COPT Defense Properties Quarterly report pursuant to Section 13 or 15(d)

Quarterly report pursuant to Section 13 or 15(d)

Summary of Significant Accounting Policies

Summary of Significant Accounting Policies

9 Months Ended

Sep. 30, 2018

Summary of Significant Accounting Policies

Basis of Presentation

The COPT consolidated financial statements include the accounts of COPT, the Operating Partnership, their subsidiaries and other entities in which COPT has a majority voting interest and control. The COPLP consolidated financial statements include the accounts of COPLP, its subsidiaries and other entities in which COPLP has a majority voting interest and control. We also consolidate certain entities when control of such entities can be achieved through means other than voting rights (“variable interest entities” or “VIEs”) if we are deemed to be the primary beneficiary of such entities. We eliminate all intercompany balances and transactions in consolidation.

We use the equity method of accounting when we own an interest in an entity and can exert significant influence over but cannot control the entity’s operations. We discontinue equity method accounting if our investment in an entity (and net advances) is reduced to zero unless we have guaranteed obligations of the entity or are otherwise committed to provide further financial support for the entity.

We use the cost method of accounting when we own an interest in an entity and cannot exert significant influence over its operations.

These interim financial statements should be read together with the consolidated financial statements and notes thereto as of and for the year ended December 31, 2017 included in our 2017 Annual Report on Form 10-K. The unaudited consolidated financial statements include all adjustments that are necessary, in the opinion of management, to fairly state our financial position and results of operations. All adjustments are of a normal recurring nature. The consolidated financial statements have been prepared using the accounting policies described in our 2017 Annual Report on Form 10-K as updated for our adoption of recent accounting pronouncements discussed below.

Reclassification

We reclassified certain amounts from prior periods to conform to the current period presentation of our consolidated financial statements with no effect on previously reported net income or equity, including restricted cash and marketable securities that were reclassified to the line entitled “prepaid expenses and other assets, net” on our consolidated balance sheets after having been reported on a separate line in our Quarterly Reports on Form 10-Q filed in prior years and previous Annual Reports on Form 10-K.

Recent Accounting Pronouncements

We adopted guidance issued by the Financial Accounting Standards Board (“FASB”) effective January 1, 2018 regarding the recognition of revenue from contracts with customers (“Topic 606”). Under this guidance, an entity recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This guidance also requires improved disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. We determined that Topic 606 is applicable to our construction contract and other service revenues, which includes predominantly construction and design projects performed primarily for tenants of our properties. We used the modified retrospective method for contracts that were not completed as of January 1, 2018. Under this method, the cumulative effect of initially applying the guidance is recognized as an adjustment to the opening balance of retained earnings as of the date of initial application. Our adoption of Topic 606 effective January 1, 2018 did not affect our consolidated financial statements other than additional disclosure provided in accordance with the guidance. We did not elect to use any of the practical expedients provided for under the guidance. As discussed further below, Topic 606 will also apply to lease revenue deemed to be non-lease components (such as common area maintenance and provision of utilities) once the new guidance setting forth principles for the recognition, measurement, presentation and disclosure of leases goes into effect on January 1, 2019.

We adopted guidance issued by the FASB effective January 1, 2018 that requires entities to measure equity investments at fair value through net income, except for those that result in consolidation or are accounted for under the equity method of accounting. For equity investments without readily determinable fair values, the guidance permits the application of a measurement alternative using the cost of the investment, less any impairments, plus or minus changes resulting from observable price changes for an identical or similar investment of the same issuer. Our adoption of this guidance had no effect on our consolidated financial statements.

We adopted guidance issued by the FASB retrospectively effective January 1, 2018 that clarifies how entities should classify certain cash receipts and cash payments on the statement of cash flows with the objective of reducing the existing diversity in practice related to eight specific cash flow issues. The areas addressed in the new guidance relate to debt prepayment costs, settlement of zero-coupon debt instruments, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned and bank-owned life insurance policies, distributions received from equity method investments, beneficial interest in securitization transactions and separately identifiable cash flows and application of the predominance principle. Our adoption of this guidance had no effect on our consolidated financial statements.

