Clifford H. Schwartz, CPA
PricewaterhouseCoopers LLP
Suzanne McElyea, CPA
PricewaterhouseCoopers LLP
Real estate encompasses a variety of interests (developers, investors, lenders, tenants, homeowners, corporations, conduits, etc.) with a divergence of objectives (tax benefits, security, long-term appreciation, etc.). The industry is also a tool of the federal government's income tax policies (evidenced by the rules on mortgage interest deductions and restrictions on "passive" investment deductions). The real estate industry consists primarily of private developers and builders.
Other important forces in the industry include pension funds and insurance companies and large corporations, whose occupancy (real estate) costs generally are the second largest costs after personnel costs.
After a decade of growth spurred by steadily falling interest rates in an expanding economy, the new millennium brought in its wake a series of traumatic events that highlighted the uncertainties inherent in the real estate industry:
Collapse of the dot-coms. The sudden rise and dramatic collapse of the Internet-related economy delivered the first shock to real estate markets since the banks scandals of the 1980s. A seller's market was turned on end as rapid retrenchment left behind a glut of office space.
The attacks on the World Trade Center and the Pentagon. The attacks dealt a hard blow to an already declining economy and real estate market. It exposed the vulnerability of the United States to terrorist attacks and made planning for such attacks a central part of real estate management. It was followed by a sharp rise in unemployment and severe weakness in financial markets. It also called into question long time practices of concentrating corporate functions and resources in one location.
Enron. The collapse of Enron led investors and regulators to seriously question the use of off-balance sheet financing vehicles, such as conduits and synthetic leasing, which had become the darlings of Wall Street financiers, growing to more than $5.2 trillion over the last 30 years.
Overbuilding, accounting reform, terrorist threats, and weak markets will continue to plague the recovery of many real estate markets. The sources and extent of available capital for financings and construction will be a concern. This concern will be centered on the ability and willingness of financing institutions to continue lending in an uncertain market, and lenders will increasingly require creditworthiness or enhancements to reduce to their exposure to real estate risk.
Real estate sales transactions are generally material to the entity's financial statements. "Is the earnings process complete?" is the primary question that must be answered regarding such sales. In other words, assuming a legal sale, have the risks and rewards of ownership been transferred to the buyer?
Prior to 1982, guidance related to real estate sales transactions was contained in two American Institute of Certified Public AccountantsAmerican Institute of Certified Public Accountants (AICPA) Accounting Guides: "Accounting for Retail Land Sales" and "Accounting for Profit Recognition on Sales of Real Estate." These guides had been supplemented by several AICPA Statements of Position that provided interpretations
In October 1982, Statement of Financial Accounting StandardsStatement of Financial Accounting Standards (SFAS) No. 66, "Accounting for Sales of Real Estate," was issued as part of the Financial Accounting Standards BoardFinancial Accounting Standards Board (FASB) project to incorporate, where appropriate, AICPA Accounting Guides into FASB Statements. This Statement adopted the specialized profit recognition principles of the above guides.
The FASB formed the Emerging Issues Task ForceEmerging Issues Task Force (EITF) in 1984 for the early identification of emerging issues. The EITF has dealt with many issues affecting the real estate industry, including issues that clarify or address SFAS No. 66.
Regardless of the seller's business, SFAS No. 66 covers all sales of real estate, determines the timing of the sale and resultant profit recognition, and deals with seller accounting only. This Statement does not discuss nonmonetary exchanges, cost accounting, and most lease transactions or disclosures.
The two primary concerns under SFAS No. 66 are:
Has a sale occurred?
Under what method and when should profit be recognized?
The concerns are answered by determining the buyer's initial and continuing investment and the nature and extent of the seller's continuing involvement. The guidelines used in determining these criteria are complex and, within certain provisions, arbitrary. Companies dealing with these types of transactions are often faced with the difficult task of analyzing the exact nature of a transaction in order to determine the appropriate accounting approach. Only with a thorough understanding of the details of a transaction can the accountant perform the analysis required to decide on the appropriate accounting method.
SFAS No. 66 (pars. 44– 50) discussed separate rules for retail land sales (see Subsection 30.2(h)). The following information is for all real estate sales other than retail land sales. To determine whether profit recognition is appropriate, a test must first be made to determine whether a sale may be recorded. Then additional tests are made related to the buyer's investment and the seller's continued involvement.
Generally, real estate sales should not be recorded prior to closing. Since an exchange is generally required to recognize profit, a sale must be consummated. A sale is consummated when all the following conditions have been met:
The parties are bound by the terms of a contract.
All consideration has been exchanged.
Any permanent financing for which the seller is responsible has been arranged.
All conditions precedent to closing have been performed.
Usually all those conditions are met at the time of closing. On the other hand, they are not usually met at the time of a contract to sell or a preclosing.
Exceptions to the "conditions precedent to closing" have been specifically provided for in SFAS No. 66. They are applicable where a sale of property includes a requirement for the seller to perform future construction or development. Under certain conditions, partial sale recognition is permitted during the construction process because the construction period is extended. This exception usually is not applicable to single-family detached housing because of the shorter construction period.
Transactions that should not be treated as sales for accounting purposes because of continuing seller's involvement include the following:
The seller has an option or obligation to repurchase the property.
The seller guarantees return of the buyer's investment.
The seller retains an interest as a general partner in a limited partnership and has a significant receivable.
The seller is required to initiate or support operations or continue to operate the property at its own risk for a specified period or until a specified level of operations has been obtained.
If the criteria for recording a sale are not met, the deposit, financing, lease, or profit sharing (co-venture) methods should be used, depending on the substance of the transaction.
Once it has been determined that a sale can be recorded, the next test relates to the buyer's investment. For the seller to record full profit recognition, the buyer's down payment must be adequate in size and in composition.
The minimum down payment requirement is one of the most important provisions in SFAS No. 66. Appendix A of this pronouncement, reproduced here as Exhibit 30.1, lists minimum down payments ranging from 5 percent to 25 percent of sales value based on usual loan limits for various types of properties. These percentages should be considered as specific requirements because it was not intended that exceptions be made. Additionally, EITF Consensus No. 88-24, "Effect of Various Forms of Financing under FASB Statement No. 66," discusses the impact of the source and nature of the buyer's down payment on profit recognition. Exhibit A to EITF No. 88-24 has been reproduced here as Exhibit 30.2
If a newly placed permanent loan or firm permanent loan commitment for maximum financing exists, the minimum down payment must be the higher of (1) the amount derived from Appendix A or (2) the excess of sales value over 115 percent of the new financing. However, regardless of this test, a down payment of 25 percent of the sales value of the property is usually considered sufficient to justify the recognition of profit at the time of sale.
Figure 30.1. Minimum initial investment requirements. (Source: SFAS No. 66, "Accounting for Sales of Real Estate" (Appendix A), FASB, 1982. Reprinted with permission of FASB.)
Figure 30.2. Examples of the application of the EITF consensus on Issue No. 88-24. Source: EITF Issue No. 88-24, "Effect of Various Forms of Financing under FASB Statement No. 66" (Exhibit 88-24A), FASB, 1988. (Reprinted with permission of FASB.)
An example of the down payment test—Appendix A compared to the newly placed permanent loan test—is given in the following:
The down payment requirements must be related to sales value, as described in SFAS No. 66 (par. 7). Sales value is the stated sales price increased or decreased for other consideration that clearly constitutes additional proceeds on the sale, services without compensation, imputed interest, and so forth.
Consideration payable for development work or improvements that are the responsibility of the seller should be included in the computation of sales value.
The primary acceptable down payment is cash, but additional acceptable forms of down payment are:
Notes from the buyer (only when supported by irrevocable letters of credit from an independent established lending institution)
Cash payments by the buyer to reduce previously existing indebtedness
Cash payments that are in substance additional sales proceeds, such as prepaid interest that by the terms of the contract is applied to amounts due the seller
Examples of other forms of down payment that are not acceptable are:
Other noncash consideration received by the seller, such as notes from the buyer without letters of credit or marketable securities. Noncash consideration constitutes down payment only at the time it is converted into cash.
Funds that have been or will be loaned to the buyer builder/developer for acquisition, construction, or development purposes or otherwise provided directly or indirectly by the seller. Such amounts must first be deducted from the down payment in determining whether the down payment test has been met. An exemption from this requirement was provided in paragraph 115 of SFAS No. 66, which states that if a future loan on normal terms from a seller who is also an established lending institution bears a fair market interest rate and the proceeds of the loan are conditional on use for specific development of or construction on the property, the loan need not be subtracted in determining the buyer's investment.
Funds received from the buyer from proceeds of priority loans on the property. Such funds have not come from the buyer and therefore do not provide assurance of collectibility of the remaining receivable; such amounts should be excluded in determining the adequacy of the down payment. In addition, EITF Consensus No. 88-24 provides guidelines on the impact that the source and nature of the buyer's initial investment can have on profit recognition.
Marketable securities or other assets received as down payment will constitute down payment only at the time they are converted to cash.
Cash payments for prepaid interest that are not in substance additional sales proceeds.
Cash payments by the buyer to others for development or construction of improvements to the property.
If the buyer's down payment is inadequate, the accrual method of accounting is not appropriate, and the deposit, installment, or cost recovery method of accounting should be used.
When the sole consideration (in addition to cash) received by the seller is the buyer's assumption of existing nonrecourse indebtedness, a sale could be recorded and profit recognized if all other conditions for recognizing a sale were met. If, however, the buyer assumes recourse debt and the seller remains liable on the debt, he has a risk of loss comparable to the risk involved in holding a receivable from the buyer, and the accrual method would not be appropriate.
EITF Consensus No. 88-24 states that the initial and continuing investment requirements for the full accrual method of profit recognition of SFAS No. 66 are applicable unless the seller receives one of the following as the full sales value of the property:
Cash, without any seller contingent liability on any debt on the property incurred or assumed by the buyer
The buyer's assumption of the seller's existing nonrecourse debt on the property
The buyer's assumption of all recourse debt on the property with the complete release of the seller from those obligations
Any combination of such cash and debt assumption
Even if the required down payment is made, a number of factors must be considered by the seller in connection with a receivable from the buyer. They include:
Collectibility of the receivable
Buyer's continuing investment—amortization of receivable
Future subordination
Release provisions
Imputation of interest
Collectibility of the receivable must be reasonably assured and should be assessed in light of factors such as the credit standing of the buyer (if recourse), cash flow from the property, and the property's size and geographical location. This requirement may be particularly important when the receivable is relatively short term and collectibility is questionable because the buyer will be required to obtain financing. Furthermore, a basic principle of real estate sales on credit is that the receivable must be adequately secured by the property sold.
Continuing investment requirements for full profit recognition require that the buyer's payments on its total debt for the purchase price must be at least equal to level annual payments (including principal and interest) based on amortization of the full amount over a maximum term of 20 years for land and over the customary term of a first mortgage by an independent established lending institution for other property. The annual payments must begin within one year of recording the sale and, to be acceptable, must meet the same composition test as used in determining adequacy of down payments. The customary term of a first mortgage loan is usually considered to be the term of a new loan (or the term of an existing loan placed in recent years) from an independent financial lending institution.
All indebtedness on the property need not be reduced proportionately. However, if the seller's receivable is not being amortized, realization may be in question and the collectibility must be more carefully assessed. Lump-sum (balloon) payments do not affect the amortization requirement as long as the scheduled amortization is within the maximum period and the minimum annual amortization tests are met.
For example, if the customary term of the mortgage by an independent lender required amortizing payments over a period of 25 years, then the continuing investment requirement would be based on such an amortization schedule. If the terms of the receivable required principal and interest payments on such a schedule only for the first five years with a balloon at the end of year 5, the continuing investment requirements are met. In such cases, however, the collectibility of the balloon payment should be carefully assessed.
If the amortization requirements for full profit recognition as set forth above are not met, a reduced profit may be recognized by the seller if the annual payments are at least equal to the total of:
Annual level payments of principal and interest on a maximum available first mortgage
Interest at an appropriate rate on the remaining amount payable by the buyer
The reduced profit is determined by discounting the receivable from the buyer to the present value of the lowest level of annual payments required by the sales contract excluding requirements to pay lump sums. The present value is calculated using an appropriate interest rate, but not less than the rate stated in the sales contract.
The amount calculated would be used as the value of the receivable for the purpose of determining the reduced profit. The calculation of reduced profit is illustrated in Exhibit 30.3
The requirements for amortization of the receivable are applied cumulatively at the closing date (date of recording the sale for accounting purposes) and annually thereafter. Any excess of down payment received over the minimum required is applied toward the amortization requirements.
If the receivable is subject to future subordination to a future loan available to the buyer, profit recognition cannot exceed the amount determined under the cost recovery method (see Subsection 30.2(j)(iii)) unless proceeds of the loan are first used to reduce the seller's receivable. Although this accounting treatment is controversial, the cost recovery method is required because collectibility of the sales price is not reasonably assured. The future subordination would permit the primary lender to obtain a prior lien on the property, leaving only a secondary residual value for the seller, and future loans could indirectly finance the buyer's initial cash investment. Future loans would include funds received by the buyer arising from a permanent loan commitment existing at the time of the transaction unless such funds were first applied to reduce the seller's receivable as provided for in the terms of the sale.
The cost recovery method is not required if the receivable is subordinate to a previous mortgage on the property existing at the time of sale.
Some sales transactions have provisions releasing portions of the property from the liens securing the debt as partial payments are made. In this situation, full profit recognition is acceptable only if the buyer must make, at the time of each release, cumulative payments that are adequate in relation to the sales value of property not released.
Careful attention should be given to the necessity for imputation of interest under Accounting Principles BoardAccounting Principles Board (APB) Opinion No. 21, "Interest on Receivables and Payables," since it could have a significant effect on the amount of profit or loss recognition. As stated in the first paragraph of APB Opinion No. 21: "The use of an interest rate that varies from prevailing interest rates warrants evaluation of whether the face amount and the stated interest rate of a note or obligation provide reliable evidence for properly recording the exchange and subsequent related interest."
If imputation of interest is necessary, the mortgage note receivable should be adjusted to its present value by discounting all future payments on the notes using an imputed rate of interest at the prevailing rates available for similar financing with independent financial institutions. A distinction must be made between first and second mortgage loans because the appropriate imputed rate for a second mortgage would normally be significantly higher than the rate for a first mortgage loan. It may be necessary to obtain independent valuations to assist in the determination of the proper rate.
If the criteria for recording a sale have been met but the tests related to the collectibility of the receivable as set forth herein are not met, the accrual method of accounting is not appropriate and the installment or cost recovery method of accounting should be used. These methods are discussed in Subsection 30.2(j) of this chapter.
A seller sometimes continues to be involved over long periods of time with property legally sold. This involvement may take many forms such as participation in future profits, financing, management services, development, construction, guarantees, and options to repurchase. With respect to profit recognition when a seller has continued involvement, the two key principles are as follows:
A sales contract should not be accounted for as a sale if the seller's continued involvement with the property includes the same kinds of risk as does ownership of property.
Profit recognition should follow performance and in some cases should be postponed completely until a later date.
A sale of real estate may include or be accompanied by an agreement that provides for the seller to participate in future operating profits or residual values. As long as the seller has no further obligations or risk of loss, profit recognition on the sale need not be deferred. A receivable from the buyer is permitted if the other tests for profit recognition are met, but no costs can be deferred.
