Chapter 1

Acquisition, Development, and Construction of Real Estate

1.1 Overview

Investments in real estate projects require significant amounts of capital. For real estate properties that are developed and constructed, rather than purchased, project costs include the costs of tangible assets, such as land and other hard costs (sometimes referred to as “bricks and mortar”); intangible assets and other soft costs, such as architectural planning and design; and interest and taxes. Costs are often incurred before the actual acquisition of the project, which raises certain questions—for example, from what point in time should costs be capitalized? What types of costs are capitalizable?

Determining what types of costs to capitalize in the preacquisition, acquisition, development, and construction stages of a real estate project has been an issue for many years. Several decades ago, in reaction to significant diversity in practice, the American Institute of Certified Public Accountants (AICPA) issued this accounting guidance related to cost capitalization:

In 1982, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 67, Accounting for Costs and Initial Operations of Real Estate Projects, codified in Topic 970, Real Estate—General, extracting the accounting principles provided by these AICPA pronouncements. Nevertheless, diversity in practice has continued to exist in some areas, including the capitalization of indirect costs during the development and construction period and the treatment of repair and major maintenance costs incurred subsequent to the completion of real estate projects.

The AICPA undertook another project to develop a comprehensive framework for cost capitalization and, in 2003, issued for public comment the proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment. That proposed SOP was approved by the AICPA Accounting Standards Executive Committee (AcSEC) in September 2003; however, a final SOP was never issued. In April 2004, the FASB decided not to clear that proposed SOP, mainly for these stated reasons:

1.2 Acquisition, Development, and Construction Costs

The Real Estate Project Costs guidance of Topic 970 (FASB Statement No. 67) provides the primary authoritative guidance for the cost capitalization of real estate project costs. That Statement divides the costs incurred to acquire, develop, and construct a real estate project into preacquisition and project costs. Preacquisition costs encompass costs incurred in connection with, but prior to the acquisition of, real estate. Project costs include costs incurred at the time of the real estate acquisition as well as costs incurred during the subsequent development and construction phase (see Exhibit 1.1).

Real estate developed by a company for use in its own operations other than for sale or rental is not within the scope of the Real Estate Project Costs Subsections of Topic 970 (Statement No. 67).¹ Because—aside from the proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment—there is no authoritative literature related to the capitalization of costs for properties used by an enterprise in its own operations, the guidelines in the Real Estate Project Costs Subsections of Topic 970 (Statement No. 67) are generally also applied to properties used by an entity in its own operations.

1.2.1 Preacquisition Costs

Preacquisition costs are costs related to a real estate property that are incurred for the express purpose of, but prior to, obtaining that property.² They may include a variety of costs, such as:

1.2.1.1 Principles for the Capitalization of Preacquisition Costs

Options to Acquire Real Property.

Payments for options to acquire real property are capitalized.³

Preacquisition Costs Other than Options to Acquire Real Property.

Preacquisition costs other than the cost of options can only be capitalized if the acquisition of the property (or an option to acquire the property) is probable,⁴ and if the costs meet these two criteria:

The guidance in Accounting Standards Codification (ASC) 970-340-25-1 through 25-3 (FASB Statement No. 67) has established a high threshold for the capitalization of preacquisition costs with the requirement that the acquisition of real property be probable. If the purchaser is not actively seeking to acquire the real estate property or does not have the ability to finance or obtain financing for the property, or if there is an indication that the real estate property the purchaser seeks to acquire will not be available for sale, the project is not considered probable.⁶ Any costs (other than costs related to an option to acquire real estate) incurred before a project is considered probable have to be expensed as incurred. If the project becomes probable at a later point in time, costs incurred prior to the project becoming probable cannot subsequently be capitalized.

Preacquisition costs that meet the requirements for capitalization outlined above are capitalized. Once the real estate property is acquired, any capitalized preacquisition costs are included in project costs. If, however, a company determines that the acquisition of the property is no longer probable, capitalized preacquisition costs are charged to expense to the extent they are not recoverable through the sale of plans, options, and the like.⁷

The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, states with respect to the accounting for preacquisition costs when it is no longer probable that the property will be acquired:⁸

If it becomes no longer probable that specific PP&E [property, plant, and equipment] will be acquired or constructed, previously capitalized preacquisition stage costs related to the specific PP&E should be reduced to the lower of cost or fair value. A rebuttable presumption exists that the fair value of the asset consisting of those preacquisition stage costs (excluding option costs) is zero (that is, the costs of the asset would be charged to expense), unless management, having the authority to approve the action, has committed to a plan to either (a) sell the asset and the proceeds can be reasonably estimated or (b) redeploy the asset in other specific PP&E of the entity and the redeployed asset meets the criteria for capitalization under the project stage framework in this SOP. If an entity subsequently acquires or constructs PP&E previously considered no longer probable to acquire or construct, preacquisition stage costs charged to expense under this paragraph should not be reversed.

AcSEC establishes a rebuttable presumption that the fair value of any capitalized preacquisition costs is zero once a project is abandoned, because the majority of the costs incurred in this stage are “soft” costs that generate only limited value for other projects.⁹

1.2.1.2 Capitalization of Internal Preacquisition Costs

Activities in the preacquisition stage may be carried out by a company's in-house departments, which raises the question of (1) whether and (2) to what extent such internal preacquisition costs should be capitalized.

The Other Assets and Deferred Costs Subsection of Topic 970 (Emerging Issues Task Force (EITF) Issue No. 97-11, Accounting for Costs Relating to Real Estate Property Acquisitions) provides that internal preacquisition costs¹⁰ are only capitalizable if the property is expected to be nonoperating at the date of acquisition. They are not capitalizable if the property is expected to be operating at the date of acquisition, such as internal preacquisition costs related to the purchase of an existing shopping mall.¹¹

A prerequisite for the capitalization of internal preacquisition costs is that they be directly identifiable with the specific property.¹² While “directly identifiable” is not further defined in Topic 970 (Statement No. 67), the term has been interpreted narrowly in practice.

One may look to the proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, for implementation guidance:¹³

. . . [d]irectly identifiable costs include only:

Notwithstanding the foregoing, an option to acquire property, plant, and equipment that meets the definition of a derivative instrument within the scope of Topic 815, Derivatives and Hedging (FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities), is accounted for following the guidance in that topic (Statement No. 133).¹⁴

Further, the proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, states that costs of facilities, such as rent and depreciation, as well as general and administrative costs, should be expensed as incurred, as should all costs of executive management, corporate accounting, acquisitions, office management and administration, marketing, human resources, and similar costs or functions.¹⁵

While that proposed SOP has never been issued in final form, the guidance it provides nevertheless proves helpful when interpreting the provisions in the Real Estate Project Cost Subsections of Topic 970 (Statement No. 67).

1.2.2 Project Costs

Project costs are defined as “[c]osts clearly associated with the acquisition, development, and construction of a real estate project.”¹⁶ In certain real estate projects, land is developed and structures are being built or refurbished. In addition to the costs of acquiring land, development and construction costs are incurred to complete the project. Other real estate projects involve property acquisition only, such as the acquisition of shopping centers that are already in operation.

ASC 970-360-25-2 (paragraph 7 of Statement No. 67) states the general concept for the accounting for project costs:

Project costs clearly associated with the acquisition, development, and construction of a real estate project shall be capitalized as a cost of that project.

While this concept may appear straightforward, determining which costs are clearly associated with a real estate project can require significant judgment.

1.2.2.1 Direct Costs

Direct project costs are incremental costs that are directly related to the acquisition, development, and construction of the property. They may include the same types of costs as preacquisition costs, because certain activities can be performed before or after the acquisition. In addition to the types of costs listed in Section 1.2.1 of this chapter, project costs typically include:

All costs incurred need to be carefully evaluated to determine whether they qualify for capitalization. For example, the costs of real estate donated to governmental agencies that benefit a certain project are part of that project's costs.¹⁹ However, if donated land does not benefit (and was not made in conjunction with) a real estate project, the costs should be expensed rather than capitalized. Similarly, demolition costs incurred within a reasonable period after the acquisition of property are generally capitalized when they are incurred, if demolition is probable at the time of acquisition.²⁰ Industry practice is diverse with respect to the capitalization of demolition costs that are not incurred within a reasonable period after acquisition. The proposed SOP, if it had been issued in final form as proposed, would have required that demolition costs not incurred within a reasonable period of time after acquisition be expensed.²¹ Questions also arise with respect to the capitalization of environmental remediation costs. While environmental remediation costs incurred within a reasonable period of time after the acquisition of property are generally capitalized as part of the project costs, determining whether environmental remediation costs incurred at a later point in time are capitalizable is more complex and involves significant judgment.²²

1.2.2.2 Indirect Costs

Indirect project costs are capitalized to the extent that they clearly relate to the acquisition, development, or construction of a real estate project. Examples of indirect internal project costs include:

For internally incurred indirect costs to be capitalizable, a cost accounting system needs to be in place, and adequate documentation needs to be maintained to support cost capitalization. For example, time may be recorded by the in-house designers to determine the percentage of their salaries to be allocated to a certain project. Indirect costs for which sufficient support cannot be provided, or that do not clearly relate to a project under development or construction, including general and administrative expenses, are expensed as incurred.²⁵

U.S. generally accepted accounting principles (GAAP) does not provide any further guidance on how to determine what costs are clearly associated with the acquisition, development, and construction of a real estate project. As a result, considerable diversity in practice exists with respect to the types of indirect project costs that are capitalized.