We adopted guidance issued by the FASB retrospectively effective January 1, 2018 that requires the statement of cash flows to explain the change during the period in the total of cash, cash equivalents and amounts described as restricted cash or restricted cash equivalents. Under the new guidance, amounts described as restricted cash and restricted cash equivalents will be included with cash and cash equivalents when reconciling the beginning of period and end of period total amounts shown on the statement of cash flows. As a result of our adoption of this guidance, the change in restricted cash is no longer reported as either operating or investing activities on our statements of cash flows. Our restricted cash primarily consists of cash escrowed under mortgage debt for capital improvements and real estate taxes and certain tenant security deposits. Our adoption of this guidance had the following effects on our consolidated statements of cash flows for the nine months ended September 30, 2017 (in thousands):



	As Previously Reported			Impact of Adoption			As Adjusted
Net cash provided by operating activities	$	170,678		$	(1,250	)	$	169,428
Net cash used in investing activities	$	(52,730	)	$	260		$	(52,470	)
Net decrease in cash and cash equivalents and restricted cash	$	(199,005	)	$	(990	)	$	(199,995	)
Beginning of period cash and cash equivalents and restricted cash	$	209,863		$	2,756		$	212,619
End of period cash and cash equivalents and restricted cash	$	10,858		$	1,766		$	12,624

We adopted guidance issued by the FASB that clarifies the scope of provisions and accounting for nonfinancial asset derecognition, including partial sales of real estate assets, effective January 1, 2018 using the full retrospective method. The new guidance requires recognition of a sale of real estate and resulting gain or loss when control transfers and the buyer has the ability to direct use of, or obtain substantially all of the remaining benefit from, the asset (which generally will occur on the closing date); the factor of continuing involvement is no longer a specific consideration for the timing of recognition. The new guidance eliminates the need to consider adequacy of buyer investment, which was replaced by additional judgments regarding collectability and intent and/or ability to pay. The new guidance also requires an entity to derecognize nonfinancial assets and in-substance nonfinancial assets once it transfers control of such assets. When an entity transfers its controlling interest in a nonfinancial asset but retains a noncontrolling ownership interest, the entity is required to measure any non-controlling interest it receives or retains at fair value and recognize a full gain or loss on the transaction; as a result, sales and partial sales of real estate assets are now subject to the same derecognition model as all other nonfinancial assets. We had a transaction in July 2016 accounted for as a partial sale under the previous guidance that meets the criteria for immediate full gain recognition under the new guidance; as a result, we retrospectively recognized an additional $18 million in income in 2016 that was being amortized into income in subsequent periods under the previous guidance. The recognition pattern for our other sales of real estate were not changed by this new guidance. The full retrospective method requires adjustment of each reporting period presented at the time of adoption.

The tables below set forth the impact of the adoption of this guidance for amounts previously reported on the consolidated financial statements of COPT and subsidiaries (in thousands):



	As of December 31, 2017								As of September 30, 2017								As of December 31, 2016
Consolidated Balance Sheets	As Previously Reported			Impact of Adoption		As Adjusted			As Previously Reported			Impact of Adoption		As Adjusted			As Previously Reported			Impact of Adoption		As Adjusted
Investment in unconsolidated real estate joint venture	$	25,066		$	16,721	$	41,787		$	25,194		$	17,069	$	42,263		$	25,548		$	18,113	$	43,661
Cumulative distributions in excess of net income	$	(818,190	)	$	16,105	$	(802,085	)	$	(800,290	)	$	16,442	$	(783,848	)	$	(765,276	)	$	17,451	$	(747,825	)
Noncontrolling interests in subsidiaries	$	65,549		$	616	$	66,165		$	44,089		$	627	$	44,716		$	71,605		$	662	$	72,267