If the seller has an option or obligation to repurchase property (including a buyer's option to compel the seller to repurchase), a sale cannot be recognized (SFAS No. 66, par. 26). However, neither a commitment by the seller to assist or use his best efforts (with appropriate compensation) on a resale nor a right of first refusal based on a bona fide offer by a third party would preclude sale recognition. The accounting to be followed depends on the repurchase terms. EITF Consensus No. 86-6 discusses accounting for a sale transaction when antispeculation clauses exist. A consensus was reached that the contingent option would not preclude sale recognition if the probability of buyer noncompliance is remote.
When the seller has an obligation or an option that is reasonably expected to be exercised to repurchase the property at a price higher than the total amount of the payments received and to be received, the transaction is a financing arrangement and should be accounted for under the financing method. If the option is not reasonably expected to be exercised, the deposit method is appropriate.
In the case of a repurchase obligation or option at a lower price, the transaction usually is, in substance, a lease or is part lease, part financing and should be accounted for under the lease method. Where an option to repurchase is at a market price to be determined in the future, the transaction should be accounted for under the deposit method or the profit-sharing method.
When the seller is a general partner in a limited partnership and has a significant receivable related to the property, the transaction would not qualify as a sale. It should usually be accounted for as a profit-sharing arrangement. A significant receivable is one that is in excess of 15 percent of the maximum first lien financing that could be obtained from an established lending institution for the property sold.
The buyer's investment in the property cannot be evaluated until adequate permanent financing at an acceptable cost is available to the buyer. If the seller must obtain or provide this financing, obtaining the financing is a prerequisite to a sale for accounting purposes. Even if not required to do so, the seller may be presumed to have such an obligation if the buyer does not have financing and the collectibility of the receivable is questionable. The deposit method is appropriate if lack of financing is the only impediment to recording a sale.
SFAS No. 66 (par. 28) states: "If the seller guarantees return of the buyer's investment, ... the transaction shall be accounted for as a financing, leasing, or profit-sharing arrangement."
Accordingly, if the terms of a transaction are such that the buyer may expect to recover the initial investment through assured cash returns, subsidies, and net tax benefits, even if the buyer were to default on debt to the seller, the transaction is probably not in substance a sale.
When the seller guarantees cash returns on the buyer's investment, the accounting method to be followed depends on whether the guarantee is for an extended or limited period and whether the seller's expected cost of the guarantee is determinable.
SFAS No. 66 states that when the seller contractually guarantees cash returns on investments to the buyer for an extended period, the transaction should be accounted for as a financing, leasing, or profit-sharing arrangement. An "extended period" was not defined but should at least include periods that are not limited in time or specified lengthy periods, such as more than five years.
If the guarantee of a return on the buyer's investment is for a limited period, SFAS No. 66 indicates that the deposit method of accounting should be used until such time as operation of the property covers all operating expenses, debt service, and contractual payments. At that time, profit should be recognized based on performance (see Subsection 30.2(j)). A "limited period" was not defined but is believed to relate to specified shorter periods, such as five years or less.
Irrespective of the above, if the guarantee is determinable or limited, sale and profit recognition may be appropriate if reduced by the maximum exposure to loss as described below.
If the amount can be reasonably estimated, the seller should record the guarantee as a cost at the time of sale, thus either reducing the profit or increasing the loss on the transaction.
If the amount cannot be reasonably estimated, the transaction is probably in substance a profit-sharing or co-venture arrangement.
If the amount cannot be reasonably estimated but a maximum cost of the guarantee is determinable, the seller may record the maximum cost of the guarantee as a cost at the time of sale, thus either reducing the profit or increasing the loss on the transaction. Alternatively, the seller may account for the transaction as if the guarantee amount is not determinable. Implications of a seller's guarantee of cash flow on an operating property that is not considered a sale-leaseback arrangement are discussed in Subsection 30.2(f)(x).
A guarantee of cash flow to the buyer sometimes takes the form of a leaseback arrangement. Since the earnings process in this situation has not usually been completed, profits on the sale should generally be deferred and amortized.
Accounting for a sale-leaseback of real estate is governed by SFAS No. 13, "Accounting for Leases," as amended by SFAS No. 28, "Accounting for Sales with Leasebacks," SFAS No. 98, "Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate," and SFAS No. 66. SFAS No. 98 specifies the accounting by a seller-lessee for a sale-leaseback transaction involving real estate, including real estate with equipment. SFAS No. 98 provides that:
A sale-leaseback transaction involving real estate, including real estate with equipment, must qualify as a sale under the provisions of SFAS No. 66 as amended by SFAS No. 98, before it is appropriate for the seller-lessee to account for the transaction as a sale. If the transaction does not qualify as a sale under SFAS No. 66, it should be accounted for by the deposit method or as a financing transaction (see Subsection 30.2(j)(v)).
A sale-leaseback transaction involving real estate, including real estate with equipment, that includes any continuing involvement other than a normal leaseback in which the seller-lessee intends to actively use the property during the lease should be accounted for by the deposit method or as a financing transaction.
A lease involving real estate may not be classified as a sales-type lease unless the lease agreement provides for the transfer of title to the lessee at or shortly after the end of the lease term. Sales-type leases involving real estate should be accounted for under the provisions of SFAS No. 66.
Profits should be deferred and amortized in a manner consistent with the classification of the leaseback:
If the leaseback is an operating lease, deferred profit should be amortized in proportion to the related gross rental charges to expense over the lease term.
If the leaseback is a capital lease, deferred profit should be amortized in proportion to the amortization of the leased asset. Effectively, the sale is treated as a financing transaction. The deferred profit can be presented gross, but normally is offset against the capitalized asset for balance sheet classification purposes.
In situations where the leaseback covers only a minor portion of the property sold or the period is relatively minor compared to the remaining useful life of the property, it may be appropriate to recognize all or a portion of the gain as income. Sales with minor leasebacks should be accounted for based on the separate terms of the sale and the leaseback unless the rentals called for by the leaseback are unreasonable in relation to current market conditions. If rentals are considered to be unreasonable, they must be adjusted to a reasonable amount in computing the profit on the sale.
The leaseback is considered to be minor when the present value of the leaseback based on reasonable rentals is 10 percent or less of the fair value of the asset sold. If the leaseback is not considered to be minor (but less than substantially all of the use of the asset is retained through a leaseback) profit may be recognized to the extent it exceeds the present value of the minimum lease payments (net of executory costs) in the case of an operating lease or the recorded amount of the leased asset in the case of a capital lease.
Losses should be recognized immediately to the extent that the undepreciated cost (net carrying value) exceeds the fair value of the property. Fair value is frequently determined by the selling price from which the loss on the sale is measured. Many sale-leasebacks are entered into as a means of financing, or for tax reasons, or both. The terms of the leaseback are negotiated as a package. Because of the interdependence of the sale and concurrent leaseback, the selling price in some cases is not representative of fair value. It would not be appropriate to recognize a loss on the sale that would be offset by future cost reductions as a result of either reduced rental costs under an operating lease or depreciation and interest charges under a capital lease. Therefore, to the extent that the fair value is greater than the sale price, losses should be deferred and amortized in the same manner as profits.
A sales contract may be accompanied by an agreement for the seller to provide management or other services without adequate compensation. Compensation for the value of the services should be imputed, deducted from the sales price, and recognized over the term of the contract. See discussion of implied support of operations in Subsection 30.2(f)(x) if the contract is noncancelable and the compensation is unusual for the services to be rendered.
A sale of undeveloped or partially developed land may include or be accompanied by an agreement requiring future seller performance of development or construction. In such cases, all or a portion of the profit should be deferred. If there is a lapse of time between the sale agreement and the future performance agreement, deferral provisions usually apply if definitive development plans existed at the time of sale and a development contract was anticipated by the parties at the time of entering into the sales contract.
In addition, SFAS No. 66 (par. 41) provides that "The seller is involved with future development or construction work if the buyer is unable to pay amounts due for that work or has the right under the terms of the arrangement to defer payment until the work is done."
If the property sold and being developed is an operating property (such as an apartment complex, shopping center, or office building) as opposed to a nonoperating property (such as a land lot, condominium unit, or single-family detached home), Subsection 30.2(f)(x) may also apply.
If a seller is obligated to develop the property or construct facilities and total costs and profit cannot be reliably estimated (e.g., because of lack of seller experience or nondefinitive plans), all profit, including profit on the sale of land, should be deferred until the contract is completed or until the total costs and profit can be reliably estimated. Under the completed contract method, all profit, including profit on the sale of land, is deferred until the seller's obligations are fulfilled.
If the costs and profit can be reliably estimated, profit recognition over the improvement period on the basis of costs incurred (including land) as a percentage of total costs to be incurred is required. Thus, if the land was a principal part of the sale and its market value greatly exceeded cost, part of the profit that can be said to be related to the land sale is deferred and recognized during the development or construction period.
The same rate of profit is used for all seller costs connected with the transaction. For this purpose, the cost of development work, improvements, and all fees and expenses that are the responsibility of the seller should be included. The buyer's initial and continuing investment tests, of course, must be met with respect to the total sales value. Exhibit 30.4 illustrates the cost incurred method.
If the property sold is an operating property, as opposed to a nonoperating property, deferral of all or a portion of the profit may be required under SFAS No. 66 (pars. 28– 30). These paragraphs establish guidelines not only for stated support but also for implied support.
Although the implied support provisions do not usually apply to undeveloped or partially developed land, they do apply if the buyer has commitments to construct operating properties and there is stated or implied support.
Assuming that the criteria for recording a sale and the test of buyer's investment are met, the following sets forth guidelines for profit recognition where there is stated or implied support.
A seller may be required to support operations by means of a guaranteed return to the buyer. Alternatively, a guarantee may be made to the buyer that there will be no negative cash flow from the project, buy may not guarantee a positive return on the buyer's investment. For example, EITF Consensus No. 85-27 "Recognition of Receipts from Made-Up Rental Shortfalls," considers the impact of a master lease guarantee. The broad exposure that such a guarantee creates has a negative impact on profit recognition.
The seller may be presumed to be obligated to initiate and support operations of the property sold, even in the absence of specified requirements in the sale contract or related document. The following conditions under which support is implied are described in footnote 10 of SFAS No. 66:
A seller obtains an interest as general partner in a limited partnership that acquires an interest in the property sold.
A seller retains an equity interest in the property, such as an undivided interest or an equity interest in a joint venture that holds an interest in the property.
A seller holds a receivable from a buyer for a significant part of the sales price and collection of the receivable is dependent on the operation of the property.
A seller agrees to manage the property for the buyer on terms not usual for the services to be rendered and which is not terminable by either seller or buyer.
When profit recognition is appropriate in the case of either stated or implied support, the following general rules apply:
Profit is recognized on the ratio of costs incurred to total costs to be incurred. Revenues for gross profit purposes include rent from operations during the rent-up period; costs include land and operating expenses during the rent-up period as well as other costs.
As set forth in SFAS No. 66 (par. 30):
[S]upport shall be presumed for at least two years from the time of initial rental unless actual rental operations cover operating expenses, debt service, and other contractual commitments before that time. If the seller is contractually obligated for a longer time, profit recognition shall continue on the basis of performance until the obligation expires.
Estimated rental income should be adjusted by reducing estimated future rent receipts by a safety factor of 33⅓ percent unless signed lease agreements have been obtained to support a projection higher than the rental level thus computed. As set forth in SFAS No. 66 (par. 29), when signed leases amount to more than 66
A partial sale includes the following:
A sale of an interest in real estate
A sale of real estate where the seller has an equity interest in the buyer (e.g., a joint venture or partnership)
A sale of a condominium unit
Except for operating properties, profit recognition is appropriate in a sale of a partial interest if all the following conditions exist:
Sale is to an independent buyer.
Collection of sales price is reasonably assured.
The seller will not be required to support the property, its operations, or related obligations to an extent greater than its proportionate interest.
Buyer does not have preferences as to profits or cash flow. (If the buyer has such preferences, the cost recovery method is required.)
In the case of a sale of a partial interest in operating properties, if the conditions set forth in the preceding paragraph are met, profit recognition must reflect an adjustment for the implied presumption that the seller is obligated to support the operations.
No profit may be recognized if the seller controls the buyer. If seller does not control the buyer, profit recognition (to the extent of the other investors' proportionate interests) is appropriate if all other necessary requirements for profit recognition are satisfied. The portion of the profit applicable to the equity interest of the seller/investor should be deferred until such costs are charged to operations by the venture. Again, with respect to a sale of operating properties, a portion of the profit relating to other investors' interests may have to be spread as described in Subsection 30.2(f)(x) because there is an implied presumption that the seller is obligated to support the operations.
Although the definition of "condominium" varies by state, the term generally is defined as a multiunit structure in which there is fee simple title to individual units combined with an undivided interest in the common elements associated with the structure. The common elements are all areas exclusive of the individual units, such as hallways, lobbies, and elevators.
A cooperative is contrasted to a condominium in that ownership of the building is generally vested in the entity, with the respective stockholders of the entity having a right to occupy specific units. Operation, maintenance, and control of the building are exercised by a governing board elected by the owners. This section covers only sales of condominium units.
The general principles of accounting for profit on sales of condominiums are essentially those previously discussed for sales of real estate in general. The following criteria must be met prior to recognition of any profit on the sale of a dwelling unit in a condominium project:
All parties must be bound by the terms of the contract. For the buyer to be bound, the buyer must be unable to require a refund. Certain state and federal laws require appropriate filings by the developer before the sales contract is binding; otherwise, the sale may be voidable at the option of the buyer.
All conditions precedent to closing, except completion of the project, must be performed.
An adequate cash down payment must be received by the seller. The minimum down payment requirements are 5 percent for a primary residence and 10 percent for a secondary or recreational residence.
The buyer must be required to adequately increase the investment in the property annually; the buyer's commitment must be adequately secured. Typically, a condominium buyer pays the remaining balance from the proceeds of a permanent loan at the time of closing. If, however, the seller provides financing, the same considerations as other sales of real estate apply concerning amortization of the buyer's receivable.
The developer must not have an option or obligation to repurchase the property.
Sales of condominium units are accounted for by using the closing (completed contract) method or the percentage of completion method. Most developers use the closing method.
Additional criteria must be met for the use of the percentage of completion method:
The developer must have the ability to estimate costs not yet incurred.
Construction must be beyond a preliminary stage of completion. This generally means at least beyond the foundation stage.
Sufficient units must be sold to assure that the property will not revert to rental property.
The developer must be able to reasonably estimate aggregate sales proceeds.
This method involves recording the sale and related profit at the time a unit closes. Since the unit is completed, actual costs are used in determining profit to be recognized.
All payments or deposits received prior to closing are accounted for as a liability. Direct selling costs may be deferred until the sale is recorded. Where the seller is obligated to complete construction of common areas or has made guarantees to the condominium association, profit should be recognized based on the relationship of costs already incurred to total estimated costs, with a portion deferred until the future performance is completed.
This method generally involves recording sales at the date a unit is sold and recognizing profit on units sold as construction proceeds. As a result, this method allows some profit recognition during the construction period. Although dependent on estimates, this method may be considered preferable for some long-term projects. A lack of reliable estimates, however, would preclude the use of this method.
Profit recognition is based on the percentage of completion of the project multiplied by the gross profit arising from the units sold. Percentage of completion may be determined by using either of the following alternatives:
The ratio of costs incurred to date to total estimated costs to be incurred. These costs could include land and common costs or could be limited to construction costs. The costs selected for inclusion should be those that most clearly reflect the earnings process.