The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, limits the capitalization of indirect costs to:

The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, provides that the capitalization of directly identifiable indirect project costs should be limited to:

The proposed SOP does not provide for the capitalization of other indirect costs, such as occupancy costs (including rent, depreciation, and other costs associated with facilities); these costs should be charged to expense as incurred.²⁹ While the proposed SOP may prove helpful in interpreting the Real Estate Project Costs guidance in the Codification (Statement No. 67), one has to keep in mind that the proposed SOP is not authoritative.

1.2.2.3 General and Administrative Expenses

Topic 970 (FASB Statement No. 67) provides that “[i]ndirect costs that do not clearly relate to projects under development or construction, including general and administrative expenses . . . be charged to expense as incurred”³⁰ without providing further guidance as to which expenses should be considered general and administrative expenses. The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment is more specific: “All costs (including payroll and payroll benefit–related costs) of executive management, corporate accounting, acquisitions, office management and administration, marketing, human resources, and similar costs and functions should be charged to expense as incurred.”³¹

1.2.2.4 Property Taxes and Insurance

Property taxes, insurance, and interest are commonly referred to as holding costs. Taxes and insurance are capitalized as part of the property's cost during the period in which activities necessary to get the property ready for its intended use are in progress.³² The capitalization period for property taxes and insurance (beginning, end, and suspension) coincides with the capitalization period for interest set forth in ASC 835-20-25-3 and 25-4 and 835-20-25-8 (FASB Statement No. 34, Capitalization of Interest Cost)³³ outlined in Section 1.2.2.5 of this chapter. After the real estate property is ready for its intended use, property taxes and insurance are charged to expense as incurred. Special considerations are necessary when development activities occur only on a portion of a real estate property. For example, a company may own a 50-acre parcel of land and is constructing a building on 5 of these 50 acres. The capitalization of property taxes and insurance would only be appropriate for interest and taxes relating to the 5 acres under construction.³⁴

Insurance and taxes are capitalized during the construction period irrespective of whether the real estate is newly acquired or has been used subsequent to its acquisition, with construction activities starting at a later point in time. For example, a hotel building may be redeveloped (refurbished) after it has been operating for many years. The proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, uses the “avoidable cost concept” to determine whether property taxes and insurance should be capitalized.³⁵ If the property has been used in the past as an operating asset, but is removed from operations for purposes of construction, property taxes and insurance are avoidable costs of construction, even though they are not incremental to the entity, since the entity could avoid the property taxes and insurance by choosing to dispose of the property. However, for properties under construction that remain in operation while construction takes place, the proposed SOP suggests that costs incurred for property taxes and insurance should be capitalized only if they are incremental and directly attributable to the construction activities.³⁶

1.2.2.5 Interest

Undertaking real estate projects requires significant capital, and financing cost is a major cost factor. If real estate is acquired that is not ready for its intended use, interest expense incurred during the development and construction period is part of a project's costs that is capitalized.³⁷ FASB believes that through interest capitalization, a measure of acquisition cost is obtained that reflects the company's investment in the real estate asset.³⁸ Accordingly, interest capitalization is not discontinued when a real estate project is impaired; any write-down is increased by interest expected to be capitalized in future accounting periods.³⁹

There may be a period of time in which a company generates interest income from the investment of unused funds on project financing obtained. Generally, such interest income is recognized as income when earned. It is not offset against interest cost when determining the amount of interest cost to be capitalized, except in the case of certain tax-exempt borrowings.⁴⁰

The determination of the amount of interest to be capitalized in a real estate project is a four-step process:

Step 1. Determine Whether the Real Estate Project Qualifies for Interest Capitalization.

These two types assets qualify for interest capitalization:⁴¹

Additionally, investments in equity method investees may be qualifying assets, as explained in Section 1.7.6 of this chapter.

Topic 835, Interest (FASB Statement No. 34, Capitalization of Interest Cost), precludes interest capitalization for certain types of assets, including ⁴² (1) assets that are in use or ready for their intended use, and (2) assets that, although not in use, are not undergoing activities to get them ready for their use.

Land that is not undergoing activities necessary to get it ready for its intended use is not an asset qualifying for interest capitalization. Once activities are undertaken for the purpose of developing land for a particular use, the acquisition and development expenditures qualify for interest capitalization while those activities are in progress. If a structure is built on the land, such as a plant or an office building, interest capitalized on the land expenditures is part of the cost of the structure. If a tract of land is developed and subdivided to be sold as developed lots, interest capitalized on the land expenditures becomes part of the cost of the land.⁴³

Step 2. Determine the Types of Expenditures That Qualify for Interest Capitalization.

After it has been determined that a project qualifies for interest capitalization, the expenditures incurred for that project have to be evaluated to determine whether they qualify for interest capitalization. As a general rule, expenditures that do not require the transfer of cash or other assets or the incurrence of liabilities on which interest is accrued do not qualify for interest capitalization. As such, capitalized amounts financed through trade payables, retainages, or progress payment collections from customers may lead to differences between capitalized project costs and the amount of expenditures that qualify for interest capitalization. ASC 835-20-30-5 (paragraph 16 of FASB Statement No. 34) provides, however, that capitalized expenditures for an asset may be used as a reasonable approximation of expenditures on which interest is capitalized, unless the difference is material.

Step 3. Determine the Capitalization Period.

Interest is capitalized when these three conditions are present:⁴⁴

The term “activities that are necessary to get the asset ready for its intended use” is interpreted broadly in practice. Such activities include administrative and technical activities before ground is broken, such as the development of plans or the process of obtaining permits from governmental authorities. If a company suspends substantially all activities related to the development of the property, the company has to evaluate the reason and duration of the suspension and determine whether interest capitalization during such period of suspension is appropriate. An interruption that is brief or inherent in the asset development process, such as labor strikes or weather conditions, would not lead to a cessation of interest capitalization, whereas a company-induced suspension in construction activities due to a decline in the real estate market would preclude interest capitalization.⁴⁵

The capitalization period ends when the asset is substantially complete and ready for its intended use. By requiring that the capitalization period end when the asset is “substantially complete,” the FASB intended to prohibit the continuation of interest capitalization in situations in which the final completion of assets is intentionally delayed. For example, a developer may choose to defer installing fixtures and fittings until condominium units are being sold to give buyers a choice of styles and colors.⁴⁶

ASC 970-605-25-2 (paragraph 22 of FASB Statement No. 67) allows for a maximum period of one year after cessation of major construction activities, over which a developer may assert that the project is not substantially completed, by requiring that “[a] real estate project shall be considered substantially completed and held available for occupancy upon completion of tenant improvements by the developer but no later than one year from cessation of major construction activity.”

Real estate projects may need to be divided into separate assets or parts for purposes of determining whether they are ready for their intended use. For example, a condominium building is comprised of individual condominiums, which can be used independently from each other.⁴⁷ Each such condominium constitutes a separate asset, and interest ceases to be capitalized on condominiums that have been completed and are ready for use. Other real estate assets must be completed in their entirety before any part of the asset can be used, such as the construction of a manufacturing facility. ASC 835-20-25-5 (paragraph 18 of Statement No. 34) provides as an example “oil wells drilled in Alaska before completion of the pipeline. For such assets, interest capitalization shall continue until the separate facility is substantially complete and ready for use.”

Judgment must be exercised when determining whether a real estate project should be divided into separate parts for purposes of interest capitalization.

Step 4. Determine the Amount of Interest Cost to Be Capitalized.

The amount of interest cost to be capitalized is intended to be that portion of the interest cost incurred during the asset's acquisition and construction period that theoretically could have been avoided if expenditures for the asset had not been made.⁴⁸ The total amount of interest cost that may be capitalized in an accounting period is limited to the total amount of interest cost incurred by the company in that period.⁴⁹

For purposes of Topic 835 (FASB Statement No. 34),⁵⁰ interest cost incurred by a company includes:

The amount of interest cost to be capitalized in an accounting period is determined by applying an interest rate to the average amount of accumulated expenditures for the asset during the period. In determining what interest rate to use, the objective is to determine a reasonable measure of the cost of financing the acquisition and development of the asset. The interest rate or interest rates used should be based on the rates applicable to borrowings outstanding during the period. If a company has obtained a specific loan for a qualifying asset, the company may use the rate on that borrowing as the capitalization rate for the expenditures for the asset. If the average accumulated expenditures for the asset exceed the amounts of that loan, the capitalization rate applied to any excess is a weighted average of the rates applicable to other borrowings of the company.⁵¹ ASC 835-20-30-4 (paragraph 14 of Statement No. 34) provides with respect to the weighted average interest rate to be used: “In identifying the borrowings to be included in the weighted average rate, the objective is a reasonable measure of the cost of financing acquisition of the asset in terms of the interest cost incurred that otherwise could have been avoided. Accordingly, judgment will be required to make a selection of borrowings that best accomplishes that objective in the circumstances.”