	For the Three Months Ended September 30, 2017									For the Nine Months Ended September 30, 2017
Consolidated Statements of Operations and Comprehensive Income	As Previously Reported			Impact of Adoption			As Adjusted			As Previously Reported			Impact of Adoption			As Adjusted
Equity in income of unconsolidated entities	$	719		$	(348	)	$	371		$	2,162		$	(1,044	)	$	1,118
Net income	$	22,682		$	(348	)	$	22,334		$	64,977		$	(1,044	)	$	63,933
Net income attributable to noncontrolling interests - Common units in COPLP	$	(704	)	$	11		$	(693	)	$	(1,611	)	$	35		$	(1,576	)
Net income attributable to COPT	$	20,916		$	(337	)	$	20,579		$	60,133		$	(1,009	)	$	59,124
Net income attributable to COPT common shareholders	$	20,916		$	(337	)	$	20,579		$	47,067		$	(1,009	)	$	46,058
Earnings per common share - basic and diluted	$	0.21		$	—		$	0.21		$	0.47		$	(0.01	)	$	0.46
Comprehensive income	$	22,996		$	(348	)	$	22,648		$	65,879		$	(1,044	)	$	64,835
Comprehensive income attributable to COPT	$	21,220		$	(337	)	$	20,883		$	61,005		$	(1,009	)	$	59,996

The tables below set forth the impact of the adoption of this guidance for amounts previously reported on the consolidated financial statements of COPLP and subsidiaries (in thousands):



	As of December 31, 2017						As of September 30, 2017						As of December 31, 2016
Consolidated Balance Sheets	As Previously Reported		Impact of Adoption		As Adjusted		As Previously Reported		Impact of Adoption		As Adjusted		As Previously Reported		Impact of Adoption		As Adjusted
Investment in unconsolid. real estate joint venture	$	25,066	$	16,721	$	41,787	$	25,194	$	17,069	$	42,263	$	25,548	$	18,113	$	43,661
Common units	$	1,428,301	$	16,721	$	1,445,022	$	1,394,911	$	17,069	$	1,411,980	$	1,401,597	$	18,113	$	1,419,710



	For the Three Months Ended September 30, 2017							For the Nine Months Ended September 30, 2017
Consolidated Statements of Operations and Comprehensive Income	As Previously Reported		Impact of Adoption			As Adjusted		As Previously Reported		Impact of Adoption			As Adjusted
Equity in income of unconsolidated entities	$	719	$	(348	)	$	371	$	2,162	$	(1,044	)	$	1,118
Net income	$	22,682	$	(348	)	$	22,334	$	64,977	$	(1,044	)	$	63,933
Net income attributable to COPLP	$	21,785	$	(348	)	$	21,437	$	62,239	$	(1,044	)	$	61,195
Net income attributable to COPLP common unitholders	$	21,620	$	(348	)	$	21,272	$	48,678	$	(1,044	)	$	47,634
Earnings per common unit - basic and diluted	$	0.21	$	—		$	0.21	$	0.47	$	(0.01	)	$	0.46
Comprehensive income	$	22,996	$	(348	)	$	22,648	$	65,879	$	(1,044	)	$	64,835
Comprehensive income attributable to COPLP	$	22,099	$	(348	)	$	21,751	$	63,141	$	(1,044	)	$	62,097

Adoption of this guidance had no impact to cash provided by or used in operating, financing or investing activities on our consolidated statements of cash flows for the nine months ended September 30, 2017.

We early adopted guidance issued by the FASB effective January 1, 2018 that makes targeted improvements to hedge accounting. This new guidance simplifies the application of hedge accounting and better aligns financial reporting for hedging activities with companies’ economic objectives in undertaking those activities. Under the new guidance, all changes in the fair value of highly effective cash flow hedges will be recorded in other comprehensive income instead of income. The new guidance also eases the administrative burden of hedge documentation requirements and assessing hedge effectiveness. We adopted this guidance using the modified retrospective transition method under which we eliminated $276,000 in previously-recorded cumulative hedge ineffectiveness as of January 1, 2018 by means of a cumulative-effect adjustment to our beginning balance of accumulated other comprehensive income (“AOCI”), with a corresponding adjustment to the beginning balance of: cumulative distributions in excess of net income for COPT and subsidiaries; and common units for COPLP and subsidiaries.

In August 2018, the Securities and Exchange Commission amended its rules to simplify or eliminate outdated, duplicative or overlapping disclosure requirements. The amendments also expand certain disclosure requirements, such as requiring (effective January 1, 2019) current and comparative quarter and year-to-date reporting of changes in shareholders’ equity in interim periods. We adopted these rules effective November 5, 2018 for the changes in disclosure that were required for this Quarterly Report on Form 10-Q, the effect of which was not material to the consolidated financial statements included herein, and we do not expect our adoption of these rules to have a material impact on our consolidated financial statements included in our future periodic filings.