The percentage of completed construction based on architectural plans or engineering studies.
Under either method of accounting, if the total estimated costs exceed the estimated proceeds, the total anticipated loss should be charged against income in the period in which the loss becomes evident so that no anticipated losses are deferred to future periods. See further discussion of this method in Section 30.6, "Construction Contracts."
As previously mentioned, future costs to complete must be estimated under either the closing method or the percentage of completion method. Estimates of future costs to complete are necessary to determine net realizable value of unsold units. Estimated future costs should be based on adequate architectural and engineering studies and should include reasonable provisions for:
Unforeseen costs in accordance with sound cost estimation practices
Anticipated cost inflation in the construction industry
Costs of offsite improvements, utility facilities, and amenities (to the extent that they will not be recovered from outside third parties)
Operating losses of utility operations and recreational facilities (Such losses would be expected to be incurred for a relatively limited period of time—usually prior to sale of facilities or transfer to some public authority.)
Other guaranteed support arrangements or activities to the extent that they will not be recovered from outside parties or be the responsibility of a future purchaser
Estimates of amounts to be recovered from any sources should be discounted to present value as of the date the related costs are expected to be incurred.
Estimated costs to complete and the allocation of such costs should be reviewed at the end of each financial reporting period, with costs revised and reallocated as necessary on the basis of current estimates, as recommended in SFAS No. 67, "Accounting for Costs and Initial Rental Operations of Real Estate Projects." How to record the effects of changes in estimates depends on whether full revenues have been recorded or whether reporting of the revenue has been deferred due to an obligation for future performance or otherwise.
When sales of condominiums are recorded in full, it may be necessary to accrue certain estimated costs not yet incurred and also related profit thereon. Adjustments of accruals for costs applicable to such previously recognized sales, where deferral for future performance was not required, must be recognized and charged to costs of sales in the period in which they become known. See Subsection 30.2(g)(ii) for further discussion.
In many cases, sales are not recorded in full (such as when the seller has deferred revenue because of an obligation for future performance to complete improvements and amenities of a project). In these situations, the adjustments should not affect previously recorded deferred revenues applicable to future improvements but should be recorded prospectively in the current and future periods. An increase in the estimate of costs applicable to deferred revenues will thus result in profit margins lower than those recorded on previous revenues from the project.
An exception exists, however, when the revised total estimated costs exceed the applicable deferred revenue. If that occurs, the total anticipated loss should be charged against income in the period in which the need for adjustment becomes evident.
In addition, an increase in estimated costs to complete without comparable increases in market value could raise questions as to whether the estimated total costs of the remaining property exceed the project's net realizable value.
APB Opinion No. 20, "Accounting Changes," has been interpreted to permit both the cumulative catch-up method and the prospective method of accounting for changes in accounting estimates. It should be noted that SFAS No. 67 (pars. 42–43) requires the prospective method.
Retail land sales, a unique segment of the real estate industry, is the retail marketing of numerous lots subdivided from a larger parcel of land. The relevant accounting guidance originally covered by the AICPA Industry Accounting Guide, "Accounting for Retail Land Sales," and now included in SFAS No. 66, applies to retail lot sales on a volume basis with down payments that are less than those required to evaluate the collectibility of casual sales of real estate. Wholesale or bulk sales of land and retail sales from projects comprising a small number of lots, however, are subject to the general principles for profit recognition on real estate sales.
Sales should not be recorded until:
The customer has made all required payments and the period of cancellation with refund has expired.
Aggregate payments (including interest) equal or exceed 10 percent of contract sales price.
The selling company is clearly capable of providing land improvements and offsite facilities promised as well as meeting all other representations it has made.
If these conditions are met, either the accrual or the installment method must be used. If the conditions are not met, the deposit method of accounting should be used.
The following tests for the use of accrual method should be applied on a project-by-project basis:
The seller has fulfilled the obligation to complete improvements and to construct amenities or other facilities applicable to the lots sold.
The receivable is not subject to subordination to new loans on the property, except subordination for home construction purposes under certain conditions.
The collection experience for the project indicates that collectibility of receivable balances is reasonably predictable and that 90 percent of the contracts in force six months after sales are recorded will be collected in full. A down payment of at least 20 percent shall be an acceptable indication of collectibility.
To predict collection results of current sales, there must be satisfactory experience on prior sales of the type of land being currently sold in the project. In addition, the collection period must be sufficiently long to allow reasonable estimates of the percentage of sales that will be fully collected. In a new project, the developers' experience on prior projects may be used if they have demonstrated an ability to successfully develop other projects with the same characteristics (environment, clientele, contract terms, sales methods) as the new project.
Collection and cancellation experience within a project may differ with varying sales methods (such as telephone, broker, and site visitation sales). Accordingly, historical data should be maintained with respect to each type of sales method used.
Unless all conditions for use of the accrual method are met for the entire project, the installment method of accounting should be applied to all recorded sales of the project.
Revenues and costs should be accounted for under the accrual method as follows:
The contract price should be recorded as gross sales.
Receivables should be discounted to reflect an appropriate interest rate using the criteria established in APB Opinion No. 21.
An allowance for contract cancellation should be recorded and deducted from gross sales to derive net sales.
Cost of sales should be calculated based on net sales after reductions for sales reasonably expected to cancel.
Frequently, the conditions for use of the accrual method are met, except the seller has not yet completed the improvements, amenities, or other facilities required by the sales contract. In this situation the percentage of completion method should be applied provided both of the following conditions are met:
There is a reasonable expectation that the land can be developed for the purposes represented.
The project's improvements have progressed beyond preliminary stages, and there are indications that the work will be completed according to plan. Indications that the project has progressed beyond the preliminary stage include the following:
Funds for the proposed improvements have been expended.
Work on the improvements has been initiated.
Engineering plans and work commitments exist relating to the lots sold.
Access roads and amenities such as golf courses, clubhouses, and swimming pools have been completed.
In addition, there shall be no indication of significant delaying factors such as the inability to obtain permits, contractors, personnel, or equipment, and estimates of costs to complete and extent of progress toward completion shall be reasonably dependable.
The following general procedures should be used to account for revenues and costs under the percentage of completion method of accounting:
The amount of revenue recognized (discounted where appropriate pursuant to APB Opinion No. 21) is based on the relationship of costs already incurred to the total estimated costs to be incurred.
Costs incurred and to be incurred should include land, interest and project carrying costs incurred prior to sale, selling costs, and an estimate for future improvement costs.
Estimates of future improvement costs should be reviewed at least annually. Changes in those estimates do not lead to adjustment of deferred revenue applicable to future improvements that has been previously recorded unless the adjusted total estimated costs exceeds the applicable revenue. When cost estimates are revised, the relationship of the two elements included in the revenue not yet recognized—cost and profit—should be recalculated on a cumulative basis to determine future income recognition as performance takes place. If the adjusted total estimated cost exceeds the applicable deferred revenue, the total anticipated loss should be charged to income. When anticipated losses on lots sold are recognized, the enterprise should also consider recognizing a loss on land and improvements not yet sold.
Future performance costs such as roads, utilities, and amenities may represent a significant obligation for a retail land developer. Estimates of such costs should be based on adequate engineering studies, appropriately adjusted for anticipated inflation in the local construction industry, and should include reasonable estimates for unforeseen costs.
If the criteria for the accrual or percentage of completion methods are not satisfied, the installment or deposit method may be used. See Subsection 30.2(j) for a general discussion of these methods.
When the conditions required for use of the percentage of completion method are met on a project originally recorded under the installment method, the percentage of completion method of accounting should be adopted for the entire project (current and prior sales). The effect should be accounted for as a change in accounting estimate due to different circumstances. See Subsection 30.2(g)(iii) for further discussion of methodology.
On February 6, 1992, the AICPA issued Statement of PositionStatement of Position (SOP) 92-1, which provides guidance on accounting for real estate syndication income.
Syndicators expect to earn fees and commissions from a variety of sources: up-front fees such as lease-up fees, construction supervision fees, and financing fees; fees serving as an incentive; property management; participation in future profit or appreciation. At the time of the syndication, partnerships usually pay cash to the syndicator for portions of their up-front fees. These fees are usually paid from investor contributions or the proceeds of borrowings. Subsequent fees are expected to be paid from operations, refinancings, sale of property, or remaining investor payments.
The SOP states that SFAS No. 66 applies to the recognition of profit on the sales of real estate by syndicators to partnerships. It concludes that profit on real estate syndication transactions be accounted for in accordance with SFAS No. 66, even if the syndicator never had ownership interests in the properties acquired by the real estate partnerships.
The SOP states that fees charged by syndicators (except for syndication fees and fees for future services) should be included in the determination of "sales value" in conformity with SFAS No. 66. It further states that SFAS No. 66 does not apply to the fees excluded from "sales value." Fees for future services should be recognized when the earning process is complete and collection of the fee is reasonably assured.
This SOP requires that income recognition on syndication fees and fees for future services be deferred if the syndicator is exposed to future losses or costs from material involvement with the properties, partnerships or partners, or uncertainties regarding the collectibility of partnership notes. The income should be deferred until the losses or costs can be reasonably estimated.
The SOP requires that for the purpose of determining whether buyers' initial and continuing investments satisfy the requirements for recognizing full profit in accordance with SFAS No. 66, cash received by syndicators should be allocated to unpaid syndication fees before being allocated to the initial and continuing investment. After the syndication fee is fully paid, additional cash received should first be allocated to unpaid fees for future services, to the extent those services have been performed by the time the cash is received, before being allocated to the initial and continuing investment.
As previously discussed, in some circumstances the accrual method is not appropriate and other methods must be used. It is not always clear which method should be used or how it should be applied. Consequently, it is often difficult to determine the appropriate method and whether alternative ones are acceptable.
The methods prescribed where the buyer's initial or continuing investment is inadequate are the deposit, installment, cost recovery, and reduced profit methods.
The methods prescribed for a transaction that cannot be considered a sale because of the seller's continuing involvement are the financing, lease, and profit sharing (or co-venture) methods.
When the substance of a real estate transaction indicates that a sale has not occurred, for accounting purposes, as a result of the buyer's inadequate investment, recognition of the sale should be deferred and the deposit method used. This method should be continued until the conditions requiring its use no longer exist. For example, when the down payment is so small that the substance of the transaction is an option arrangement, the sale should not be recorded.
All cash received under the deposit method (including down payment and principal and interest payments by the buyer to the seller) should be reported as a deposit (liability). An exception is interest received that is not subject to refund may appropriately offset carrying charges (property taxes and interest on existing debt) on the property. Note also the following related matters:
Notes receivable arising from the transaction should not be recorded.
The property and any related mortgage debt assumed by the buyer should continue to be reflected on the seller's balance sheet, with appropriate disclosure that such properties and debt are subject to a sales contract. Even nonrecourse debt assumed by the buyer should not be offset against the related property.
Subsequent payments on the debt assumed by the buyer become additional deposits and thereby reduce the seller's mortgage debt payable and increase the deposit liability account until a sale is recorded for accounting purposes.
Depreciation should be continued.
Under the deposit method, a sale is not recorded for accounting purposes until the conditions in SFAS No. 66 are met. Therefore, for purposes of the down payment tests, interest received and credited to the deposit account can be included in the down payment and sales value at the time a sale is recorded.
If a buyer defaults and forfeits his nonrefundable deposit, the deposit liability is no longer required and may be credited to income. The circumstances underlying the default should be carefully reviewed since such circumstances may indicate deteriorating value of the property. In such a case it may be appropriate to treat the credit as a valuation reserve. These circumstances may require a provision for additional loss. See Section 30.5 for further discussion.
When the substance of a real estate transaction indicates that a sale has occurred for accounting purposes, but that collectibility of the total sales price cannot be reasonably estimated (i.e., inadequate buyer's investment), the installment method may be appropriate. However, circumstances may indicate that the cost recovery method is required or is otherwise more appropriate. For example, when the deferred gross profit exceeds the net carrying value of the related receivable, profit may have been earned to the extent of such excess.
Profit should be recognized on cash payments, including principal payments by the buyer on any debt assumed (either recourse or nonrecourse), and should be based on the ratio of total profit to total sales value (including a first mortgage debt assumed by the buyer, if applicable). Interest received on the related receivable is properly recorded as income when received.
The total sales value (from which the deferred gross profit should be deducted) and the cost of sales should be presented in the income statement. Deferred gross profit should be shown as a deduction from the related receivable, with subsequent income recognition presented separately in the income statement.
The cost recovery method must be used when the substance of a real estate transaction indicates that a sale has occurred for accounting purposes but no profit should be recognized until costs are recovered. This may occur when (1) the receivable is subject to future subordination, (2) the seller retains an interest in the property sold and the buyer has preferences, (3) uncertainty exists as to whether all or a portion of the cost will be recovered, or (4) there is uncertainty as to the amount of proceeds. As a practical matter, the cost recovery method can always be used as an alternative to the installment method.
Under the cost recovery method, no profit is recognized until cash collections (including principal and interest payments) and existing debt assumed by the buyer exceed the cost of the property sold. Cash collections in excess of cost should be recorded as revenue in the period of collection.
Financial statement presentation under the cost recovery method is similar to that for the installment method.
When the substance of a real estate transaction indicates that a sale has occurred for accounting purposes, but the continuing investment criteria for full profit recognition is not met by the buyer, the seller may sometimes recognize a reduced profit at the time of sale (see additional discussion in Subsection 30.2(e)(ii)). This alternative is rarely used since a full accrual of anticipated costs of continuing investment will permit full accrual of the remaining profit.
A real estate transaction may be, in substance, a financing arrangement rather than a sale. This is frequently the case when the seller has an obligation to repurchase the property (or can be compelled by the buyer to repurchase the property) at a price higher than the total amount of the payments received and to be received. In such a case the financing method must be used.
Accounting procedures under the financing method should be similar to the accounting procedures under the deposit method, with one exception. Under the financing method, the difference between (1) the total amount of all payments received and to be received and (2) the repurchase price is presumed to be interest expense. As such, it should be accrued on the interest method over the period from the receipt of cash to the date of repurchase. As in the deposit method, cash received is reflected as a liability in the balance sheet. Thus, at the date of repurchase, the full amount of the repurchase obligation should be recorded as a liability.
In the case of a repurchase option, if the facts and circumstances at the time of the sale indicate a presumption or a likelihood that the seller will exercise the option, interest should be accrued as if there were an obligation to repurchase. This presumption could result from the value of the property, the property being an integral part of development, or from management's intention. If such a presumption does not exist at the time of the sale transaction, interest should not be accrued and the deposit method is appropriate.
A real estate transaction may be, in substance, a lease rather than a sale. Accounting procedures under the lease method should be similar to the deposit method, except as follows:
Payments received and to be received that are in substance deferred rental income received in advance should be deferred and amortized to income over the presumed lease period. Such amortization to income should not exceed cash paid to the seller.
Cash paid out by the seller as a guarantee of support of operations should be expensed as paid.
The seller may agree to make loans to the buyer in support of operations, for example, when cash flow does not equal a predetermined amount or is negative. In such a situation, deferred rental income to be amortized to income should be reduced by all the loans made or reasonably anticipated to be made to the buyer, thus reducing the periodic income to be recognized. Where the loans made or anticipated exceed deferred rental income, a loss provision may be required if the collectibility of the loan is questionable.