Section 1.7.6 of this chapter discusses special considerations if financing is provided by related parties. It also discusses interest capitalization by a company on investments in an equity method investee.

1.2.3 Cost Allocation

As real estate projects often span long time periods until their completion, it is of critical importance to evaluate at the outset of a real estate project whether—for cost allocation purposes—a project should be divided into two or more phases. For example, a real estate development company may purchase a large tract of land to be developed over several years; portions of the land will be developed and sold before the project as a whole is completed. If that real estate development project is not divided into phases, the appropriate allocation and monitoring of costs is difficult, and project costs relating to the earlier stages of the development may inappropriately be allocated to a later stage, thereby overstating profits in the earlier years. Certain project costs may benefit one individual unit (such as a lot, home, or condominium unit) or a group of units within one phase; other costs may benefit one or more phases of a project or more than one project, such as utilities or access roads. As such, the allocation of costs to individual units, between different phases of one project, or to different projects generally involves several cost pools and multiple steps.

When allocating project costs, one needs to consider costs already incurred as well as costs to be incurred in current and future periods. For example, in a master-planned community, individual homes are often sold before amenities (e.g., golf courses, swimming pools, or parks) have been completed. To appropriately reflect the cost of sales that relates to one individual home sold, a portion of the costs expected to be incurred in future periods for the construction of the amenities must be allocated to that home.⁵²

Selecting an appropriate cost allocation method requires judgment. As a general rule, costs should be allocated to the portions of a project that benefit from the costs. The intent is to achieve a constant gross margin on sales for the project, irrespective of the point in time sales occur. The Real Estate Project Costs guidance in Topic 970 (FASB Statement No. 67) outlines three different ways to allocate costs:⁵³

Specific Identification Method.

Where practicable, the costs of a real estate project are assigned to individual components of a project based on specific identification. The specific identification method is most frequently used for the allocation of acquisition costs and direct construction costs in small projects. For example, costs charged by a contractor to install a staircase in a new home directly relate to that home. The amount invoiced by the contractor should be included in the cost basis of that home.

Relative Value Method.

If specific identification is not feasible or is impracticable, as is the case for indirect costs or common costs, costs should be allocated based on the relative value of the components, if possible.⁵⁴ Under this method, costs are allocated based on the relative fair values of the individual components of a project, based on either (1) the fair value before construction or (2) the relative sales value of the units.

Allocation Based on Relative Fair Value before Construction.

Land costs and all other common costs incurred before construction occurs (including the costs of any amenities) are allocated to the land parcels benefited, with cost allocation based on the relative fair value before construction. For example, a developer that purchases a tract of land on which to build a master-planned community, a shopping center, and an office building would allocate the cost of the land based on estimates of the relative fair value of the land parcels of (1) the master-planned community, (2) the shopping center, and (3) the office building, prior to the construction of the structures. A cost allocation based on the size of the parcels would not reflect any differences in values and is generally not considered appropriate. Unusable land and land that is donated to municipalities or other governmental agencies that will benefit the project are allocated as common costs of the project.⁵⁵

Allocation Based on the Relative Sales Value of the Units.

Under the relative value method, construction costs for a project, such as a condominium complex, are allocated to the individual units (e.g., homes, condominium units) based on the relative sales value of the units.⁵⁶ When allocating costs based on the relative value method, the sales values of the units must be comparable. This is achieved by assuming that all of the units will be completed and ready for sale at the same point in time; any expected price increases for units that will be completed in future periods are not taken into consideration.

The relative sales value method results in allocating greater costs to more valuable components of a project. In practice, the relative value method is often implemented through the application of a gross profit method. Under the gross profit method, a cost-of-sales percentage is calculated by dividing the sum of capitalized project costs and project costs to be incurred in the current and future periods by the estimated sales value of the unsold units. When a unit is sold, the cost-of-sales amount attributable to that sale is determined by multiplying the sales value of that unit by the cost-of-sales percentage.

Area Methods or Other Value Methods.

If the relative value method cannot be applied, as would be the case if a real estate development company has not determined the ultimate use of the land, another method for cost allocation has to be used. The Real Estate Project Costs guidance in Topic 970 (FASB Statement No. 67) suggests the use of the area method, such as the allocation of costs to parcels based on square footage, or another reasonable value method.⁵⁷

Under the area method, costs are allocated based on lot sizes, the square footage of a structure, or the number of units in a development. The use of the area method is appropriate only if the allocation is not materially different from an allocation that is based on relative value methods or if the application of the relative value method is impracticable.

The allocation of costs needs to be reviewed every reporting period to ensure that changes in circumstances, such as a change in estimate of project costs or sales prices or in the design of the project, are taken into consideration.⁵⁸ Cost reallocations within or between phases of a project are not uncommon, as the design of a project may evolve.

1.2.4 Change in Estimates or Project Plans and Abandonments of Projects

Due to the length of time involved in the development and construction of real estate properties, a project's plans, cost estimates, and expected sales prices may change over the course of the project.

Change in Estimates.

ASC 970-340-35-1 (paragraph 12 of FASB Statement No. 67) requires that estimates and cost allocations be reviewed at the end of each financial reporting period until a project is substantially completed and available for sale. Generally, any changes in cost estimates are accounted for prospectively as changes in estimate, in accordance with ASC 250-10-45-17 through 45-20 and 250-10-50-4 (paragraphs 19 through 22 of FASB Statement No. 154, Accounting Changes and Error Corrections).

The accounting for any cost revisions may be reflected in the current period or in current or future periods, depending on the facts and circumstances:

The prospective accounting for changes in common cost estimates can lead to different margins over the time of project development and construction. If cost estimates for common costs increase, common costs attributable to units already sold will be allocated to the costs of unsold units. Consequently, the profit margin of units sold in future periods would be lower than the profit margin of units already sold.

Changes in estimates in sales values that impact cost allocation under the relative value methods are also accounted for as a change in estimate pursuant to ASC 250-10-45-17 through 45-20 and 250-10-50-4 (paragraphs 19 through 22 of FASB Statement No. 154).

Change in Development Plans.

Changes in market demand or other factors may arise after significant development and construction costs have already been incurred (such as the decline in the housing market in the summer of 2007). If a developer decides to change its development plans, development and construction costs need to be charged to expense to the extent that the capitalized costs incurred and to be incurred for the redesigned project exceed the estimated value of the redesigned project when it is substantially complete and ready for its intended use.⁵⁹ This charge to expense based on the fair value upon completion is required irrespective of whether an impairment loss needs to be recognized pursuant to the provisions of Subtopic 360-10 (FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets).

When determining the amount to be charged to expense upon such change in plans, any future interest capitalization has to be taken into consideration pursuant to ASC 835-20-25-7 (paragraph 19 of FASB Statement No. 34, Capitalization of Interest Cost), which provides, in part:

Interest capitalization shall not cease when present accounting principles require recognition of a lower value for the asset than acquisition cost. The provision required to reduce acquisition cost to such lower value shall be increased appropriately.

Abandonment of a Real Estate Project.

If a real estate project is abandoned, the capitalized costs of that project need to be expensed to the extent they are not recoverable; for example, a lender may foreclose on a property, or a real estate option may lapse. Any capitalized expenses for which a future use cannot be clearly established should not be allocated to other phases or other projects.⁶⁰

1.3 Costs Incurred to Sell or Rent a Real Estate Project

In real estate properties that are intended for rent or sale after development is completed, leasing and selling activities generally occur throughout the acquisition, development, and construction phases of a project. Successful preleasing and preselling efforts are evidence of a project's viability, and funds received from buyers are often used to finance a project's development. Commissions, legal fees, closing costs, advertising costs, and costs for grand openings are examples of costs to sell or rent. However, based on the type of real estate property, leasing and sales activities—and related costs incurred—may vary.

1.3.1 Costs Incurred to Sell a Real Estate Project

Costs incurred to sell a real estate project are generally substantial. Depending on the type of selling costs incurred, they are accounted for in one of three ways:

Selling Costs to Be Included in Project Costs.⁶¹

Selling costs are included in project costs if all of these criteria are met:

Examples of costs that generally qualify as project costs are:⁶²

Selling costs that qualify for inclusion in project costs become part of a common cost pool that is allocated to individual units. Model units and their furnishings are generally sold at the end of the sales period; the amount allocated to common costs is the excess of the costs of the model units over their estimated sales proceeds.