In February 2016, the FASB issued guidance that sets forth principles for the recognition, measurement, presentation and disclosure of leases. This guidance requires lessees to apply a dual approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase of the leased asset by the lessee. The resulting classification determines whether the lease expense is recognized based on an effective interest method or straight-line basis over the term of the lease. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term of greater than 12 months regardless of their classification. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases. The guidance requires lessors of real estate to account for leases using an approach that is substantially equivalent to existing guidance for sales-type leases, direct financing leases and operating leases. This guidance will be adopted by us on January 1, 2019 using a modified retrospective transition approach under which will apply the guidance effective January 1, 2019, with a cumulative-effect adjustment as of such date, and not adjust prior comparative reporting periods. The guidance permits lessees and lessors to elect to apply a package of practical expedients that allow them not to reassess upon adoption: the lease classification for any expired or existing leases; their deferred recognition of incremental direct costs of leasing for any expired or existing leases; and whether any expired or existing contracts are, or contain, leases. The guidance also permits lessors to elect a practical expedient (by class of underlying asset) to avoid separating non-lease components that otherwise would need to be accounted for under the recently-adopted revenue accounting guidance (such as common area maintenance and provision of utilities) from the associated lease component if (1) the non-lease components have the same timing and pattern of transfer as the associated lease component and (2) the lease component, if accounted for separately, would be classified as an operating lease; once this practical expedient is adopted, the lessor would be able to account for the combination of the lease component and non-lease components as an operating lease as long as the lease component is the predominant component of the combined components. We expect to elect each of the above practical expedients. Below is a summary of the anticipated effects of this guidance on our accounting and reporting.


•	Real estate leases in which we are the lessor:


◦	Balance sheet reporting: We believe that we will apply an approach under the new guidance that is similar to the current accounting for operating leases, in which we will continue to recognize the underlying leased asset as property on our balance sheet.


◦	Deferral of non-incremental lease costs: Under the new lease guidance, we will be expensing future non-incremental costs in connection with new or extended tenant leases the recognition of which would have been deferred under current accounting (refer to amounts reported in our 2017 Annual Report on Form 10-K for amounts deferred in 2017, 2016 and 2015).


•	Leases in which we are the lessee:

◦

Our most significant leases as lessee are ground leases; as of September 30, 2018, our future minimum rental payments under these leases totaled $87.5 million, with various expiration dates extending to the year 2100. We believe that we will be required to recognize right-of-use assets and lease liabilities for the present value of these minimum lease payments. We also believe that these types of leases would be classified as finance leases under the new guidance, which would result in the interest component of each lease payment being recorded as interest expense and the right-of-use asset being amortized into expense using the straight-line method over the life of the lease; however, we expect to elect to apply the package of practical expedients under which we would continue to account for our existing ground leases as operating leases upon adoption of the guidance.

In June 2016, the FASB issued guidance that changes how entities measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. The guidance replaces the current incurred loss model with an expected loss approach, resulting in a more timely recognition of such losses. The guidance will apply to most financial assets measured at amortized cost and certain other instruments, including trade and other receivables, loans, held-to-maturity debt securities, net investments in leases, and off-balance-sheet credit exposures (e.g. loan commitments). Under the new guidance, an entity will recognize its estimate of expected credit losses as an allowance, as the guidance requires that financial assets be measured on an amortized cost basis and to be presented at the net amount expected to be collected. The guidance is effective for us beginning January 1, 2020, with early adoption permitted after December 2018. We are currently assessing the financial impact of this guidance on our consolidated financial statements.

In August 2018, the FASB issued guidance that modifies disclosure requirements for fair value measurements. This guidance is effective for us beginning January 1, 2020. Early adoption is permitted for this guidance, and entities are permitted to early adopt with respect to any removed or modified disclosures while delaying adoption of additional disclosure requirements until the effective date. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In August 2018, the FASB issued guidance that aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. FASB guidance did not previously address the accounting for such implementation costs. The guidance is effective for us beginning January 1, 2020, with early adoption permitted. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.