A real estate transaction may be, in substance, a profit-sharing arrangement rather than a sale. For example, a sale of real estate to a limited partnership in which the seller is a general partner or has similar characteristics is often a profit-sharing arrangement. If such a transaction does not meet the tests for recording a sale, it usually would be accounted for under the profit-sharing method. This accounting method should also be followed when it is clear that the buyer is acting merely as an agent for the seller.
Under the profit-sharing method, giving consideration to the seller's continued involvement, the seller would be required to account for the operations of the property through its income statement as if it continued to own the properties.
In October 1982, the FASB issued SFAS No. 67. This Statement incorporates the specialized accounting principles and practices from the AICPA SOPs No. 80-3, "Accounting for Real Estate Acquisition, Development and Construction Costs," and No. 78-3, "Accounting for Costs to Sell and Rent, and Initial Rental Operations of Real Estate Projects," and those in the AICPA Industry Accounting Guide, "Accounting for Retail Land Sales," that address costs of real estate projects. SFAS No. 67 establishes whether costs associated with acquiring, developing, constructing, selling, and renting real estate projects should be capitalized. Guidance is also provided on the appropriate methods of allocating capitalized costs to individual components of the project.
SFAS No. 67 also established that a rental project changes from nonoperating to operating when it is substantially completed and held available for occupancy, but not later than one year from cessation of major construction activities.
What are the general precepts? Costs incurred in real estate operations range from brick-and-mortar costs that clearly should be capitalized to general administrative costs that clearly should not be capitalized. Between these two extremes lies a broad range of costs that are difficult to classify. Therefore, judgmental decisions must be made as to whether such costs should be capitalized.
These costs include payments to obtain options to acquire real property and other costs incurred prior to acquisition such as legal, architectural, and other professional fees, salaries, environmental studies, appraisals, marketing and feasibility studies, and soil tests. Capitalization of costs related to a property that are incurred before the enterprise acquires the property, or before the enterprise obtains an option to acquire it, is appropriate provided all of the following conditions are met:
The costs are directly identifiable with the specific property.
The costs would be capitalized if the property had already been acquired.
Acquisition of the property or of an option to acquire the property is probable (i.e., likely to occur). This condition requires that the prospective purchaser is actively seeking acquisition of the property and has the ability to finance or obtain financing for the acquisition. In addition, there should be no indication that the property is not available for sale.
Capitalized preacquisition costs should be included as project costs on acquisition of the property or should be charged to expense when it is probable that the property will not be acquired. The charge to expense should be reduced by the amount recoverable by the sale of the options, plans, and so on.
Costs directly related to the acquisition of land should be capitalized. These costs include option fees, purchase cost, transfer costs, title insurance, legal and other professional fees, surveys, appraisals, and real estate commissions. The purchase cost may have to be increased or decreased for imputation of interest on mortgage notes payable assumed or issued in connection with the purchase, as required under APB Opinion No. 21.
Costs directly related to improvements of the land should be capitalized by the developer. They may include:
Land planning costs, including marketing and feasibility studies, direct salaries, legal and other professional fees, zoning costs, soil tests, architectural and engineering studies, appraisals, environmental studies, and other costs directly related to site preparation and the overall design and development of the project
On-site and off-site improvements, including demolition costs, streets, traffic controls, sidewalks, street lighting, sewer and water facilities, utilities, parking lots, landscaping, and related costs such as permits and inspection fees
Construction costs, including onsite material and labor, direct supervision, engineering and architectural fees, permits, and inspection fees
Project overhead and supervision, such as field office costs
Recreation facilities, such as golf courses, clubhouse, swimming pools, and tennis courts
Sales center and models, including furnishings
General and administrative costs not directly identified with the project should be accounted for as period costs and expensed as incurred.
Construction activity on a project may be suspended before a project is completed for reasons such as insufficient sales or rental demand. These conditions may indicate an impairment of the value of a project that is other than temporary, which suggests valuation issues (see Section 30.5).
In EITF Issue No. 90-8, "Capitalization of Costs to Treat Environmental Contamination," the EITF reached a consensus that, in general, costs incurred as a result of environmental contamination should be charged to expense. Such costs include costs to remove contamination, such as that caused by leakage from underground tanks; costs to acquire tangible property, such as air pollution control equipment; costs of environmental studies; and costs of fines levied under environmental laws. Nevertheless, those costs may be capitalized if recoverable but only if any one of the following criteria is met:
The costs extend the life, increase the capacity, or improve the safety or efficiency of property owned by the company, provided that the condition of the property after the costs are incurred must be improved as compared with the condition of the property when originally constructed or acquired, if later.
The costs mitigate or prevent environmental contamination that has yet to occur and that otherwise may result from future operations or activities. In addition, the costs improve the property compared with its condition when constructed or acquired, if later.
The costs are incurred in preparing for sale that property currently held for sale.
In EITF Issue No. 93-5, "Accounting for Environmental Liabilities," the EITF reached a consensus that an environmental liability should be evaluated independently from any potential claim for recovery (a two-event approach) and that the loss arising from the recognition of an environmental liability should be reduced only when it is probable that a claim for recovery will be realized.
The EITF also reached a consensus that discounting environmental liabilities for a specific clean-up site to reflect the time value of money is allowed, but not required, only if the aggregate amount of the obligation and the amount and timing of the cash payments for that site are fixed or reliably determinable.
The EITF discussed alternative rates to be used in discounting environmental liabilities but did not reach a consensus on the rate to be used. However, the Securities and Exchange CommissionSecurities and Exchange Commission (SEC) observer stated that SEC registrants should use a discount rate that will produce an amount at which the environmental liability theoretically could be settled in an arm's-length transaction with a third party. That discount rate should not exceed the interest rate on monetary assets that are essentially risk-free and have maturities comparable to that of the environmental liability. In addition, SEC Staff Accounting BulletinStaff Accounting Bulletin (SAB) 92 requires registrants to separately present the gross liability and related claim recovery in the balance sheet. SAB 92 also requires other accounting and disclosure requirements relating to product or environmental liabilities.
In October 1996, the AICPA issued SOP 96-1, "Environmental Remediation Liabilities." The SOP has three parts. Part I provides an overview of environmental laws and regulations. Part II provides authoritative guidance on the recognition, measurement, display, and disclosure of environmental liabilities. And part III (labeled as an appendix) provides guidance for auditors. A major objective of the SOP is to articulate a framework for the recognition, measurement, and disclosure of environmental liabilities. That framework is derived from SFAS No. 5, "Accounting for Contingencies."
The accounting guidance in the SOP is generally applicable when an entity is mandated to remediate a contaminated site by a governmental agency. However, the SOP does not address the following:
Accounting for pollution control costs with respect to current operations, which is addressed in EITF Issue No. 90-8, "Capitalization of Costs to Treat Environmental Contamination"
Accounting for costs with respect to asbestos removal, which is addressed in EITF Issue No. 89-13, "Accounting for the Costs of Asbestos Removal"
Accounting for costs of future site restoration or closure that are required upon the cessation of operations or sale of facilities, which is the subject of the FASB's project, "Obligations Associated with Disposal Activities"
Accounting for environmental remediation actions that are undertaken at the sole discretion of management and that are not undertaken by the threat of assertion of litigation, a claim, or an assessment
Recognizing liabilities of insurance companies for unpaid claims, which is addressed in SFAS No. 60, "Accounting and Reporting by Insurance Enterprises"
Asset impairment issues discussed in SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," and EITF Issue No. 95-23, "The Treatment of Certain Site Restoration/Environmental Exit Costs When Testing a Long-Lived Asset for Impairment"
Prior to 1979, many developers capitalized interest costs as a necessary cost of the asset in the same way as bricks-and-mortar costs. Others followed an accounting policy of charging off interest cost as a period cost on the basis that it was solely a financing cost that varied directly with the capability of a company to finance development and construction through equity funds. This long-standing debate on capitalization of interest cost was resolved in October 1979 when the FASB published SFAS No. 34, "Capitalization of Interest Cost," which provides specific guidelines for accounting for interest costs.
SFAS No. 34 requires capitalization of interest cost as part of the historical cost of acquiring assets that need a period of time in which to bring them to that condition and location necessary for their intended use. The objectives of capitalizing interest are to obtain a measure of acquisition cost that more closely reflects the enterprise's total investment in the asset and to charge a cost that relates to the acquisition of a resource that will benefit future periods against the revenues of the periods benefited. Interest capitalization is not required if its effect is not material.
Assets qualifying for interest capitalization in conformity with SFAS No. 34 include real estate constructed for an enterprise's own use or real estate intended for sale or lease. Qualifying assets also include investments (equity, loans, and advances) accounted for by the equity method while the investee has activities in progress necessary to commence its planned principal operations, but only if the investee's activities include the use of such to acquire qualifying assets for its operations.
Capitalization is not permitted for assets in use or ready for their intended use, assets not undergoing the activities necessary to prepare them for use, assets that are not included in the consolidated balance sheet, or investments accounted for by the equity method after the planned principal operations of the investee begin. Thus land that is not undergoing activities necessary for development is not a qualifying asset for purposes of interest capitalization. If activities are undertaken for developing the land, the expenditures to acquire the land qualify for interest capitalization while those activities are in progress.
The capitalization period commences when:
Expenditures for the asset have been made.
Activities that are necessary to get the asset ready for its intended use are in progress.
Interest cost is being incurred.
Activities are to be construed in a broad sense and encompass more than just physical construction. All steps necessary to prepare an asset for its intended use are included. This broad interpretation includes administrative and technical activities during the preconstruction stage (such as developing plans or obtaining required permits).
Interest capitalization must end when the asset is substantially complete and ready for its intended use. A real estate project should be considered substantially complete and held available for occupancy upon completion of major construction activity, as distinguished from activities such as routine maintenance and cleanup. In some cases, such as in an office building, tenant improvements are a major construction activity and are frequently not completed until a lease contract is arranged. If such improvements are the responsibility of the developer, SFAS No. 67 indicates that the project is not considered substantially complete until the earlier of (1) completion of improvements or (2) one year from cessation of major construction activity without regard to tenant improvements. In other words, a one-year grace period has been provided to complete tenant improvements.
If substantially all activities related to acquisition of the asset are suspended, interest capitalization should stop until such activities are resumed. However, brief interruptions in activities, interruptions caused by external factors, and inherent delays in the development process do not necessarily require suspension of interest capitalization.
Under SFAS No. 34, interest capitalization must end when the asset is substantially complete and ready for its intended use. For projects completed in parts, where each part is capable of being used independently while work continues on other parts, interest capitalization should stop on each part that is substantially complete and ready for use. Examples include individual buildings in a multiphase or condominium project. For projects that must be completed before any part can be used, interest capitalization should continue until the entire project is substantially complete and ready for use. Where an asset cannot be used effectively until a particular portion has been completed, interest capitalization continues until that portion is substantially complete and ready for use. An example would be an island resort complex with sole access being a permanent bridge to the project. Completion of the bridge is necessary for the asset to be used effectively.
Interest capitalization should not stop when the capitalized costs exceed net realizable value. In such instances, a valuation reserve should be recorded or appropriately increased to reduce the carrying value to net realizable value (see Subsection 30.3(l)).
The basic principle is that the amount of interest cost to be capitalized should be the amount that theoretically could have been avoided during the development and construction period if expenditures for the qualifying asset had not been made. These interest costs might have been avoided either by forgoing additional borrowing or by using the funds expended for the asset to repay existing borrowings in the case where no new borrowings were obtained.
The amount capitalized is determined by applying a capitalization rate to the average amount of accumulated capitalized expenditures for the asset during the period. Such expenditures include cash payments, transfer of other assets, or incurrence of liabilities on which interest has been recognized, and they should be net of progress payments received against such capitalized costs. Liabilities such as trade payables, accruals, and retainages, on which interest is not recognized, are not expenditures. Reasonable approximations of net capitalized expenditures may be used.
In general, the capitalization rate should be based on the weighted average of the rates applicable to borrowings outstanding during the period. If a specific new borrowing is associated with an asset, the rate on that borrowing may be used. If the average amount of accumulated expenditures for the asset exceeds the amounts of specific new borrowings associated with the asset, a weighted average interest rate of all other borrowings must be applied to the excess. Under this alternative, judgment will be required to select the borrowings to be included in the weighted average rate so that a reasonable measure will be obtained of the interest cost incurred that could otherwise have been avoided. It should be remembered that the principle is not one of capitalizing interest costs incurred for a specific asset, but one of capitalizing interest costs that could have been avoided if it were not for the acquisition, development, and construction of the asset.
The amount of interest cost capitalized in an accounting period is limited to the total amount of interest cost incurred in the period. However, interest cost should include amortization of premium or discount resulting from imputation of interest on certain types of payables in accordance with APB Opinion No. 21 and that portion of minimum lease payments under a capital lease treated as interest in accordance with SFAS No. 13.
Interest cost capitalized is an integral part of the cost of acquiring a qualifying asset, and therefore its disposition should be the same as any other cost of that asset. For example, if a building is subsequently depreciated, capitalized interest should be included in the depreciable base the same as bricks and mortar.
In the case of interest capitalized on an investment accounted for by the equity method, its disposition should be made as if the investee were consolidated. In other words, if the assets of the investee were being depreciated, the capitalized interest cost should be depreciated in the same manner and over the same lives. If the assets of the investee were developed lots being sold, the capitalized interest cost should be written off as the lots are sold.
Costs incurred on real estate for property taxes and insurance should be treated similarly to interest costs. They should be capitalized only during periods in which activities necessary to get the property ready for its intended use are in progress. Costs incurred for such items after the property is substantially complete and ready for its intended use should be charged to expense as incurred.
Indirect project costs that relate to a specific project, such as costs associated with a project field office, should be capitalized as a cost of that project. Other indirect project costs that relate to several projects, such as the costs associated with a construction administration department, should be capitalized and allocated to the projects to which the cost related. Indirect costs that do not clearly relate to projects under development or construction should be charged to expense as incurred.
The principal problem is defining and identifying the cost to be capitalized. It is necessary to consider all of the following points:
Specific information should be available (such as timecards) to support the basis of allocation to specific projects.
The costs incurred should be incremental costs; that is, in the absence of the project or projects under development or construction, these costs would not be incurred.
The impact of capitalization of such costs on the results of operations should be consistent with the pervasive principle of matching costs with related revenue.
The principle of conservatism should be considered.
Indirect costs related to a specific project that should be considered for capitalization include direct and indirect salaries of a field office and insurance costs. Costs that are not directly related to the project should be charged to expense as incurred.
Real estate developers incur various types of general and administrative expenses, including officers' salaries, accounting and legal fees, and various office supplies and expenses. Some of these expenses may be closely associated with individual projects, whereas others are of a more general nature. For example, a developer may open a field office on a project site and staff it with administrative personnel, such as a field accountant. The expenses associated with the field office are directly associated with the project and are therefore considered to be overhead. On the other hand, the developer may have a number of expenses associated with general office operations that benefit numerous projects and for which specifically identifiable allocations are not reasonable or practicable. Those administrative costs that cannot be clearly related to projects under development or construction should be charged to current operations.