Selling Costs to Be Deferred.⁶³

ASC 970-340-25-15 (FASB Statement No. 67) provides for the deferral of certain selling costs. It is important to note that deferred selling costs are not part of project costs. If the percentage-of-completion method were applied, the incurrence of selling costs would not increase a project's percentage of completion. Additionally, deferred selling costs are not part of qualifying expenditures for interest capitalization.

Selling costs are accounted for as prepaid costs; that is, they are deferred if they meet these criteria: They must be directly associated with successful sales efforts, and their recovery must be reasonably expected from sales. ASC 970-340-25-15 (FASB Statement No. 67) provides for the deferral of such selling costs until the related profit is recognized. If profit is recorded under the accrual method of accounting, a deferral of selling costs is generally not necessary, as the selling costs are incurred in the period of sale. For example, a seller may incur brokerage commissions at the time of closing. If profit from a real estate sale is recognized under a method of accounting other than the accrual method, such as the deposit or installment method, ASC 970-340-35-15 (paragraph 18 of Statement No. 67) provides for cost deferral until the related profit is recognized.

If a sales contract is canceled or if the receivable from a real estate sale is written off as uncollectible, any related unrecoverable deferred selling costs are charged to expense.⁶⁴

Advertising Costs.

Costs of advertising, which include the costs of producing advertisements (such as the costs of idea development, artwork, printing, and audio and video production) and communicating advertisements that have been produced (such as the costs of magazine space, television airtime, billboard space, and distribution costs) are accounted for based on the provisions of Subtopics 720-35 and 340-20 (SOP 93-7, Reporting on Advertising Costs).

Costs of advertising are expensed, either as incurred or the first time the advertising takes place (e.g., the first public showing of a television commercial or the first appearance of a magazine advertisement) with these two exceptions provided for in ASC 340-20-25-2 and 25-4 (paragraphs 26 and 27 of that SOP):

Selling Costs to Be Expensed.⁶⁶

Costs that do not meet the criteria for capitalization as project costs or for cost deferral are expensed as incurred.

1.3.2 Costs Incurred to Rent a Real Estate Project⁶⁷

Costs to rent a real estate project under operating leases fall in one of two categories: (1) initial direct costs and (2) other than initial direct costs. Costs to rent projects under direct financing or sales-type leases are treated like costs to sell.

The Real Estate Project Costs guidance in Topic 970 (FASB Statement No. 67) does not apply to initial direct costs.⁶⁸ Initial direct costs are incremental direct costs incurred by the lessor in negotiating and consummating leasing transactions and certain costs directly related to specified activities performed by the lessor.⁶⁹ The accounting for such costs is provided in Subtopic 840-20 (FASB Statement No. 13) and further discussed in Section 4.5.2 of Chapter 4.

Costs other than initial direct costs to rent real estate projects under operating leases that are related to and are expected to be recovered from future rental operations are deferred (capitalized). Examples of such costs are costs of:⁷⁰

Deferred rental costs that are directly related to a specific operating lease are amortized over the lease term. Deferred rental costs not directly related to revenue from a specific operating lease are amortized over the period of expected benefit. The amortization period of capitalized rental costs begins when the project is substantially complete and held available for occupancy. Any amounts of unamortized capitalized rental costs associated with a lease or group of leases that are estimated not to be recoverable are charged to expense when it becomes probable that the lease or group of leases will be terminated.⁷¹

Costs of advertising are accounted for based on the provisions of Subtopics 720-35 and 340-20 (SOP 93–7, Reporting on Advertising Costs).

Costs that do not meet the criteria for capitalization and are not advertising costs—for example, general and administrative costs—are expensed as incurred.⁷²

1.4 Incidental Operations

Incidental operations are revenue-producing activities, such as rentals, that are undertaken during the holding or development period to reduce the cost of holding or developing the property for its intended purpose. For example, a developer may engage in these incidental operations to reduce the cost of project development:

Incremental revenue from incidental operations in excess of incremental costs of incidental operations is accounted for as a reduction of capitalized project costs, whereas incremental costs from incidental operations in excess of incremental revenue from incidental operations are charged to current operations. The different accounting treatment reflects the intent for undertaking incidental operations; incidental operations are entered into to reduce the cost of developing the property for its intended use rather than to generate revenues.⁷³ Accordingly, if the objective of reducing costs has not been achieved, any excess operating expenses from incidental operations are charged to expense.⁷⁴

A real estate company may construct an office building that it intends to lease. Some offices may be leased before the office building is substantially complete and ready for occupancy. Until the building in its entirety is substantially complete and ready for occupancy, it is not depreciated, and any rental income and expense is accounted for as incidental operations.⁷⁵

1.5 Accounting for Costs Incurred Subsequent to Project Completion

1.5.1 Determining the Date of Project Completion

A real estate project is considered substantially completed and held available for occupancy upon completion of tenant improvements by the developer, but no later than one year from cessation of major construction activity.⁷⁶ Once a real estate project is substantially completed and held available for occupancy, a rental project changes from nonoperating to operating, with these consequences:

ASC 970-340-25-17 (paragraph 23 of Statement No. 67) states:

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 shall be accounted for as a separate project. Costs incurred shall be allocated between the portions under construction and the portions substantially completed and held available for occupancy.

Judgment must be used to determine what constitutes a project and, once identified, when that project is substantially completed and ready for its intended use. For example, a company may identify separate buildings in an office complex as separate projects. However, an individual rental project, such as an office building, is considered one real estate project in its entirety, and that rental project is evaluated in its entirety of whether it is substantially complete. The FASB considered and rejected a phase-in of depreciation and other operating costs based on a percentage-of-occupancy method over the period of lease-up of a building.⁷⁸ Accordingly, depreciation commences for an office building held for rental in its entirety rather than on a floor-by-floor basis. Similarly, costs incurred for property taxes and insurance relate to the building and land as a whole; therefore, capitalization of those costs should cease when the building is substantially complete and ready for its intended use rather than being phased in over time.

1.5.2 Costs Incurred Subsequent to Project Completion

For properties that are developed for a company's own use or rental operations, costs will be incurred subsequent to the completion of the project. Questions of how to account for costs incurred subsequent to a property's completion are encountered not only by real estate companies but by all companies owning real estate.

The accounting treatment of such costs will depend on the type of costs incurred and the reason for their incurrence. Costs incurred may be start-up costs within the scope of Subtopic 720-15, Other Expenses—Start-up Costs (SOP 98-5, Reporting on the Costs of Start-up Activities);⁷⁹ they may constitute normal maintenance expenses; or they may stem from renovations, remodeling, or refurbishing activities.

Normal repair and maintenance costs are commonly expensed as incurred. Questions remain, however, with respect to other costs incurred. If a company replaces the roof of a building, for example, should that new roof be capitalized? If so, is it appropriate or necessary to write off the estimated net book value of the existing roof?

Aside from a general rule that expenditures that extend the life of the property or increase its value are capitalized and that normal recurring repair and maintenance expenditures are expensed, very little guidance exists with respect to the accounting treatment of costs incurred subsequent to project completion. The proposed SOP, Accounting for Certain Costs and Activities Relating to Property, Plant, and Equipment, offers guidance with respect to costs incurred during the “in service stage;” however, that proposed SOP was not cleared by the FASB. Additionally, the proposed SOP introduces the concept of components, which is generally not followed in U.S. GAAP.

1.6 Purchase of Income-Producing Property

A transaction to acquire real estate held for rental, commonly referred to as income-producing property, may constitute the purchase of a business or the purchase of an asset/asset group. With the issuance of Statement No. 141(R), now codified in Topic 805, Business Combinations, the definition of a business was significantly broadened. For example, under current guidance, the acquisition of an entity in the development stage may qualify as the acquisition of a business but would not have qualified as business prior to the effective date of Statement No. 141(R).⁸⁰ The determination of whether an acquisition constitutes the acquisition of a business or of an asset/asset group is essential for appropriate accounting—for example, for the allocation of purchase price and for the accounting for transaction costs. An overview of accounting differences between business and asset acquisitions is presented in Section 1.6.7 of this chapter.

1.6.1 Purchase of a Business

The guidance for the determination of whether a business or an asset/asset group is being purchased is provided by Topic 805, Business Combinations.⁸¹ A business is defined as “[a]n integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.”⁸²

In order for such integrated set of activities and assets to be capable of being conducted and managed for the purpose of providing such return, two elements must be present: (1) inputs and (2) processes applied to those inputs, which together are or will be used to create outputs.⁸³ Exhibit 1.2 depicts the elements of a business.

Although businesses usually have outputs, outputs are not required in order for an integrated set of activities and assets to qualify as a business.⁸⁴ If the integrated set of activities and assets does not have outputs, the acquirer should consider other factors to determine whether the set is a business. Those factors include, but are not limited to, whether the set:

Further, a business need not include all of the inputs or processes necessary to operate that set as a business, if market participants are capable of acquiring the business and continuing to produce outputs (e.g., by integrating the business with their own inputs and processes).⁸⁶ For purposes of determining whether the acquisition of a set of assets and activities acquired meets the definition of a business, it is irrelevant whether the seller operated the set as a business; it is also irrelevant whether the acquirer intends to operate the set as a business.

