $37 million.

KEY CONSIDERATIONS INVOLVED IN THE ACCOUNTING QUESTIONS

1. What type of arrangement is between ABC and the Landlord?
2. Who is responsible and owns the tenant improvements and lease incentive obligation on the leasing space?
3. What are the risks with tenant improvements?
4. How does ABC account for tenant improvements?
5. What is the treatment of lease incentives and are the tenant improvements subject to amortization for the lease period?

SUMMARY CONCLUSION ON ACCOUNTING QUESTIONS

1. The arrangement between ABC and the Landlord is classified as an operating lease based on the criteria ASC840. The agreement fails to meet any one of the 4 criteria that determine the classification of a capital lease.

2. For the tenant improvements, ABC will be responsible for any expenses above $13 million. The Landlord is giving ABC the tenant improvements as a tenant incentive.

3. ABC will assume the risk and expenses of construction overruns. 4. ABC will need to record the tenant improvements as rent expense.

5. The cost of the improvements will be recorded in fixed assets and be depreciated over the shorter of the estimated useful life of the improvements or the life of the lease.

AUTHORITATIVE AND INTREPRETIVE GUIDANCE CONSIDERED

Refer to FAS no. 05-6(Determining the Amortization Period for Leasehold Improvements) Refer to FAS no. 13 (Accounting for Leases)
Refer to FAS no. 91 (Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases) Refer to ASC 840-20-25-01 (Overall Guidance on Recognition of Leases) ASC 840-20-55-01(Examples of Estimated Loss on Assumption of a Preexisting Lease) Refer to ASC 840-40-55-09  ASC 840-40-55-09-h (Amounts Included in the Maximum Guarantee Test) Refer to ASC 970-340-25-16 (Costs Incurred to Rent Real Estate Projects) Refer to ASC 970-720-25-1 (Preacquisition Costs)

DETAILED DISCUSSION, ANALYSIS, EVALUATION OF ALTERNATIVES & REASONS FOR CONCLUSION

QUESTION 1
What type of arrangement is between ABC and the Landlord?

The arrangement between ABC and the Landlord is classified as an operating lease based on the criteria ASC 840-20-25-1. The agreement fails to meet any one of the 4 criteria that determine the classification of a capital lease. In an operating lease, the Landlord transfers only the right to use the property to ABC. At the end of the lease period, ABC returns the property to the Landlord. Since ABC does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement and the lease does not affect the balance sheet.

QUESTION 2
Who is responsible and owns the tenant improvements and lease incentive obligation on the leasing space?

For the tenant improvements, ABC will be responsible for any expenses above $13 million. The Landlord is giving ABC the tenant improvements as a tenant incentive. The incentive is for ABC to sign a long term lease. The original lease term extends for 7 years from the inception date. In addition, the lease contains two 5-year renewal options, the first at 95% of fair value at the time of renewal. The lease also includes an early termination option (for a fee) relating to certain floors after 5 years for one floor and after 6 years for 2 additional floors.

QUESTION 3
What are the risks with tenant improvements?

ABC will assume the risk and expenses of construction overruns. Refer to ASC 840-40-55-2 for Criteria for Determining Whether the Lessee Should Be Considered the Owner of the Asset Under Construction. The risk will increase if the Landlord does the construction. The Landlord has little to no incentive to keep costs within the agreed tenant improvement amount since the Landlord does not have to pay for any excess. For this reason, it may be preferable for ABC to suggest another way to handle tenant improvements.

QUESTION 4
How does ABC account for tenant improvements?

Even though there is no rent during the construction period, ABC will need to record rent expense. ABC will need to set up a deferred asset account and adjust it to achieve the straight-line rent expense. Refer to ASC 970-340-25-5.

QUESTION 5
What is the treatment of lease incentives and are the tenant improvements subject to amortization for the lease period?

The cost of the improvements will be recorded in fixed assets and be depreciated over the shorter of the estimated useful life of the improvements or the life of the lease. Under U.S. GAAP, payments made for improvement requires ABC to record the incentives at gross value on the balance sheet. Refer to ASC 840-40-55-1.

REQUIRED FINANCIAL STATEMENT DISCLOSURE

In accordance with ASC 840-20-25-01, the following information should be disclosed in ABC’s financial statements relative to the transaction:

Tenant improvements will be recorded in a deferred asset account and adjust to achieve the straight-line rent expense; For tenant improvements to be recorded as rent expense.