Real estate developments often include amenities such as golf courses, utilities, clubhouses, swimming pools, and tennis courts. The accounting for the costs of these amenities should be based on management's intended disposition as follows:
Amenity to Be Sold or Transferred with Sales Units. All costs in excess of anticipated proceeds should be allocated as common costs because the amenity is clearly associated with the development and sale of the project. Common costs should include estimated net operating costs to be borne by the developer until they are assumed by buyers of units in the project.
Amenity to Be Sold Separately or Retained by Developer. Capitalizable costs of the amenity in excess of its estimated fair value on the expected date of its substantial physical completion should be allocated as common costs. The costs capitalized and allocated to the amenity should not be revised after the amenity is substantially completed and available for use. A later sale of the amenity at more or less than the determined fair value as of the date of substantial physical completion, less any accumulated depreciation, should result in a gain or loss in the period in which the sale occurs.
Real estate, including rights to real estate, may be abandoned, for example, by allowing a mortgage to be foreclosed or by allowing a purchase option to lapse. Capitalized costs, including allocated common costs, of real estate abandoned should be written off as current expenses or, if appropriate, to allowances previously established for that purpose. They should not be allocated to other components of the project or to other projects, even if other components or other projects are capable of absorbing the losses.
Donation of real estate to municipalities or other governmental agencies for uses that will benefit the project are not abandonment. The cost of real estate donated should be allocated as a common cost of the project.
Changes in the intended use of a real estate project may arise after significant development and construction costs have been incurred. If the change in use is made pursuant to a formal plan that is expected to produce a higher economic yield (as compared to its yield based on use before change), the project costs should be charged to expense to the extent the capitalized costs incurred and to be incurred exceed the estimated fair value less cost to sell of the revised project when it is substantially completed and ready for its intended use.
Costs incurred to sell real estate projects should be accounted for in the same manner as, and classified with, construction costs of the project when they meet both of the following criteria:
The costs incurred are for tangible assets that are used throughout the selling period or for services performed to obtain regulatory approval for sales.
The costs are reasonably expected to be recovered from sales of the project or incidental operations.
Examples of costs incurred to sell real estate projects that ordinarily meet the criteria for capitalization are costs of model units and their furnishings, sales facilities, legal fees for the preparation of prospectuses, and semipermanent signs.
SFAS No. 67 states that other costs incurred to sell real estate projects should be capitalized as prepaid costs if they are directly associated with and their recovery is reasonably expected from sales that are being accounted for under a method of accounting other than full accrual. Costs that do not meet the criteria for capitalization should be expensed as incurred.
Capitalized selling costs should be charged to expense in the period in which the related revenue is recognized as earned. When a sales contract is canceled (with or without refund) or the related receivable is written off as uncollectible, the related unrecoverable capitalized selling costs are charged to expense or to an allowance previously established for that purpose.
AICPA SOP 92-3, "Accounting for Foreclosed Assets," provides guidance on determining the balance sheet treatment of foreclosed assets after foreclosure.
The SOP contains a rebuttable presumption that foreclosed assets are held for sale, rather than for the production of income. That presumption may be overcome if (1) management intends to hold a foreclosed asset, (2) laws and regulations as applied permit management to hold the asset, and (3) management's intent is supported by a preponderance of the evidence.
After foreclosure, foreclosed assets held for sale should be carried at the lower of (a) fair value less estimated costs to sell or (b) cost (fair value at the time of foreclosure). The SOP states that, if the fair value of the asset less the estimated cost to sell is less than the asset's cost, the deficiency should be recognized as a valuation allowance. However, that provision has been superseded by SFAS No. 121 and SFAS No. 144, which prohibit the subsequent restoration of previously recognized impairment losses.
The amount of any senior debt (principal and accrued interest) to which the asset is subject should be reported as a liability at the time of foreclosure and should not be deducted from the carrying amount of the asset.
At the time of this book's publication, the AICPA's Accounting Standards Executive CommitteeAccounting Standards Executive Committee (AcSEC) was considering a proposed SOP, "Accounting for Certain Costs and Activities Related to Property, Plant and Equipment," which would address accounting and disclosure issues related to PP&E&E, including those for initial acquisition, construction, improvements, betterments, additions, and repairs and maintenance.
The proposed SOP tentatively sets forth a four-stage accounting framework for PP&E: preliminary, preacquisition, acquisition-or-construction, and in-service.
During the preliminary stage, an option to acquire PP&E would be carried at the lower of fair value less cost to sell. Once the purchase is probable, the option would be included in the cost of PP&E and no longer carried at the lower of cost or fair value less cost to sell. An option not deemed probable of exercise would be carried at the lower of cost or fair value less cost to sell until sale or expiration.
Costs related to PP&E that are incurred during the preacquisition stage would be charged to expense as incurred unless the costs are directly identifiable with the specific PP&E.
Costs incurred during the acquisition-or-construction stage would be charged to expense as incurred unless they are directly identifiable with the specific PP&E or meet a set of criteria to be determined by AcSEC.
The in-service stage begins once PP&E is substantially complete or ready for its intended use. Once this stage is reached, most costs related to PP&E would be charged to expense as incurred. Exceptions would be costs incurred for (1) the acquisition of additional PP&E or (2) the replacement of existing PP&E.
The individual costs incurred for planned major maintenance activities would be evaluated to determine whether they should be capitalized as (1) the acquisition of additional components of PP&E or (2) the replacement of existing components of PP&E. All other costs incurred in a planned major maintenance activity would be charged to expense as incurred.
After it has been determined what costs are capitalized, it becomes important to determine how the costs should be allocated, because those costs will enter into the calculation of cost of sales of individual units. Although a number of methods of allocation can be used in different circumstances, judgment often must be used to make sure that appropriate results are obtained.
Capitalized costs of real estate projects should first be assigned to individual components of the project based on specific identification. If specific identification on an overall basis is not practicable, capitalized costs should be allocated as follows:
Land costs and all other common costs should be allocated to each land parcel benefited. Allocation should be based on the relative fair value before construction.
Construction costs should be assigned to buildings on a specific identification basis and allocated to individual units on the basis of relative value of each unit.
In the usual situation, sales prices or rentals are available to compute relative values. In rare situations, however, where relative value is impracticable, capitalized costs may be allocated based on the area method/or the relative cost method as appropriate under the circumstances.
The following sections describe the specific identification, value, and area methods of cost allocation.
This method of cost allocation is based on determining actual costs applicable to each parcel of land. It rarely is used for land costs because such costs usually encompass more than one parcel. However, it frequently is used for direct construction costs because these costs are directly related to the property being sold. This method should be used wherever practicable.
The relative value method is the method usually used after costs have been assigned on a specific identification basis. Under this method, the allocation of common costs should be based on relative fair value (before value added by on-site development and construction activities) of each land parcel benefited. In multiproject developments, common costs are normally allocated based on estimated sales prices net of direct improvements and selling costs. This approach is usually the most appropriate because it is less likely to result in deferral of losses.
With respect to condominium sales, certain units will usually have a higher price because of location. With respect to time-sharing sales, holiday periods such as Easter, Fourth of July, and Christmas traditionally sell at a premium. Depending on the resort location, the summer or winter season will also sell at a premium as compared with the rest of the year. Caution should be exercised to ensure that the sales values utilized in cost allocation are reasonable.
This method of cost allocation is based on square footage, acreage, or frontage. The use of this method will not always result in a logical allocation of costs. When negotiating the purchase price for a large tract of land, the purchaser considers the overall utility of the tract, recognizing that various parcels in the tract are more valuable than others. For example, parcels on a lake front are usually more valuable than those back from the lake. In this situation, if a simple average based on square footage or acreage is used to allocate costs to individual parcels, certain parcels could be assigned costs in excess of their net realizable value.
Generally, the area method should be limited to situations where each individual parcel is estimated to have approximately the same relative value. Under such circumstances, the cost allocations as determined by either the area or value methods would be approximately the same.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." SFAS No. 144 retains many of the fundamental provisions of SFAS No. 121, particularly that long-lived assets be measured at the lower of carrying amount or fair value less cost to sell.
A major change to previous practice is that the accounting model for long-lived assets to be disposed of by sale applies to all long-lived assets, including discontinued operations, thus superseding provisions of APB Opinion No. 30, "Reporting Results of Operations—Reporting the Effects of Disposal of a Segment of a Business." Discontinued operations no longer are measured at net realizable value, nor do they include amounts for operating losses that have not yet occurred. However, SFAS No. 144 retains the requirement in APB Opinion No. 30 to report separately discontinued operations and extends the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. The new reporting requirements are intended to more clearly communicate in the financial statements a change in its business that results from a decision to dispose of operations and, thus, provide users with information needed to better focus on the ongoing activities of the entity.
In another major change from SFAS No. 121, the scope of SFAS No. 144 does not encompass goodwill. That is, goodwill will not be written down as a result of applying the Statement, but goodwill may be included in the carrying amount of an asset group for purposes of applying the Statement's provisions if that group is a reporting unit or includes a reporting unit. SFAS No. 144 also does not address impairment of other intangible assets that are not amortized; SFAS No. 142, "Goodwill and Other Intangible Assets," issued in July 2001, addresses impairment of goodwill and intangible assets that are not amortized.
SFAS No. 144 establishes the following three steps for recognizing and measuring impairment on long-lived assets and certain identifiable intangibles to be held and used:
Indicators: The Statement provides a list of indicators that serve as a warning light when the value of an asset to be held and used may have been impaired. The presence of any of the following indicators evidence a need for additional investigation:
— A significant decrease in the market value of an asset
— A significant change in the extent or manner in which an asset is used or a significant change in an asset
— A significant adverse change in legal factors or in business climate that could affect the value of an asset or an adverse action or assessment by a regulator
— An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset
— A current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with an asset used for the purpose of producing revenue
— A current expectation that it is more likely than not (greater than 50 percent likelihood) that an asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life
The list of indicators is not intended to be all-inclusive. Other events or changes in circumstances may indicate that the carrying amount of an asset that an entity expects to hold and use may not be recoverable.
Gross Cash Flow Analysis. An entity that detects one or more of the indicators discussed above should evaluate whether the sum of the expected future net cash flows (undiscounted and without interest charges) associated with an asset to be held and used is at least equal to the asset's carrying amount. The FASB imposed a high threshold for triggering the impairment analysis. The selection of a cash flow test based on undiscounted amounts will trigger the recognition of an impairment loss less frequently than would a test based on fair value.
Measurement. For assets to be held and used, the Statement requires an impairment loss to be measured as the amount by which the carrying amount of the impaired asset exceeds its fair value. The distinction between the recognition process, which uses undiscounted cash flows, and the measurement process, which uses fair value or discounted cash flows, is significant. As a result of a relatively minor change in undiscounted cash flows, the impairment measurement process might kick in, thus causing the balance sheet amount to drop off suddenly in any period in which undiscounted cash flows fall below a long-lived asset's carrying amount. Once assets to be held and used are written down, the Statement does not permit them to be written back up. Thus, a new depreciable cost basis is established after a write-down, and subsequent increases in the value or recoverable cost of the asset may not be recognized until its sale or disposal. In addition, an asset that is assessed for impairment should be evaluated to determine whether a change to the useful life or salvage value estimate is warranted under APB Opinion No. 20, "Accounting Changes." SFAS No. 144 thus forces entities to immediately record a loss on an impaired asset instead of shortening the depreciable life or decreasing the salvage value of the asset.
SFAS No. 144 requires long-lived assets held for sale to be reported at the lower of carrying amount or fair value less cost to sell regardless of whether the assets previously were held for use or recently acquired with the intent to sell. The cost to sell generally includes the incremental direct costs to transact the sale, such as broker commissions, legal and title transfer fees, and closing costs. Costs generally excluded from cost to sell include insurance, security services, utility expenses, and other costs of protecting or maintaining the asset. Subsequent upward adjustments to the carrying amount of an asset to be disposed of may not exceed the carrying amount of the asset before an adjustment was made to reflect the decision to dispose of it. A long-lived asset that is classified as held for sale is not depreciated during the holding period.
While SFAS No. 121 required an entity's management to be committed to a disposal plan before it could classify that asset as held for sale, it did not specify other factors that an entity should consider before reclassifying the asset. SFAS No. 144 lists six criteria that must be met in order to classify an asset as held for sale:
Management with the authority to do so commits to a plan to sell the asset (disposal group).
The asset (disposal group) is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets (disposal groups). This criterion does not preclude an entity from using an asset while it is classified as held for sale nor does it require a binding agreement for future sale as a condition of reporting an asset as held for sale.
The entity initiates an active program to locate a buyer and other actions that are required to complete the plan to sell the asset (disposal group).
The entity believes that the sale of the asset (disposal group) is probable (i.e., likely to occur), and, in general, it expects to record the transfer of the asset (disposal group) as a completed sale within one year.
The entity actively is marketing the asset (disposal group) for sale at a price that is reasonable in relation to its current fair value.
Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.
SFAS No. 144 requires an asset or group that will be disposed of other than by sale to continue to be classified as held for use until the disposal transaction occurs. As a result, the asset continues to be depreciated until the date of disposal. Dispositions other than by sale include abandonment or a transaction that will be accounted for at the asset's carrying amount, such as an exchange for a similar productive long-lived asset or a distribution to owners in a spinoff.
For homebuilders and other real estate developers, SFAS No. 144 classifies land to be developed and projects under development as assets to be held and used until the six criteria for reclassification as held for sale are met (see previous subsection). As a result, unlike assets to be disposed of, such assets are analyzed in light of the impairment indicator list and gross cash flows generated before any consideration is given to measuring an impairment loss. In the absence of such a provision, nearly all long-term projects, regardless of their overall profitability, would be subject to write-downs in their early stages of development, only to be reversed later in the life of the project. Upon completion of development, the project is reclassified as an asset to be disposed of.
Although most real estate developers acquire land in order to develop and construct improvements for their own use or for sale to others, some develop and construct improvements solely for others. There are also many general contractors whose principal business is developing and constructing improvements for others and rarely, if ever, do they own the land.
This section covers guidelines for accounting for development and construction contracts where the contractor does not own the land but is providing such services for others. The principal issue in accounting for construction contracts is when to record income. Construction contracts are generally of two types: fixed price and cost-plus. Under fixed price contracts, a contractor agrees to perform services for a fixed amount. Although the contract price is fixed, it may frequently be revised as a result of change orders as construction proceeds. If the contract is longer than a few months, the contractor usually receives advances from the customer as construction progresses.
Cost-plus contracts are employed in a variety of forms, such as cost plus a percentage of cost or cost plus a fixed fee. Sometimes defined costs may be limited and penalties provided in situations where stated maximum costs are exceeded. Under cost-plus agreements, the contractor is usually reimbursed for its costs as costs are incurred and, in addition, is paid a specified fee. In most cases, a portion of the fee is retained until the construction is completed and accepted. The method of recording income under cost-plus contracts generally is the same as for fixed price contracts and is described below.
In 1955, the AICPA Committee on Accounting Procedures issued ARB No. 45 "Long-Term Construction-Type Contracts." This document described the generally accepted methods of accounting for long-term construction-type contracts for financial reporting purposes and described the circumstances in which each method is preferable.
In 1981, the AICPA issued SOP 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts." This Statement culminated extensive reconsideration by the AICPA of construction-type contracts. The recommendations set forth therein provide guidance on the application of ARB No. 45 but do not amend that Bulletin. In 1982, the FASB issued SFAS No. 56, "Contractor Accounting" which states that the specialized accounting and reporting principles and practices contained in SOP 81-1 are preferable accounting principles for purposes of justifying a change in accounting principles.