Established businesses typically have many different types of inputs, processes, and outputs, whereas new businesses may have few inputs and processes and few (or no) outputs. Similarly, while businesses typically have liabilities, not every business has liabilities. As the elements of a business vary depending on industry and an entity's operations, the determination of whether a business has been acquired requires judgment.⁸⁷

Under current guidance, as it is interpreted in the United States, most acquisitions of income-producing properties are accounted for as acquisitions of businesses. Exceptions are acquisitions of properties that do not require active management or the existence of significant processes, such as the acquisition of a warehouse that is leased to a single tenant. Before the effective date of Statement No. 141(R), the purchase of individual income-producing properties, such as office buildings or warehouses, was often deemed not to constitute the acquisition of a business, whereas the purchase of a hotel or restaurant was often accounted for following business combinations guidance.⁸⁸

1.6.2 Purchase of an Asset/Asset Group

If the purchase of real estate⁸⁹ does not meet the criteria of a business as defined in Topic 805 (FAS 141(R)), it constitutes the purchase of an asset/asset group.

One key accounting difference between the acquisition of an asset/asset group and the acquisition of a business is that in the acquisition of a business, the assets acquired and liabilities assumed are recorded at their fair values, with any excess of acquisition cost over the amounts assigned to the assets acquired and liabilities assumed being recognized as goodwill. In an asset acquisition, however, the allocation of the purchase price is based on the relative fair values of the individual assets and liabilities of the purchased set, which may differ from their fair values. Section 1.6.5 in this chapter includes an example that illustrates the purchase price allocation in the acquisition of a business versus the acquisition of an asset group.

Another key difference is that under business combinations accounting guidance, the acquirer is required to expense all acquisition-related costs, such as fees paid to brokers, accountants, lawyers, and valuation specialists,⁹⁰ whereas acquisition-related costs are capitalized in asset acquisitions.

1.6.3 Recognition of Intangible Assets Acquired

Before the effective date of FASB Statements No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, in June 2001, the purchase price for income-producing real estate was generally allocated to land and buildings. Any intangible assets acquired, such as lease agreements, were considered part of the value of the land or buildings and not separately accounted for. Since then the FASB has mandated that intangible assets be identified and recognized separately from land and buildings.

Recognition Criteria in Business Acquisitions versus Asset Acquisitions.

In the acquisition of a business, for an intangible asset to be recognized as a separate asset, the intangible asset must be “identifiable.” An asset is “identifiable” if one of these two criteria is met:

In a purchase of income-producing property that does not meet the definition of a business, however, all intangible assets that meet the asset recognition criteria in Concepts Statement (CON) No. 5, Recognition and Measurement in Financial Statements of Business Enterprises,⁹² must be recognized in the financial statements, even though they may not meet either of these two asset recognition criteria.⁹³ Examples are specially trained employees or a unique manufacturing process related to an acquired manufacturing plant.

Intangible Assets in the Acquisition of Income-Producing Properties.

Intangible assets commonly encountered in the acquisition of income-producing real estate properties—both in the acquisition of businesses and the acquisition of assets—are:

Other intangible assets, such as tenant (customer) lists or trade names, may also be present, depending on the individual facts and circumstances.

In-Place Leases..

Companies acquiring income-producing properties segregate leases that are in place at the date of acquisition (“in-place leases”) into (1) an at-market component and (2) an above- and below-market component.

The at-market component of in-place leases represents the value of having lease contracts in place at terms that are market.

The above- and below-market components of in-place leases represent the present value of the difference in cash flows between the contractually agreed-upon rentals and current prevailing rental rates for the in-place leases. If in-place leases are above market, they represent assets from the acquiring company's perspective, because the acquiring company will receive rentals that are above market in future periods. If in-place leases are below market, they represent liabilities (balance sheet credits). The above- and below-market components of acquired leases are determined on a lease-by-lease basis. As a result, the acquisition of one income-producing property may result in both above-market leases (assets) and below-market leases (liabilities/balance sheet credits); the amounts of above- and below-market leases are not presented “net” on the balance sheet.

Tenant Relationships..

A tenant relationship is a relationship between the lessor of the property and its tenants, akin to a customer relationship.

Topic 805 (FASB Statement No. 141(R)) states with respect to customer relationships:⁹⁴

A customer relationship exists between an entity and its customer if the entity has information about the customer and has regular contact with the customer and the customer has the ability to make direct contact with the entity. Customer relationships meet the contractual-legal criterion if an entity has a practice of establishing contracts with its customers, regardless of whether a contract exists at the acquisition date. Customer relationships also may arise through means other than contracts, such as through regular contact by sales or service representatives.

A tenant relationship may provide the landlord with the ability to generate a future income stream besides rentals from in-place leases; for example, a landlord may be able to attract an anchor tenant of one shopping mall to its other shopping malls.⁹⁵

1.6.4 Measurement of Property, Plant, Equipment, and Intangibles

Generally, assets and liabilities are initially measured based on their fair values.⁹⁶ “Fair value” is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.⁹⁷ A fair value measurement assumes the highest and best use by the market participants, taking into consideration the use of the asset that is physically possible, legally permissible, and financially feasible at the measurement date.⁹⁸

Items worth highlighting in the context of measurement include:

Property, Plant, and Equipment.

Items of property, plant, and equipment (PP&E) acquired in a business combination, are measured at fair value upon initial recognition.⁹⁹ This is the case even if an entity acquires PP&E—for example, a real estate property—that it intends to use in a manner other than its highest and best use. Highest and best use is a valuation concept that refers to the use of an asset that maximizes the value of the asset or the group of assets in which the asset is used by market participants.¹⁰⁰ In particular for PP&E, the application of the highest and best use concept could have a significant effect on the fair value measurement.

Property, Plant, and Equipment to Be Sold.

An exception to the fair value measurement principle is provided in situations in which PP&E is acquired with the intention that it be sold, provided that the PP&E meets the criteria as “held for sale” outlined in ASC 360-10-45-9 (paragraph 30 of Statement No. 144).¹⁰² Such PP&E is classified as held for sale and measured at fair value less costs to sell.¹⁰³

Intangible Assets.

Intangible assets are generally to be measured based on their fair values.¹⁰⁴ An intangible asset arising from a contractual or other legal right represents the future cash flows that are expected to result from the ownership of that contractual or legal right. The FASB observed that “a contract may have value for reasons other than terms that are favorable relative to market prices. The Board therefore concluded that the amount by which the terms of a contract are favorable relative to market prices would not always represent the fair value of that contract.”¹⁰⁵

Since the issuance of Statements Nos. 141 and 142, industry practice, largely driven by Securities and Exchange Commission (SEC) comment letters, has developed with respect to identifying and measuring the individual assets and liabilities (balance sheet credits) that are recorded upon the acquisition of real estate properties. Changes to prior industry practice relate primarily to the valuation of buildings—to be valued on an as-if-vacant basis—and the separate recognition and valuation of in-place leases.

The requirement to measure intangibles at fair value necessitates a consideration of future contract renewals, consistent with FASB's view that estimates used should incorporate assumptions that market participants would use in making estimates of fair value. In a lease with renewal options granted to the lessee, it appears appropriate to assume that a lessee would likely not renew a lease at above-market terms and that a lessee would renew the lease if it could renew at below-market terms (or if the lessee was to incur a contractual or economic penalty if it decided not to exercise its renewal option).

In-Place Leases at Market.

With respect to the valuation of in-place leases at market, one possible valuation approach may be to calculate—from an investor's perspective—the present value of the cash flow difference of acquiring the property with the in-place leases (at current market rates) versus acquiring the property without leases in place and having to lease up the property. That cash flow differential is an approximation of the difference a seller would expect to receive when selling a building already leased up versus selling a building without leases in place. The following elements are often significant when evaluating that cash flow differential in the purchase of income-producing properties:

In-Place Leases above and below Market.

The fair value of the above- and below-market component of in-place leases is generally determined by calculating the present value of the difference in cash flows between the contractually agreed-upon rentals and current prevailing rental rates for the leases in place in the same geographic area at the time of acquisition.

1.6.5 Allocation of Acquisition Cost

Purchase of a Business.¹⁰⁶

In the purchase of real estate property that meets the definition of a business, the acquisition cost is allocated to the assets acquired and liabilities assumed based on their fair values; acquisition-related costs are expensed. Any excess of cost over the amounts assigned to assets acquired and liabilities assumed is recognized as goodwill. In certain purchase transactions, commonly referred to as bargain purchases, the fair value of the real property acquired exceeds the consideration transferred; the difference is recognized as gain in the period of acquisition.¹⁰⁷ Bargain purchases may occur, for example, in a forced liquidation or distress sale (i.e., the purchase is a true bargain).¹⁰⁸

Purchase of Asset/Asset Group.