Prior to the issuance of SOP 81-1, authoritative accounting literature used the terms long term and short term in identifying types of contracts. SOP 81-1 chose not to use those terms as identifying characteristics because other characteristics were considered more relevant for identifying the types of contracts covered. The guidelines set forth below are based largely on SOP 81-1.
The determination of the point or points at which revenue should be recognized as earned and costs should be recognized as expenses is a major accounting issue common to all business enterprises engaged in the performance of construction contracting. Accounting for such contracts is essentially a process of measuring the results of relatively long-term events and allocating those results to relatively short-term accounting periods. This involves considerable use of estimates in determining revenues, costs, and profits and in assigning the amounts to accounting periods. The process is complicated by the need to continually evaluate the uncertainties that are inherent in the performance of contracts and by the need to rely on estimates of revenues, costs, and the extent of progress toward completion.
There are two generally accepted methods of accounting for construction contracts: the percentage of completion method and the completed contract method. The determination of the preferable method should be based on an evaluation of the particular circumstances, as the two methods are not acceptable alternatives for the same set of circumstances. The method used and circumstances describing when it is used should be disclosed in the accounting policy footnote to the financial statements.
The use of this approach depends on the ability of the contractor to make reasonably dependable estimates. The percentage of completion method should be used in circumstances in which reasonably dependable estimates can be made and in which all the following conditions exist:
The contract is clear about goods or services to be provided, the consideration to be exchanged, and the manner and terms of settlement.
The buyer can be expected to pay for the services performed.
The contractor can be expected to be able to perform his contractual obligations.
The percentage of completion method presents the economic substance of activity more clearly and in a more timely manner than does the completed contract method. It should be noted that estimates of revenues, costs, and percentage of completion are the primary criteria for income recognition. Billings may have no real relationship to performance and generally are not a suitable basis for income recognition.
This method may be used in circumstances in which an entity's financial position and results of operations would not vary materially from those resulting from the percentage of completion method. The completed contract method should be used when reasonably dependable estimates cannot be made or when there are inherent hazards that cause forecasts to be doubtful.
It is possible that a contractor may use one method for some contracts and the other for additional contracts. There is no inconsistency, since consistency in application lies in using the same accounting treatment for the same set of conditions from one accounting period to another. The method used, and circumstances when it is used, should be disclosed in the accounting policy footnote to the financial statements.
The percentage of completion method recognizes the legal and economic results of contract performance on a timely basis. Financial statements based on the percentage of completion method present the economic substance of a company's transactions and events more clearly and more timely than financial statements based on the completed contract method, and they present more accurately the relationships between gross profit from contracts and related period costs. The percentage of completion method informs the users of the general purpose financial statements concerning the volume of a company's economic activity.
In practice, several methods are used to measure the extent of progress toward completion. These methods include the cost-to-cost method, the efforts-expended method, the units-of-delivery method and the units-of-work-performed method. These methods are intended to conform to the recommendations of ARB 45 (par. 4), which states:
... that the recognized income be that percentage of estimated total income, either:
that incurred costs to date bear to estimated total costs after giving effect to estimates of costs to complete based upon most recent information, or
that may be indicated by such other measure of progress toward completion as may be appropriate having due regard to work performed.
One generally accepted method of measuring such progress is the stage of construction, as determined through engineering or architectural studies.
When using the "cost incurred" approach, there may be certain costs that should be excluded from the calculation. For example, substantial quantities of standard materials not unique to the project may have been delivered to the job site but not yet utilized. Or engineering and architectural fees incurred may represent 20 percent of total estimated costs whereas only 10 percent of the construction has been performed.
The principal disadvantage of the percentage of completion method is that it is necessarily dependent on estimates of ultimate costs that are subject to the uncertainties frequently inherent in long-term contracts.
The estimation of total revenues and costs is necessary to determine estimated total income. Frequently a contractor can estimate total contract revenue and total contract cost in single amounts. However, on some contracts a contractor may be able to estimate only total contract revenue and total contract cost in ranges of amounts. In such situations, the most likely amounts within the range should be used, if determinable. If not, the least favorable amounts should be used until the results can be estimated more precisely.
Estimating revenue on a contract is an involved process. The major factors that must be considered in determining total estimated revenue include the basic contract price, contract options, change orders, claims, and contract provisions for incentive payments and penalties. All these factors and other special contract provisions must be evaluated throughout the life of a contract in estimating total contract revenue.
At any time during the life of a contract, total estimated contract cost consists of two components: costs incurred to date and estimated cost to complete the contract. A company should be able to determine costs incurred on a contract with a relatively high degree of precision. The other component, estimated cost to complete, is a significant variable in the process of determining income earned and is thus a significant factor in accounting for contracts. SOP 81-1 states that the following five practices should be followed in estimating costs to complete:
Systematic and consistent procedures that are correlated with the cost accounting system should be used to provide a basis for periodically comparing actual and estimated costs.
In estimating total contract costs the quantities and prices of all significant elements of cost should be identified.
The estimating procedures should provide that estimated cost to complete includes the same elements of cost that are included in actual accumulated costs; also, those elements should reflect expected price increases.
The effects of future wage and price escalations should be taken into account in cost estimates, especially when the contract performance will be carried out over a significant period of time. Escalation provisions should not be blanket overall provisions but should cover labor, materials, and indirect costs based on percentages or amounts that take into consideration experience and other pertinent data.
Estimates of cost to complete should be reviewed periodically and revised as appropriate to reflect new information.
Adjustments to the original estimates of the total contract revenue, cost, or extent of progress toward completion are often required as work progresses under the contract, even though the scope of the work required under the contract has not changed. Such adjustments are changes in accounting estimates as defined in APB Opinion No. 20. Under this Opinion, the cumulative catch-up method is the only acceptable method. This method requires the difference between cumulative income and income previously recorded to be recorded in the current year's income.
Exhibit 30.5 illustrates the percentage of completion method.
The amount of revenue, costs, and income recognized in the three periods would be as follows:
A contracting company has a lump-sum contract for $9 million to build a bridge at a total estimated cost of $8 million. The construction period covers three years. Financial data during the construction period is as follows:
This method recognizes income only when a contract is completed or substantially completed, such as when the remaining costs to be incurred are not significant. Under this method, costs and billings are reflected in the balance sheet, but there are no charges or credits to the income statement.
As a general rule, a contract may be regarded as substantially completed if remaining costs and potential risks are insignificant in amount. The overriding objectives are to maintain consistency in determining when contracts are substantially completed and to avoid arbitrary acceleration or deferral of income. The specific criteria used to determine when a contract is substantially completed should be followed consistently. Circumstances to be considered in determining when a project is substantially completed include acceptance by the customer, departure from the site, and compliance with performance specifications.
The completed contract method may be used in circumstances in which financial position and results of operations would not vary materially from those resulting from use of the percentage of completion method (e.g., in circumstances in which an entity has primarily short-term contracts). In accounting for such contracts, income ordinarily is recognized when performance is substantially completed and accepted. For example, the completed contract method, as opposed to the percentage of completion method, would not usually produce a material difference in net income or financial position for a small contractor that primarily performs relatively short-term contracts during an accounting period.
If there is a reasonable assurance that no loss will be incurred on a contract (e.g., when the scope of the contract is ill-defined but the contractor is protected by a cost-plus contract or other contractual terms), the percentage of completion method based on a zero profit margin, rather than the completed contract method, should be used until more precise estimates can be made.
The significant difference between the percentage of completion method applied on the basis of a zero profit margin and the completed contract method relates to the effects on the income statement. Under the zero profit margin approach to applying the percentage of completion method, equal amounts of revenue and cost, measured on the basis of performance during the period, are presented in the income statement and no gross profit amount is presented in the income statement until the contract is completed. The zero profit margin approach to applying the percentage of completion method gives the users of general purpose financial statements an indication of the volume of a company's business and of the application of its economic resources.
The principal advantage of the completed contract method is that it is based on results as finally determined, rather than on estimates for unperformed work that may involve unforeseen costs and possible losses. The principal disadvantage is that it does not reflect current performance when the period of the contract extends into more than one accounting period. Under these circumstances, it may result in irregular recognition of income.
Under either of the methods above, provision should be made for the entire loss on the contract in the period when current estimates of total contract costs indicate a loss. The provision for loss should represent the best judgment that can be made in the circumstances.
Other factors that should be considered in arriving at the projected loss on a contract include target penalties for late completion and rewards for early completion, nonreimbursable costs on cost-plus contracts, and the effect of change orders. When using the completed contract method and allocating general and administrative expenses to contract costs, total general and administrative expenses that are expected to be allocated to the contract are to be considered together with other estimated contract costs.
Claims are amounts in excess of the agreed contract price that a contractor seeks to collect from customers or others for customer-caused delays, errors in specifications and designs, unapproved change orders, or other causes of unanticipated additional costs. Recognition of amounts of additional contract revenue relating to claims is appropriate only if it is probable that the claim will result in additional contract revenue and if the amount can be reliably estimated.
These requirements are satisfied by the existence of all the following conditions:
The contract or other evidence provides a legal basis for the claim.
Additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in the contractor's performance.
Costs associated with the claim are identifiable and are reasonable in view of the work performed.
The evidence supporting the claim is objective and verifiable.
If the foregoing requirements are met, revenue from a claim should be recorded only to the extent that contract costs relating to the claim have been incurred. The amounts recorded, if material, should be disclosed in the notes to the financial statements.
Change orders are modifications of an original contract that effectively change the provisions of the contract without adding new provisions. They may be initiated by either the contractor or the customer. Many change orders are unpriced; that is, the work to be performed is defined, but the adjustment to the contract price is to be negotiated later. For some change orders, both scope and price may be unapproved or in dispute. Accounting for change orders depends on the underlying circumstances, which may differ for each change order depending on the customer, the contract, and the nature of the change. Priced change orders represent an adjustment to the contract price and contract revenue, and costs should be adjusted to reflect these change orders.
Accounting for unpriced change orders depends on their characteristics and the circumstances in which they occur. Under the completed contract method, costs attributable to unpriced change orders should be deferred as contract costs if it is probable that aggregate contract costs, including costs attributable to change orders, will be recovered from contract revenues. For all unpriced change orders, recovery should be deemed probable if the future event or events necessary for recovery are likely to occur. Some factors to consider in evaluating whether recovery is probable are the customer's written approval of the scope of the change order, separate documentation for change order costs that are identifiable and reasonable, and the entity's favorable experience in negotiating change orders (especially as it relates to the specific type of contract and change order being evaluated). The following guidelines should be used in accounting for unpriced change orders under the percentage of completion method:
Costs attributable to unpriced change orders should be treated as costs of contract performance in the period in which the costs are incurred if it is not probable that the costs will be recovered through a change in the contract price.
If it is probable that the costs will be recovered through a change in the contract price, the costs should be deferred (excluded from the cost of contract performance) until the parties have agreed on the change in contract price, or, alternatively, they should be treated as costs of contract performance in the period in which they are incurred, and contract revenue should be recognized to the extent of the costs incurred.
If it is probable that the contract price will be adjusted by an amount that exceeds the costs attributable to the change order and the amount of the excess can be reliably estimated, the original contract price should also be adjusted for that amount when the costs are recognized as costs of contract performance if its realization is probable. However, since the substantiation of the amount of future revenue is difficult, revenue in excess of the costs attributable to unpriced change orders should only be recorded in circumstances in which realization is assured beyond a reasonable doubt, such as circumstances in which an entity's historical experience provides assurance or in which an entity has received a bona fide pricing offer from the customer and records only the amount of the offer as revenue.
If change orders are in dispute or are unapproved in regard to both scope and price, they should be evaluated as claims.
Operations of income-producing properties represent a distinct segment of the real estate industry. Owners are often referred to as real estate operators. Income-producing properties include office buildings, shopping centers, apartments, industrial buildings, and similar properties rented to others. A lease agreement is entered into between the owner/operator and the tenant for periods ranging from one month to many years, depending on the type of property. Sometimes an investor will acquire an existing income-producing property or alternatively will have the builder or developer construct the property. Some developers, frequently referred to as investment builders, develop and construct income properties for their own use as investment properties.
SFAS No. 13 is the principal source of standards of financial accounting and reporting for leases. Under SFAS No. 13, a distinction is made between a capital lease and an operating lease. The lessor is required to account for a capital lease as a sale or a financing transaction. The lessee accounts for a capital lease as a purchase. An operating lease, on the other hand, requires the lessor to reflect rent income, operating expenses, and depreciation of the property over the lease term; the lessee must record rent expense.
Accounting for leases is discussed in Chapter 23 and therefore is not covered in depth here. Certain unique aspects of accounting for leases of real estate classified as operating leases, however, are covered below.
Rental income from an operating lease should usually be recorded by a lessor as it becomes receivable in accordance with the provisions of the lease agreement
FTB No. 85-3 provides that the effects of scheduled rent increases, which are included in minimum lease payments under SFAS No. 13, should be recognized by lessors and lessees on a straight-line basis over the lease term unless another systematic and rational allocation basis is more representative of the time pattern in which the leased property is physically employed. Using factors such as the time value of money, anticipated inflation, or expected future revenues to allocate scheduled rent increases is inappropriate because these factors do not relate to the time pattern of the physical usage of the leased property. However, such factors may affect the periodic reported rental income or expense if the lease agreement involves contingent rentals, which are excluded from minimum lease payments and accounted for separately under SFAS No. 13, as amended by SFAS No. 29.
A lease agreement may provide for scheduled rent increases designed to accommodate the lessee's projected physical use of the property. In these circumstances, FTB No. 88-1 provides for the lessee and the lessor to recognize the lease payments as follows:
If rents escalate in contemplation of the lessee's physical use of the leased property, including equipment, but the lessee takes possession of or controls the physical use of the property at the beginning of the lease term, all rental payments including the escalated rents, should be recognized as rental expenses or rental revenue on a straight-line basis in accordance with paragraph 15 of Statement No. 13 and Technical Bulletin 85-3 starting with the beginning of the lease term.
If rents escalate under a master lease agreement because the lessee gains access to and control over additional leased property at the time of the escalation, the escalated rents should be considered rental expense or rental revenue attributable to the leased property and recognized in proportion to the additional leased property in the years that the lessee has control over the use of the additional leased property. The amount of rental expense or rental revenue attributed to the additional leased property should be proportionate to the relative fair value of the additional property, as determined at the inception of the lease, in the applicable time periods during which the lessee controls its use.
Many lessors require that the lessee pay operating costs of the leased property such as utilities, real estate taxes, and common area maintenance. Some lessors require the lessee to pay for such costs when they escalate and exceed a specified rate or amount. In some cases, the lessee pays these costs directly. More commonly, however, the lessor pays the costs and is reimbursed by the lessee. In this situation, the lessor should generally record these reimbursement costs as a receivable at the time the costs are accrued, even though they may not be billed until a later date. Since these costs are sometimes billed at a later date, collectibility from the lessee should, of course, be considered.
Many retail leases, such as those on shopping centers, enable the lessor to collect additional rents, based on the excess of a stated percentage of the tenant's gross sales over the specified minimum rent. While the minimum rent is usually payable in periodic level amounts, percentage rents (sometimes called overrides) are usually based on annual sales, often with a requirement for periodic payments toward the annual amount.
SFAS No. 29 (par. 13), "Determining Contingent Rentals," states: "Contingent rentals shall be includable in the determination of net income as accruable."
The following considerations help determine the appropriate accounting for project rental costs.
Costs incurred to rent real estate should be deferred and charged to future periods when they are related to and their recovery is reasonably expected from future operations. Examples include initial direct costs such as commissions, legal fees, costs of credit investigations, costs of preparing and processing documents for new leases acquired, and that portion of compensation applicable to the time spent on consummated leases. Other examples include costs of model units and related furnishings, rental facilities, semipermanent signs, grand openings, and unused rental brochures, but not rental overhead, such as rental salaries (see "Period Costs" below).
For leases accounted for as operating leases, deferred rental costs that can be directly related to revenue from a specific operating lease should be amortized over the term of the related lease in proportion to the recognition of rental income. Deferred rental costs that cannot be directly related to revenue from a specific operating lease should be amortized to expense over the period of expected benefit. The amortization period begins when the project is substantially completed and held available for occupancy. Estimated unrecoverable deferred rental costs associated with a lease or group of leases should be charged to expense when it becomes probable that the lease(s) will be terminated.
For leases accounted for as sales-type leases, deferred rental costs must be charged against income at the time the sale is recognized.
Costs that are incurred to rent real estate projects that do not meet the above criteria should be charged to expense as incurred. SFAS No. 67 specifically indicates that rental overhead, which is defined in its glossary to include rental salaries, is an example of such period costs. Other examples of expenditures that are period costs are initial indirect costs, such as that portion of salaries and other compensation and fees applicable to time spent in negotiating leases that are not consummated, supervisory and administrative expenses, and other indirect costs.
Under generally accepted accounting principlesGenerally Accepted Accounting Principles (GAAP), the costs of income-producing properties must be depreciated. Depreciation, as defined by GAAP, is the systematic and rational allocation of the historical cost of depreciable assets (tangible assets, other than inventory, with limited lives of more than one year) over their useful lives.
In accounting for real estate operations, the most frequently used methods of depreciation are straight-line and decreasing charge methods. The most common decreasing charge methods are the declining balance and sum-of-the-years-digits methods. Increasing charge methods, such as the sinking fund method, are not generally accepted in the real estate industry in the United States.
The major components of a building, such as the plumbing and heating systems, may be identified and depreciated separately over their respective lives. This method, which is frequently used for tax purposes, usually results in a more rapid write-off.
When a real estate project is substantially complete and held available for occupancy, the procedures listed here should be followed:
Rental revenue should be recorded in income as earned.
Operating costs should be charged to expense currently.
Amortization of deferred rental costs should begin.
Full depreciation of rental property should begin.
Carrying costs, such as interest and property taxes, should be charged to expense as accrued.
If portions of a rental project are substantially completed and occupied by tenants or held available for occupancy and other portions have not yet reached that stage, the substantially completed portions should be accounted for as a separate project. Costs incurred should be allocated between the portions under construction and the portions substantially completed and held available for occupancy.
Rental expense under an operating lease normally should be charged to operations by a lessee over the lease term on a basis consistent with the lessor's recording of income, with the exception of periodic accounting for percentage rent expense, which should be based on the estimated annual percentage rent.
The joint venture vehicle—the sharing of risk—has been widely utilized for many years in the construction, mining, and oil and gas industries as well as for real estate developments. Real estate joint ventures are typically entered into in recognition of the need for external assistance, for example, financing or market expertise. The most common of these needs is capital formation.
Real estate ventures are organized either as corporate entities or, more frequently, as partnerships. Limited partnerships are often used because of the advantages of limited liability. The venture is typically formed by a small group, with each investor actively contributing to the success of the venture and participating in overall management, and with no one individual or corporation controlling its operations. The venture is usually operated separately from other activities of the investors. Regardless of the legal form of the real estate venture, the accounting principles for recognition of profits and losses should be the same.
Accounting practices in the real estate industry in general and, more specifically, accounting for investments in real estate ventures have varied. The result was lack of comparability and, in some cases, a lack of comprehension. Therefore, the following relevant pronouncements were issued:
APB Opinion No. 18. In response to the wide variation in accounting for investments, the APB, in March 1971, issued Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock." This opinion became applicable to investments in unincorporated ventures, including partnerships, because of an interpretation promulgated in November 1971.
AICPA Statement of Position SOP No. 78-9. The AICPA recognized the continuing diversity of practice and in December 1978 issued SOP 78-9, "Accounting for Investments in Real Estate Ventures." This statement was issued to narrow the range of alternative practices used in accounting for investments in real estate ventures and to establish industry uniformity. The AICPA currently is reconsidering the guidance in SOP 78-9 as part of a broader project, "Equity Method Investments."
SFAS No. 94. In response to the perceived problem of off-balance sheet financing, of which unconsolidated majority-owned subsidiaries were deemed to be the most significant aspect, the FASB issued SFAS No. 94, "Consolidation of All Majority-Owned Subsidiaries," in October 1987. SFAS No. 94 eliminates the concept of not consolidating nonhomogeneous operations and replaces it with the concept that the predominant factor in determining whether an investment requires consolidation should primarily be control rather than ownership of a majority voting interest. This Statement is also applicable to investments in unincorporated ventures, including partnerships.
AICPA Notice to Practitioners, ADC acquisition, development, and construction (ADC) Loans, February 1986. Recognizing that financial institutions needed guidance on accounting for real estate acquisition, development, and construction (ADC) arrangements, the AICPA issued this notice (also known as the Third Notice). The notice provides accounting guidance on ADC arrangements that have virtually the same risks and potential rewards as those of joint ventures. It determined that accounting for such arrangements as loans would not be appropriate and provides guidance on the appropriate accounting.
The SEC incorporated the notice into SAB No. 71 "Views Regarding Financial Statements of Properties Securing Mortgage Loans." SAB No. 71, and its amendment SAB No. 71A, provide guidance to registrants on the required reporting under this notice. Also, EITF Issue Nos. 84-4 and 86-21, as well as SAB No. 71, extend the provisions of this notice to all entities, not just financial institutions.
Proposed FASB Interpretation, Consolidation of Certain Special-Purpose Entities (SPEs). The FASB has approved for issuance an Exposure Draft of a proposed Interpretation that establishes accounting guidance for consolidation of SPEs. The proposed Interpretation, "Consolidation of Certain Special-Purpose Entities," would apply to any business enterprise—both public and private companies—that has an ownership interest, contractual relationship, or other business relationship with an SPE. Under current practice, two enterprises generally have been included in consolidated financial statements because one enterprise controls the other through voting ownership interests. The proposed Interpretation would explain how to identify an SPE that is not subject to control through voting ownership interests and would require each enterprise involved with such an SPE to determine whether it provides financial support to the SPE through a variable interest. Variable interests may arise from financial instruments, service contracts, nonvoting ownership interests, or other arrangements. If an enterprise holds (1) a majority of the variable interests in the SPE or (2) a significant variable interest that is significantly more than any other party's variable interest, that enterprise would be the primary beneficiary. The primary beneficiary would be required to include the assets, liabilities, and results of the activities of the SPE in its consolidated financial statements.
The accounting literature mentioned above covers many of the special issues investors encounter in practice. The major areas are:
Investor accounting for results of operations of ventures
Special accounting issues related to venture losses
Investor accounting for transactions with a real estate venture, including capital contributions
Financial statement presentation and disclosures
A controlling investor should account for its income and losses from real estate ventures under the principles that apply to investments in subsidiaries, which usually require consolidation of the venture's operations. A noncontrolling investor should account for its share of income and losses in real estate ventures by using the equity method. Under the equity method, the initial investment is recorded by the investor at cost; thereafter, the carrying amount is increased by the investor's share of current earnings and decreased by the investor's share of current losses or distributions.
In accounting for transactions with a real estate venture, a controlling investor must eliminate all intercompany profit. When the investor does not control the venture, some situations require that all intercompany profit be eliminated, whereas in others, intercompany profit is eliminated by the investor only to the extent of its ownership interest in the venture. For example, as set forth in AICPA SOP 78-9, even a noncontrolling investor is precluded from recognizing any profit on a contribution of real estate or services to the venture. Accounting for other transactions covered by SOP 78-9 includes sales of real estate and services to the venture, interest income on loans and advances to the venture, and venture sales of real estate or services to an investor.
With regard to financial statement presentation, a controlling investor is usually required to consolidate venture operations. A noncontrolling investor should use the equity method, with the carrying value of the investment presented as a single amount in the balance sheet and the investor's share of venture earnings or losses as a single amount in the income statement. The proportionate share approach, which records the investor's share of each item of income, expense, asset, and liability, is not considered acceptable except for legal undivided interests.
The material above is only a very brief summary of comprehensive publications, and there are exceptions to some of those guidelines. In accounting for real estate venture operations and transactions, judgment must be exercised in applying the principles to ensure that economic substance is fairly reflected no matter how complex the venture arrangements.
The Revenue Reconciliation Act of 1993 provides tax benefits to investors in entities operating qualified affordable housing projects. The benefits take the form of tax deductions from operating loses and tax credits. In EITF Issue No. 94-1, "Accounting for Tax Benefits Resulting from Investments in Affordable Housing Projects," the EITF reached a consensus that a limited partner in a qualified low income housing project may elect to use the effective yield method (described below) if the following three conditions are met:
The availability of the limited partner's share of the tax credits is guaranteed by a creditworthy entity through a letter of credit, tax indemnity agreement or other arrangement.
The limited partner's projected yield based solely on the cash flows from the guaranteed tax credits is positive.
The limited partner's liability for both legal and tax purposes is limited to its capital investment.
Under the effective yield method, the investor recognizes tax credits as they are allocated and amortizes the initial cost of the investment to provide a constant effective yield over the period that tax credits are allocated to the investor. The effective yield is the internal rate of return on the investment, based on the cost of the investment and the guaranteed tax credits allocated to the investor. Any expected residual value of the investment should be excluded from the effective yield calculation. Cash received from operations of the limited partnership or sale of the property, if any, should be included when realized or realizable.
Under the effective yield method, the tax credit allocated, net of the amortization of the investment in the limited partnership, is recognized in the income statement as a component of income taxes attributable to continuing operations. Any other tax benefits received should be accounted for pursuant to FASB Statement No. 109, "Accounting for Income Taxes."
An investment that does not qualify for accounting under the effective yield method should be accounted for under SOP 78-9, which requires use of the equity method unless the limited partner's interest is so minor as to have virtually no influence over partnership operating and financial policies. The EITF did not establish a "bright line" as to what percentage ownership threshold is required under SOP 78-9 for selecting between the cost and equity methods. The AICPA is currently reconsidering the guidance in SOP 78-9 in its project titled, "Equity Method Investments."
If the cost method is used, the excess of the carrying amount of the investment over its residual value should be amortized over the period in which the tax credits are allocated to the investor. Annual amortization should be based on the proportion of tax credits received in the current year to total estimated tax credits to be allocated to the investor. The residual value should not reflect anticipated inflation.
During the deliberations of EITF Issue No. 94-1, the staff of the SEC announced that they had revised their position on accounting for investments in limited partnerships. Previously, the SEC had not objected to the use of the cost method for limited partnership investments of up to 20 percent, provided the investor did not have significant influence as defined in APB Opinion No. 18, "The Equity Method of Accounting for Investments in Commons Stock." However, the revised position is that the equity method should be used to account for limited partnership investments, unless the investment is "so minor that the limited partner may have virtually no influence over partnership operating and financial policies." In practice, investments of more than three to five percent would be considered more than minor. For public companies, this guidance is to be applied to any limited partnership investment made after May 18, 1995. This would include not only the investments in low income housing projects, but all real estate partnerships and any other types of limited partnership investments (such as oil and gas, etc.).
There are matters of financial statement presentation—as opposed to footnote disclosures—that are unique to the real estate industry. The financial reporting guidelines in this section are based on the principles set forth in authoritative literature and reporting practice.
Real estate companies frequently present nonclassified balance sheets; that is, they do not distinguish between current and noncurrent assets or liabilities. This is because the operating cycle of most real estate companies exceeds one year.
Real estate companies normally list their assets on the balance sheet in the order of liquidity, in the same manner as other companies. A second popular method, however, is to list the real estate assets first, to demonstrate their importance to the companies. In either case, real estate assets should be disclosed in the manner that is most demonstrative of the company's operations. These assets are often grouped according to the type of investment or operation as follows:
Unimproved land
Land under development
Residential lots
Condominium and single-family dwellings
Rental properties
Revenues and costs of sales are generally classified in a manner consistent with that described for real estate investments. In 1976, the FASB issued SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise," which states that the financial statements of an enterprise should include certain information about the industry segments of the enterprise. An industry segment is defined in paragraph 10(a) as "a component of an enterprise engaged in providing a product or service or a group of related products and services primarily to unaffiliated customers (i.e. customers outside the enterprise) for profit." Some developers, however, have traditionally considered themselves to be in only one line of business.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 supersedes SFAS No. 14, although it retains the requirement to report information about major customers. SFAS No. 131 also amends SFAS No. 94, "Consolidation of All Majority-Owned Subsidiaries," to eliminate the disclosure requirements for subsidiaries that were not consolidated prior to the effective date of SFAS No. 94. SFAS No. 131 does not apply to nonpublic entities. SFAS No. 131 adopts a "management approach" to identifying segments and permits entities to aggregate operating segments if certain attributes are present.
Because of the alternatives currently available in accounting for real estate developments, it is especially important to follow the guidelines of APB Opinion No. 22, "Disclosure of Accounting Policies." The Opinion states (par. 12) that disclosures should include the accounting principles and methods that involve any of the following:
A selection from existing acceptable alternatives.
Principles and methods peculiar to the industry in which the reporting entity operates, even if such principles and methods are predominantly followed in that industry.
Unusual or innovative applications of GAAP (and, as applicable, of principles and methods peculiar to the industry in which the reporting entity operates).
The following lists four accounting policy disclosures that are appropriate in the financial statements of a real estate company, as opposed to a manufacturing or service enterprise.
Profit Recognition. The accounting method used to determine income should be disclosed. Where different methods are used, the circumstances surrounding the application of each should also be disclosed. Similarly, a comment should be included indicating the timing of sales and related profit recognition.
Cost Accounting. The method of allocating cost to unit sales should be disclosed (e.g., relative market values, area, unit, specific identification). Financial statement disclosure should include, where applicable, capitalization policies for property taxes and other carrying costs, and policies with respect to capitalization or deferral of start-up or preoperating costs (selling costs, rental costs, initial operations).
Impairment of Long-lived Assets. Real estate held for development and sale, including property to be developed in the future as well as that currently under development, should follow the recognition and measurement principles set forth in SFAS No. 121 for assets to be held and used. A real estate project, or parts thereof, that is substantially complete and ready for its intended use shall be accounted for at the lower of carrying amount or fair value less cost to sell.
Investment in Real Estate Ventures. Disclosures of the following accounting policies should be made:
Method of inclusion in investor's accounts (e.g., equity or consolidation)
Method of income recognition (e.g., equity or cost)
Accounting principles of significant ventures
Profit recognition practices on transactions between the investor and the venture
The following list describes other financial statement disclosures that are appropriate in the notes to the financial statements of a real estate developer.
Real Estate Assets. If a breakdown is not reflected on the balance sheet, it should be included in the footnotes. Disclosure should also be made of inventory subject to sales contracts that have not been recorded as sales and the portion of inventory serving as collateral for debts.