If the purchase of real estate does not constitute a business, the acquisition cost is allocated to the individual assets and liabilities acquired based on their relative fair values.¹⁰⁹ The allocation of the acquisition cost based on the fair values of individual assets and liabilities, with a residual being allocated to one of the elements, is not an acceptable method. The SEC staff has expressed the following view with respect to the use of a residual method in business combinations, the concept of which applies—by analogy—to asset acquisitions also:¹¹⁰

Some have asserted that the residual method provides an acceptable approach for determining the fair value of the intangible asset to which the residual is assigned, either because it approximates the value that would be attained from a direct value method or because they believe that other methods of valuation are not practicable under the circumstances. Others have indicated that the residual method should be used as a proxy for fair value of the intangible asset in these situations, since the fair value of the intangible asset in question is not determinable. . . .

The SEC staff believes that the residual method does not comply with the requirements of Statement 141. . . . The SEC staff notes that a fundamental distinction between other recognized intangible assets and goodwill is that goodwill is both defined and measured as an excess or residual asset, while other recognized intangible assets are required to be measured at fair value. The SEC staff does not believe that the application of the residual method to the valuation of intangible assets can be assumed to produce amounts representing the fair values of those assets.

The requirement in Topic 350, Intangibles—Goodwill and Other (FASB Statement No. 142), to allocate the purchase price in an asset acquisition based on the relative fair values of the assets acquired and liabilities assumed is frequently implemented in the following manner:

Any difference between the acquisition cost and the fair value of the net assets acquired is allocated to the assets acquired based on their relative fair values, except for financial assets (other than investments accounted for by the equity method); assets that are subject to a fair value impairment test, such as inventories; and any indefinite-lived assets. Allocating cost to these assets in an amount above their fair values would frequently require the recognition of an impairment loss subsequent to the acquisition of the asset group.

An acquirer may find that the acquisition cost of the property is far in excess of the fair value of the assets acquired and liabilities assumed; such a large discrepancy could be an indication that either (1) not all intangibles have been identified or (2) certain fair value determinations are not appropriate.

1.6.6 Accounting for Intangibles Subsequent to Acquisition

The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with an indefinite useful life is not amortized; an intangible asset with a finite useful life is amortized over its expected useful life to the reporting entity using a method of amortization that reflects the pattern in which the economic benefits of the intangible asset are consumed or used up. A straight-line amortization method is deemed appropriate if that pattern cannot be reliably determined.¹¹² The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of the entity. The amount of an intangible asset to be amortized is the amount assigned to that asset at the time of acquisition less any residual value,¹¹³ with the presumption being that the residual value of an intangible asset is zero. ASC 350-30-35-8 (paragraph 13 of Statement No. 142) states:

The amount of an intangible asset to be amortized shall be the amount initially assigned to that asset less any residual value. The residual value of an intangible asset shall be assumed to be zero unless at the end of its useful life to the entity the asset is expected to continue to have a useful life to another entity and either of the following conditions is met:

In-Place Leases above and below Market.

The above- or below-market value of in-place leases is amortized over the remaining term of the leases (including any expected renewals if renewal assumptions were used to determine the fair value of the in-place leases¹¹⁴) and presented either as a reduction of or an addition to rental revenue. The theory behind that presentation in the income statement is that the acquirer paid a premium for above-market leases or received a discount for leases with contractual terms that are below market. When including the amortization of the above- or below-market component of in-place leases in rental revenue, the revenue in the income statement more closely reflects rental revenue that represents market terms.

1.6.7 Key Differences: Business versus Asset Acquisitions

Key differences between the acquisition of an asset/asset group and the acquisition of a business are outlined in Exhibit 1.3.

1.7 Special Accounting Issues

1.7.1 Costs of Amenities

Amenities are facilities that benefit or enhance a real estate project; they are often used by a developer as a marketing tool, particularly in a soft real estate market. They include golf courses, swimming pools, lakes, parks, and marinas to make a development more desirable as well as sewage treatment plants or other utilities required by regulatory authorities. Amenities may or may not be revenue producing.

The costs to be capitalized for the construction of amenities are determined in accordance with the criteria for cost capitalization discussed in Section 1.2 of this chapter. As a general rule, the Real Estate Project Costs Subsections of Topic 970 (FASB Statement No. 67) provide that costs of amenities be allocated among the land parcels that benefit from the amenities, to the extent that the development of the parcels is probable.¹¹⁸ The term “land parcel” is to be interpreted broadly: It may be an individual lot, unit, or phase of a real estate project.

The accounting treatment of amenities depends on whether the developer intends to (1) sell or transfer the amenities in connection with the sale of individual units or (2) sell the amenities separately to a third party or retain and operate the amenities. For example, clubhouses may be transferred to a homeowners' association upon completion or sell-out of a development, whereas golf courses may be retained and operated by a developer.

Subtopic 970-340 (FASB Statement No. 67) provides guidance for the treatment of costs incurred in connection with the construction and operation of amenities that are to be sold or transferred in connection with the sale of individual units and that are to be sold separately to a third party or retained by the developer.

Amenities That Are to Be Sold or Transferred in Connection with the Sale of Individual Units.¹¹⁹

Amenities that are to be sold or transferred in connection with the sale of individual units are clearly associated with the development and sale of the units in a project. To the extent that the costs of amenities and any expected future operating costs to be borne by the developer—until they are assumed by the buyers of the individual units—are not recoverable through proceeds from a future sale of these amenities, they are considered common costs of the project. Any changes in estimates related to construction costs, to the operating results of the amenities before they are assumed by the buyers of the individual units, or to the sales proceeds of the amenities (if any) are treated as changes in estimates and accounted for prospectively in accordance with Topic 250, Accounting Changes and Error Corrections (FASB Statement No. 154, Accounting Changes and Error Corrections).

Amenities That Are to Be Sold Separately to a Third Party or Retained by the Developer.¹²⁰

If a developer plans to sell amenities to a third party or retain them, capitalizable costs in excess of the estimated fair value of the amenities as of the date of substantial completion are allocated as common project costs. If a change in cost or fair value estimate of the amenities occurs prior to the amenities being substantially completed, the allocation of the amenities' costs to common costs of the project is revisited. After the amenities are substantially completed, no cost reallocations are made; accordingly, a subsequent sale may result in a gain or loss, which is included in the period of sale.

Operating results for amenities that are sold separately to a third party or operated by the developer are treated as follows:¹²¹

See Exhibit 1.4 for a graphic depiction of the accounting for costs of amenities.

1.7.2 Start-up Costs

Start-up activities are one-time activities relating to opening a new facility, introducing a new product or service, conducting business in a new territory or with a new class of customer, initiating a new process, organizing a new entity, or commencing some new operation.¹²² Start-up costs are costs incurred in connection with start-up activities; they are expensed as incurred.¹²³

A retailer may construct a facility in which it plans to operate a new store. Between the time of completion of the facility and the store opening, there is typically a period of time during which start-up activities take place—for example, inventory may be stocked, employees may be trained, and registers may be tested. Costs incurred in connection with these activities are not part of the acquisition, development, and construction costs of the facility; they are start-up costs. The determination of whether costs constitute start-up costs is based on the nature of the activities and not necessarily on the time period in which they occur; that is, start-up costs may be incurred before operations begin or after operations have begun but before the normal productive capacity is reached.¹²⁴

Some examples of start-up costs within the scope of Subtopic 720-15 (SOP 98-5, Reporting on the Costs of Start-up Activities) are:¹²⁵

Examples for costs incurred in conjunction with start-up activities that are outside the scope of Subtopic 720-15 (SOP 98-5) are:¹²⁶

1.7.3 Land Options

Obtaining land options is a common means for land developers and homebuilders to secure land for future development without having to finance the land, incur carrying costs, and bear the risk of a decline in land value. In exchange for the payment of an option premium, the option holder obtains the right to purchase the land under option at a fixed price over a certain period or at some future point in time. As discussed in Section 1.2.1, option premiums are preacquisition costs that qualify for cost capitalization.¹³⁰

The option holder may be required to consolidate the entity owning the land under option pursuant to the variable interest entity (VIE) consolidation guidance in Topic 810, Consolidation (the provisions of FASB Interpretation No. (FIN) 46(R), Consolidation of Variable Interest Entities), rather than merely capitalizing the option premium. Whether consolidation guidance has to be evaluated depends on the counterparty to the transaction. If the land under option is owned by an individual, such as a farmer, no further considerations are necessary. If, however, the land under option is being held by a legal entity, the VIE consolidation guidance (the provisions of FIN 46(R)) may apply. More often than not, land under option is held by a legal entity, because through a legal structure the option holder can obtain better control over the land under option; it also isolates the land from any liabilities of the owner. As such, holders of land options will likely have to consider the VIE consolidation guidance. When performing a VIE consolidation analysis, holders of land options need to consider any other arrangements with the entity; they may have agreements in place to develop the land, to provide financing, or to guarantee certain obligations of the entity. Contractual arrangements between the entity owning the land and the option holder (or any related party) may constitute variable interests that impact the evaluation of whether the option holder has to consolidate the entity owning the land.