Inventory Write-Downs. Summarized information or explanations with respect to significant inventory write-downs should be disclosed in the footnotes because write-downs are generally important and unusual items.
Nonrecourse Debt. Although it is not appropriate to offset nonrecourse debt against the related asset, a note to the financial statements should disclose the amount and interrelationship of the nonrecourse debt with the cost of the related property.
Capitalization of Interest. SFAS No. 34 requires the disclosure of the amount of interest expensed and the amount capitalized.
Deferral of Profit Recognition. When transactions qualify as sales for accounting purposes but do not meet the tests for full profit recognition and, as a result, the installment or cost recovery methods are used, disclosure should be made of significant amounts of profit deferred, the nature of the transaction, and any other information deemed necessary for complete disclosure.
Investments in Real Estate Ventures. Typical disclosures with respect to significant real estate ventures include names of ventures, percentage of ownership interest, accounting and tax policies of the venture, the difference, if any, between the carrying amount of the investment and the investor's share of equity in net assets and the accounting policy regarding amortization of the difference, summarized information as to assets, liabilities, and results of operations or separate financial statements, and investor commitments with respect to joint ventures.
Construction Contractors. The principal reporting considerations for construction contractors relate to the two methods of income recognition: the percentage of completion method and the completed contract method.
When the completed contract method is used, an excess of accumulated costs over related billings should be shown in a classified balance sheet as a current asset and an excess of accumulated billings over related costs should be shown as a current liability. If costs exceed billings on some contracts and billings exceed costs on others, the contracts should ordinarily be segregated so that the asset side includes only those contracts on which costs exceed billings, and the liability side includes only those on which billings exceed costs.
Under the percentage of completion method, assets may include costs and related income not yet billed, with respect to certain contracts. Liabilities may include billings in excess of costs and related income with respect to other contracts.
The following disclosures, which are required for SEC reporting companies should generally be made by a nonpublic company whose principal activity is long-term contracting:
Amounts billed but not paid by customers under retainage provisions in contracts, and indication of amounts expected to be collected in various years
Amounts included in receivables representing the recognized sales value of performance under long-term contracts where such amounts had not been billed and were not billable at the balance sheet date, along with a general description of the prerequisites for billing and an estimate of the amount expected to be collected in one year
Amounts included in receivables or inventories representing claims or other similar items subject to uncertainty concerning their determination or ultimate realization, together with a description of the nature and status of principal items, and amounts expected to be collected in one year
Amount of progress payments (billings) netted against inventory at the balance sheet date
The traditional accounting model does not permit the recognition of appreciation of real estate assets. This most affects depreciable income properties, but it also affects land. Using the historical cost model, appreciation of good investments cannot be used to offset losses on unsuccessful projects. Real estate companies have thus been among the strongest proponents of fair value and current value reporting, particularly during periods of rapid appreciation in property values.
The FASB has on its agenda a project to provide guidance for measuring and reporting essentially all financial assets and liabilities and certain related assets and liabilities at fair value in the financial statements. The active phases of this project as they relate to the real estate industry have addressed the valuation of financial instruments. Some of the more significant documents that have been issued are SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." A full discussion of these projects and how they affect accounting for the real estate industry is beyond the scope of this chapter. Nevertheless, many advanced forms of real estate financing may be considered financial instruments and are thus subject to the guidance set forth in those documents.
A primary example of such a financing form is the real estate conduit. Conduits are organizations that originate commercial and multifamily mortgage loans for the purpose of issuing collateralized mortgage-backed securitiesCollateralized Mortgage-Backed Securities (CMBS) instead of holding the loans in their loan portfolio. Conduits are intermediaries between real estate borrowers and investors that buy CMBS. Conduits are usually special capital market groups, which are subsidiaries of financial institutions such as commercial banks and security firms.
The AICPA had a project on current value reporting by real estate companies that was shelved after issuance of an October 10, 1994, exposure draft of a proposed SOP, "Reporting by Real Estate Companies of Supplemental Current-Value Information." As described in the exposure draft, the measurement of current value would consider the entity's intent and ability to realize asset values and settle liabilities. In addition, the reported amounts would represent the values of specific balance sheet elements—not the value of the entity as a whole. The AICPA attempted to ensure that the guidance would serve solely as the basis for optional supplemental disclosure and not as the framework for an "other comprehensive basis of accountingOther Comprehensive Basis of Accounting" (OCBOA).
The exposure draft was developed from the AICPA Real Estate Committee's 1984 "Guidance for an Experiment on Reporting Current Value Information for Real Estate," which provided for a comprehensive approach and a piecemeal approach to the presentation of current value information. Although the piecemeal approach is not discouraged, the current value project focuses primarily on the comprehensive approach, in which all assets and liabilities are reported at their current amounts in balance sheet form.
Both the Experiment and the exposure draft recommend presentation of current value information side by side with the corresponding GAAP information in comparative form. Although the Experiment discussed the idea of including current value statements of operating performance and changes in equity, those statements are not addressed in the exposure draft. Instead, the exposure draft focuses on the disclosure of interperiod changes in revaluation equity—the difference between (1) the net current value of assets and liabilities and (2) the corresponding net carrying amount determined in conformity with GAAP.
The reporting of the deferred income tax liability in the current value balance sheet has been controversial. The exposure draft would permit either of the following two methods to be used in determining the deferred income tax liability to be reported in the current value balance sheet:
Method 1—The reported deferred income tax liability is equal to the discounted amount of the estimated future tax payments, adjusted for the use of existing net operating loss carryforwards or other carryforwards. The determination of the deferred income tax liability is based on the enacted income tax rates and regulations at the balance sheet date (even if not in effect at that date). The exposure draft contains a deemed sale provision at the end of the fifteenth year, with the discounted amount of the tax that would be paid on such a sale included in the reported liability.
Method 2—The reported deferred income tax liability is based on enacted rates and regulations at the balance sheet date (even if not in effect at that date). The enacted rate is multiplied by the difference between the current value of total net assets and liabilities and their tax bases, adjusted for the use of existing net operating loss carryforwards or other carryforwards. Although this method of determining the anticipated tax liability is conceptually inconsistent with the principle of determining current value based on the discounted amount of estimated future cash flows, the method was included in the exposure draft because it is easy to apply as a result of the fact that it reflects the effect of an immediate and complete liquidation of the reporting entity's portfolio.
In May 1997, the AICPA issued SOP 97-1, Accounting by Participating Mortgage Loan Borrowers. The SOP establishes the borrower's accounting when a mortgage lender participates in either or both of the following:
Increases in the market value of the mortgaged real estate project
The project's results of operations
If a lender participates in the market appreciation of the mortgaged property, the borrower must determine the fair value of the appreciation feature at the inception of the loan. A liability equal to the appreciation feature is recognized with a corresponding charge to a debt discount account. The debt discount should be amortized using the interest method.
Interest expense in participating mortgage loans consists of the following items:
Amounts designated in the mortgage agreement as interest
Amounts related to the lender's participation in operations
Amounts representing amortization of the debt discount related to the lender's participation in the project's appreciation
The borrower remeasures the participation liability each period. Any revisions to the participation liability resulting from the remeasurement results in an adjustment to the participation liability via a debit or credit to the related debt discount. The revised debt discount should be amortized prospectively using the effective interest rate.
The FASB has on its agenda a project on "Guarantees" that promises to significantly affect real estate financiers. A proposed Interpretation will elaborate on the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. It also will require a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligations it has undertaken in issuing the guarantee. The proposed Interpretation does not address the subsequent measurement of the guarantor's recognized liability over the term of the related guarantee.
Accounting Principles Board, "The Equity Method of Accounting for Investments in Common Stock," APB Opinion No. 18, Interpretation No. 18-2. AICPA, New York, November 1971.
______, "The Equity Method of Accounting for Investments in Common Stock," APB Opinion No. 18. AICPA, New York, March 1971.
______, "Accounting Changes," APB Opinion No. 20. AICPA, New York, 1971.
______, "Interest on Receivables and Payables," APB Opinion No. 21. AICPA, New York, August 1971.
______, "Disclosure of Accounting Policies," APB Opinion No. 22. AICPA, New York, April 1972.
American Institute of Certified Public Accountants, "Inventory Pricing," "Restatement and Revision of Accounting Research Bulletins," Accounting Research Bulletin No. 43. AICPA, New York, June 1953.
______, "Long-Term Construction-Type Contracts," Accounting Research Bulletin No. 45. AICPA, New York, October 1955.
______, "Audit and Accounting Guide for Construction Contractors," Accounting Guide. AICPA, New York, 1981.
______, "Guide for the Use of Real Estate Appraisal Information," Accounting Guide. AICPA, New York, 1987.
______, Issues Paper, "Accounting for Allowances for Losses on Certain Real Estate and Loans and Receivables Collaterialized by Real Estate." AICPA, New York, June 1979.
______, "Accounting Practices of Real Estate Investment Trusts," Statement of Position No. 75-2. AICPA, New York, June 27, 1975.
______, "Accounting for Costs to Sell and Rent, and Initial Real Estate Operations of, Real Estate Projects," Statement of Position No. 78-3. AICPA, New York, 1978.
______, "Accounting for Investments in Real Estate Ventures," Statement of Position No. 78-9. AICPA, New York, December 29, 1978.
______, "Accounting for Real Estate Acquisition, Development and Construction Costs," Statement of Position No. 80-3. AICPA, New York, 1980.
______, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts," Statement of Position 81-1. AICPA, New York, July 15, 1981.
______, Third Notice to Practitioners, "Accounting for Real Estate Acquisition, Development, and Construction Arrangements." AICPA, New York, February 10, 1986.
"Accounting for Real Estate Syndication Income," Statement of Position No. 92-1. AICPA, New York, 1992.
"Accounting for Foreclosed Assets," Statement of Position 92-3. AICPA, New York, 1992.
______, "Accounting by Participating Mortgage Loan Borrowers," Statement of Position 97-1. AICPA, New York, 1997.
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Financial Accounting Standards Board, "Acquisition, Development, and Construction Loans," EITF Issue No. 84-4. FASB, Stamford, CT, 1984.
______, "Recognition of Receipts from Made-Up Rental Shortfalls," EITF Issue No. 85-27. FASB, Stamford, CT, 1985.
______, "Antispeculation Clauses in Real Estate Sales Contracts," EITF Issue No. 86-6. FASB, Stamford, CT, 1986.
______, "Application of the AICPA Notice to Practitioners Regarding Acquisition, Development, and Construction Arrangements to the Acquisition of an Operating Property," EITF Issue No. 86-21. FASB, Stamford, CT, 1986.
______, EITF Abstracts: A Summary of Proceedings of the FASB Emerging Issues Task Force, "Profit Recognition on Sale of Real Estate with Insurance Mortgages on Surety Bonds," EITF Issue No. 87-9. FASB, Norwalk, CT, 1988.
______, "Effect of Various Forms of Financing under Statement of Financial Accounting Standards No. 66," EITF Issue No. 88-24. FASB, Norwalk, CT, 1988.
______, "Accounting for Tax Benefits Resulting from Investments in Affordable Housing Projects," EITF Issue No. 94-1. FASB, Norwalk, CT, 1994.
______, "Accounting for Leases," Statement of Financial Accounting Standards No. 13. FASB, Stamford, CT, November 1976.
______, "Financial Reporting for Segments of a Business Enterprise," Statement of Financial Accounting Standards No. 14. FASB, Stamford, CT, 1976.
______, "Accounting for Sales with Leasebacks (an amendment of FASB Statement No. 13)," Statement of Financial Accounting Standards No. 28. FASB, Stamford, CT, 1979.
______, "Determining Contingent Rentals (an amendment of FASB Statement No. 13)," Statement of Financial Accounting Standards No. 29. FASB, Stamford, CT, 1979.
______, "Capitalization of Interest Cost," Statement of Financial Accounting Standards No. 34. FASB, Stamford, CT, October 1979.
______, "Designation of AICPA Guide and Statement of Position (SOP) 81-1 on Contractor Accounting and SOP 81-2 Concerning Hospital-Related Organizations as Preferable for Purposes of Applying APB Opinion 20," Statement of Financial Accounting Standards No. 56. FASB, Stamford, CT, February 1982.
______, "Accounting for Sales of Real Estate," Statement of Financial Accounting Standards No. 66. FASB, Stamford, CT, October 1982.
______, "Accounting for Costs and Initial Rental Operations of Real Estate Projects," Statement of Financial Accounting Standards No. 67. FASB, Stamford, CT, October 1982.
______, "Consolidation of All Majority-Owned Subsidiaries," Statement of Financial Accounting Standards No. 94. FASB, Stamford, CT, October 1987.
______, "Statement of Cash Flows," Statement of Financial Accounting Standards No. 95. FASB, Stamford, CT, November 1987.
______, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," Statement of Financial Accounting Standards No. 121. FASB, Norwalk, CT, March 1995.
______, "Accounting for Leases," Statement of Financial Accounting Standards No. 98. FASB, Norwalk, CT, May 1988.
______, "Disclosures About Segments of an Enterprise and Related Information," Statement of Financial Accounting Standards No. 131. FASB, Norwalk, CT, 1997.
______, "Goodwill and Other Intangible Assets," Statement of Financial Accounting Standards No. 142. FASB, Norwalk, CT, 2001.
______, "Accounting for the Impairment or Disposal of Long-Lived Assets," Statement of Financial Accounting Standards No. 144. FASB, Norwalk, CT, 2001.
______, "Accounting for Operating Leases with Scheduled Rent Increases." FASB Technical Bulletin No. 85-3. FASB, Stamford, CT, November 1985.
______, "Issues Relating to Accounting for Leases," FASB Technical Bulletin No. 88-1. FASB, Norwalk, CT, December 1988.
Cammavano, Nicholas, Jr., and Klink, James J., Real Estate Accounting and Reporting: A Guide for Developers, Investors, and Lenders, Third Edition. John Wiley & Sons, New York, 1995.
Price Waterhouse, "Accounting for Condominium Sales." New York, 1984.
______, "Accounting for Sales of Real Estate." New York, 1983.
______, "Cost Accounting for Real Estate." New York, 1983.
______, "Investor Accounting for Real Estate Ventures." New York, 1979.
Securities and Exchange Commission, "Reporting Cash Flow and Other Related Data," Financial Reporting Policy 202. SEC, Washington, DC.
______, "Requirement for Financial Statements of Special Purpose Limited Partnerships," Financial Reporting Policy 405. SEC, Washington, DC.
______, "Preparation of Registration Statements Relating to Interests in Real Estate Limited Partnerships," Guide 5. SEC, Washington, DC.
______, "Special Instructions for Real Estate Operations to Be Acquired," Regulation S-X, Article 3, Rule 3–14. SEC, Washington, DC.
______, "Consolidation of Financial Statements of the Registrant and its Subsidiaries," Regulation S-X, Article 3A, Rule 3A-02. SEC, Washington, DC.
______, "Views on Financial Statements of Properties Securing Mortgage Loans," Staff Accounting Bulletin 71-71A (Topic No. 1I). SEC, Washington, DC.
______, "Offsetting Assets and Liabilities," Staff Accounting Bulletin Topic No. 11D. SEC, Washington, DC.
Henriques, Diana B. "The Brick Stood Up Before. But Now?" New York Times, March 10, 2002, p. 1.