VIE consolidation analyses are very complex; the discussion in this section highlights some aspects that need to be considered when evaluating land options. It is not intended to cover all aspects. Section 6.2.1.1 of Chapter 6 also discusses land options in the context of the VIE consolidation guidance.

Land under Option Is Majority of Entity's Assets.

A legal entity owns land and has granted to a homebuilder the option to purchase the land at a fixed price within a specified period of time. If the land under option represents the entity's only asset or a majority of the entity's assets when measured at fair value, the option is a variable interest in the entity. In that case, the entity generally meets the definition of a VIE for this reason: As a result of the option, the option holder has the ability to participate in the future appreciation of the land. In VIE speak, the entity's holders of equity investment at risk do not have the right to receive the entity's expected residual returns.¹³¹ Whenever the holders of an entity's equity investment at risk do not have the right to receive the entity's expected residual returns, the entity meets the definition of a VIE.¹³² The entity may also be considered a VIE for reasons other than the one cited, such as insufficient equity investment at risk.

Land under Option Is Not Majority of Entity's Assets.

Variable interests in assets that comprise 50% or less of the fair value of an entity's assets are not considered variable interests in the entity and do not pose any VIE (FIN 46(R)) consolidation issues, with two exceptions:

Option Holder Holds Another Variable Interest in the Entity.

Topic 810 (FIN 46(R)) provides that a variable interest in specified assets of an entity that comprise 50% or less of the entity's assets is considered a variable interest in the entity if the variable interest holder holds another variable interest¹³³ —for example, an equity interest—in the entity itself. In that case, the entity would generally meet the definition of a VIE.

A Silo Has Been Created.¹³⁴

Silos exist if the variability arising from specified assets inures to the benefit or detriment of variable interest holders in these assets rather than to the benefit or detriment of variable interest holders in the entity. In other words, essentially none of the variability generated by these specified assets affects the expected losses or expected residual returns of the variable interest holders of the entity.

If such a silo exists, it has to be evaluated whether the entity meets the criteria of a VIE. If the entity does not meet the criteria of a VIE, no further VIE consolidation (FIN 46(R)) considerations are necessary.

The consolidation considerations related to land options are illustrated in Exhibit 1.5.

Consolidation Considerations.

Once it has been determined that the option holder holds a variable interest in a VIE or in any siloed assets of a VIE, the option holder has to evaluate whether it has to consolidate the entity or silo.¹³⁵ Broadly speaking, an option holder is required to consolidate a silo or VIE when the option holder has a controlling financial interest. Section 6.2.1.1.3 of Chapter 6 includes a discussion of the factors to be considered when determining whether the holder of a land option holds a controlling financial interest in the VIE.

The features of the option, particularly refundability and amount of option premium relative to the fair value of the optioned land, played a major role when determining which variable interest holder was the primary beneficiary before the amendment to FIN 46(R) by FASB Statement No. 167 in June 2009.¹³⁶ The assessment of whether the holder of land options has to consolidate the land option entity or not is dependent on the facts and circumstances and requires significant judgment. In many instances, homebuilders that had consolidated land option entities as a result of the application of FIN 46(R) deconsolidated these entities after the effective date of FASB Statement No. 167.¹³⁷

1.7.4 Financing as Part of a Purchase Transaction

In real estate acquisitions, financing is often an integral part of the purchase transaction. The seller may provide financing to the buyer, or the buyer may assume a mortgage on the property. When financing is provided in an arm's-length transaction, there is a presumption that the stated interest rate is fair and adequate. This presumption is not appropriate when (1) the note does not have a stated interest rate, (2) the stated interest rate is unreasonable, (3) the stated face amount of the note (together with any down payment) is materially different from the current cash sales price for similar property, or (4) the stated face amount of the note is materially different from the market value of the note at the date of the transaction.¹³⁸

If financing is provided at unreasonable rates, the property acquired should be recorded at (1) the fair value of the property or (2) an amount that approximates the market value of the note plus the fair value of any other consideration provided to the seller, whichever is more clearly determinable.¹³⁹ If such determination cannot be made due to a lack of established exchange prices or market value of the note, the present value of the note should be determined by discounting all future payments on the note using an imputed rate of interest. The rate used to determine the present value of the note should equal or approximate the rate at which the debtor could obtain financing from other sources at the date of the transaction. “The objective . . . is to approximate the rate that would have resulted if an independent borrower and . . . lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase that bears the prevailing rate of interest to maturity.”¹⁴⁰ Accordingly, the facts and circumstances of the individual transaction need to be considered. This includes an evaluation of the terms of the financing, any collateral and security provided to the lender, the down payment the purchaser has made, the credit rating of the purchaser, and tax consequences to the buyer and seller.¹⁴¹

If it has been determined that financing has been provided at an unreasonable rate and that the imputation of interest is required, the difference between the present value and the face amount of the note is treated as discount or premium and amortized as interest expense. The discount or premium is eligible for inclusion in the amount of interest cost capitalized in accordance with Topic 835 (FASB Statement No. 34).¹⁴²

With respect to the presentation of such premium or discount in the financial statements, ASC 835-30-45-1A and 45-2 (paragraph 16 of APB Opinion No. 21) provide:

The discount or premium resulting from the determination of present value in cash or noncash transactions is not an asset or liability separable from the note that gives rise to it. Therefore, the discount or premium shall be reported in the balance sheet as a direct deduction from or addition to the face amount of the note. It shall not be classified as a deferred charge or deferred credit.

The description of the note shall include the effective interest rate; the face amount shall also be disclosed in the financial statements or in the notes to the statements.

1.7.5 Environmental Costs and Liabilities

Property owners are required to comply with federal, state, and local laws that govern the removal and containment of environmental contamination in land and buildings. Being subject not only to current but also to future legislation, property owners may incur significant costs for known or yet undiscovered conditions or events.

Real estate acquisition and development is affected by accounting issues relating to environmental cleanup, particularly by issues related to the recognition and measurement of liabilities, the accounting for environmental cleanup costs (i.e., capitalizing versus expensing of costs) as well as financial statement presentation and disclosures. Depending on the type of contamination, different guidance applies to the accounting for costs incurred in connection with environmental cleanup.

1.7.5.1 Asset Retirement Obligations

Subtopic 410-20, Asset Retirement Obligations (FASB Statement No. 143, Accounting for Asset Retirement Obligations), provides guidance related to legal obligations associated with the retirement¹⁴³ of a tangible long-lived asset that result from the acquisition, development or construction, or normal operation of the long-lived asset. “Retirement” is defined as the other-than-temporary removal of a long-lived asset from service, which encompasses sale, abandonment, recycling, or disposal in some other manner. However, it does not encompass the temporary idling of a long-lived asset.¹⁴⁴

Although not addressed further in this section, asset retirement obligations are not necessarily tied to environmental contamination or cleanup. For example, a landowner that grants a company the right to cut down timber may impose an obligation on that company to reforest the land at the end of the agreement.¹⁴⁵ Obligations may also be imposed on lessees, such as the obligation to remove leasehold improvements at the end of a lease. If the lessee is obligated to make or can be required to make such payments in connection with the leased property, the payments meet the definition of minimum lease payments;¹⁴⁶ Subtopic 840-10 (FASB Statement No. 13) rather than Subtopic 410-20 (FASB Statement No. 143) applies to the obligations of a lessee that meet the definition of minimum lease payments or contingent rentals.¹⁴⁷ Determining whether an obligation to retire a leased asset should be accounted for as a minimum lease payment or as an asset retirement obligation is facts and circumstances based. As a general rule, if the obligation is directly related to the leased asset (or a component thereof), the lessee should account for the obligation in accordance with Subtopic 840-10 (Statement No. 13). Conversely, if the asset retirement obligation relates to lessee-owned assets placed into service by the lessee at the leased premises, or if the asset retirement obligation relates to improvements made to the leased property by the lessee during the lease term, the lessee would generally account for them as asset retirement obligations following the provisions of Subtopic 840-10 (Statement No. 143).

Legal obligations associated with the retirement of tangible long-lived assets, which give rise to asset retirement obligations, can result from (1) a government action, such as a law or statute; (2) an agreement between entities; or (3) a promise conveyed to a third party that imposes a reasonable expectation of performance.¹⁴⁸

Recognition and Measurement.

An asset retirement obligation should be recognized at fair value in the period in which it is incurred, if a reasonable estimate of fair value can be made; otherwise, it should be recognized at fair value at a later point in time, when such reasonable estimate of fair value can be made. Instances in which asset retirement obligations are not reasonably estimable are expected to be rare. If a tangible long-lived asset with an existing asset retirement obligation is acquired, a liability for that obligation needs to be recognized at the asset's acquisition date as if that obligation were incurred on that date.¹⁴⁹

The fair value of an asset retirement obligation is reasonably estimable if at least one of these criteria is met:¹⁵⁰

Upon recognition of an asset retirement obligation, a company capitalizes a corresponding asset retirement cost by increasing the carrying amount of the related long-lived asset by the same amount as the liability. That asset retirement cost is charged to expense over the asset's useful life, using a systematic and rational method.¹⁵¹

A liability for an asset retirement obligation may be incurred over more than one reporting period if the events that create the obligation occur over more than one reporting period. Any incremental liability incurred in a subsequent reporting period is considered to be an additional layer of the original liability. Each layer is initially measured at fair value. For example, the liability for decommissioning a nuclear power plant is incurred as contamination occurs. Each period, as contamination increases, a separate layer is measured and recognized.¹⁵²

Accounting Subsequent to Initial Recognition.

Subsequent to initial recognition, the asset retirement cost should be charged to expense over its useful life using a systematic and rational allocation method.¹⁵³

The fair value of the liability is adjusted to reflect changes resulting from:

The increase in the fair value of an asset retirement obligation due to the passage of time constitutes accretion expense; changes as a result of revisions to either the timing or the amount of the original estimate of cash flows that do not only affect the current period increase or decrease the carrying amount of the related long-lived asset.¹⁵⁵

Conditional Asset Retirement Obligations.

Conditional asset retirement obligations are not conditional obligations. Rather, they are legal obligations to perform an asset retirement activity, with the timing and/or method of settlement being conditional on a future event that may or may not be within the control of the entity.¹⁵⁶ As such, a liability needs to be recognized in the financial statements if the fair value can be reasonably estimated. When FIN 47, which established the requirement to account for conditional asset retirement obligations, became effective in 2005, many real estate companies recorded asset retirement obligations to reflect their legal obligations in connection with the removal of asbestos in their buildings.

Disclosures.

Subtopic 410-20 (FASB Statement No. 143) requires these disclosures:¹⁵⁸

Additionally, in certain rare instances in which a company is not able to estimate the fair value of an asset retirement obligation, financial statement disclosures are required describing that fact and the reason for the company's inability to determine fair value.

1.7.5.2 Environmental Remediation Liabilities

For contamination that is outside of the scope of Subtopic 410-20 (Statement No. 143), a company may nevertheless be required to recognize a liability under Subtopic 410-30 (SOP 96-1, Environmental Remediation Liabilities). Subtopic 410-30 (SOP 96–1) provides accounting guidance for “environmental remediation liabilities that relate to pollution arising from some past act, generally as a result of the provisions of the Superfund, the corrective-action provisions of the Resource Conservation and Recovery Act, or analogous state and non-U.S. Laws and regulations.”¹⁵⁹

A company's association with the site through past or present ownership or operation of a site, or the contribution or transportation of waste to a site, at which remedial actions (at a minimum, investigation) must take place may give rise to the recognition of an environmental remediation liability. For a liability to be recognized in the financial statements, this underlying cause must have occurred on or before the date of the financial statements.¹⁶⁰

Following the accounting guidance provided by Topic 450 (FASB Statement No. 5, Accounting for Contingencies), a liability needs to be accrued if (1) information available prior to the issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements (“probability criterion”) and (2) the amount of the loss can be reasonably estimated.

Probability Criterion.

ASC 410-30-25-4 (paragraph 108 of SOP 96-1) provides that in the context of environmental remediation liabilities, the probability criterion in ASC 450-20-25-2 (FASB Statement No. 5) is met if both of the following elements are present on or before the date the financial statements are issued:

If litigation has commenced, a claim or an assessment has been asserted, or commencement of litigation or assertion of a claim or assessment is probable, and the company is associated with the site, there is a presumption that the outcome of the claim or assessment will be unfavorable.¹⁶¹

Ability to Reasonably Estimate the Liability.

Once a company has determined that it is probable that an environmental remediation liability has been incurred, the company should estimate that liability based on available information. The estimate of the liability includes the company's (1) allocable share of the liability for a specific site as well as its (2) share of amounts related to the site that will not be paid by other potentially responsible parties or the government.¹⁶²

Due to the fact that environmental remediation is a complex process involving many steps, estimating the amount required to effect such remediation may prove difficult. This is particularly true in the beginning stages of remediation.¹⁶³ The ability to reasonably estimate a range of loss is sufficient to meet the requirement for the recognition of an accrual in ASC 450-20-25-2(b) (FASB Statement No. 5), assuming it is probable that an environmental remediation liability has been incurred.¹⁶⁴

Measurement.

Subtopic 410-30 (SOP 96–1) provides that “the overall liability that is recorded may be based on amounts representing the lower end of a range of costs for some components of the liability and best estimates within ranges of costs of other components of the liability.”¹⁶⁵ If various potentially responsible parties are involved, the amount to be recorded as a liability is based on the company's estimate of the share of the joint and several remediation liability that will ultimately be allocated to the company.¹⁶⁶

Costs that should be included in determining the amount of liability are:¹⁶⁷

AcSEC concluded that for purposes of measuring environmental remediation liabilities, the measurement should be based on enacted laws and adopted regulations and policies rather than laws that are expected to be in force at a future point in time. The impact of changes in laws, regulations, and policies should be recognized when such changes are enacted or adopted.¹⁶⁸

Subtopic 410-30 (SOP 96-1) is more restrictive than Subtopic 410-20 (Statement No. 143) as far as the discounting of the liability is concerned; discounting of the liability is permissible only if the aggregate amount of the liability (or component of the liability) and the amount and timing of cash payments for the liability (or component) are fixed or reliably determinable.¹⁶⁹ Entities that file with the SEC should follow the guidance in SEC Staff Accounting Bulletin (SAB) Topic 5Y.¹⁷⁰ That SAB discusses the appropriate discount rate to be used for a registrant's estimate of an environmental remediation liability that meets the criteria for discounting in ASC 410-30-35-12 (paragraph 12 of SOP 96-1): The rate used to discount the cash payments should be the rate that will produce an amount at which the environmental liability could be settled in an arm's-length transaction with a third party.

Potential Recoveries.

A company may expect to recover certain amounts expended for environmental remediation; for example, amounts may be recoverable from other potentially responsible parties, from the government, or from insurance companies. The amount of an environmental remediation liability should be determined independent from any potential claim for recovery, and an asset relating to any recovery should be recognized only when realization of the claim for recovery is deemed probable. If the claim is the subject of litigation, a rebuttable presumption exists that realization of the claim is not probable.¹⁷¹

Presentation and Disclosure.

Generally, expenses related to environmental remediation are included in operating expenses, because the events underlying the incurrence of the obligation relate to the operations of a company. ASC 410-30-45-4 (paragraph 149 of SOP 96-1) explains:

Although charging the costs of remediating past environmental impacts against current operations may appear debatable because of the time between the contribution or transportation of waste materials containing hazardous substances to a site and the subsequent incurrence of remediation costs, environmental remediation-related expenses have become a regular cost of conducting economic activity. Accordingly, environmental remediation-related expenses shall be reported as a component of operating income in income statements that classify items as operating or nonoperating. Credits arising from recoveries of environmental losses from other parties shall be reflected in the same income statement line. Any earnings on assets that are reflected on the entity's financial statements and are earmarked for funding its environmental liabilities shall be reported as investment income.

Depending on the facts and circumstances, environmental remediation liabilities may be recorded on a discounted or undiscounted basis. Subtopic 235-10, Notes to Financial Statements Overall (APB Opinion No. 22, Disclosure of Accounting Policies), requires the disclosure of accounting principles that materially affect the determination of financial position or results of operations, particularly where accounting alternatives exist. With respect to environmental remediation obligations, financial statements should disclose whether the accrual for environmental remediation liabilities is measured on a discounted or undiscounted basis.¹⁷² ASC 450-20-S99-1 (SAB Topic 5Y) also discusses disclosure requirements related to liabilities for environmental remediation that are discounted and gives detailed examples of disclosures that may be necessary to prevent the financial statements from being misleading.¹⁷³ An excerpt from that guidance follows:

The staff believes that product and environmental remediation liabilities typically are of such significance that detailed disclosures regarding the judgments and assumptions underlying the recognition and measurement of the liabilities are necessary to prevent the financial statements from being misleading and to inform readers fully regarding the range of reasonably possible outcomes that could have a material effect on the registrant's financial condition, results of operations or liquidity.

Additionally, Subtopic 450-20 (FASB Statement No. 5) requires certain disclosures for loss contingencies, including disclosures related to the nature of accruals. If no accrual is recognized for environmental remediation because the criteria for recording a liability have not been met, the contingency needs to be disclosed when there is at least a reasonable possibility that a loss may have been incurred.¹⁷³ Subtopic 410-30 (SOP 96-1) provides additional guidance related to disclosures for environmental remediation loss contingencies.¹⁷⁴

1.7.5.3 Capitalizing versus Expensing of Environmental Remediation Costs

Recording an environmental remediation liability usually results in a corresponding charge to income.¹⁷⁵ In certain limited situations, it is appropriate to capitalize environmental remediation costs. Environmental treatment costs may be capitalized if one of these criteria is met, assuming the costs are recoverable:¹⁷⁶

ASC 410-30-55-18 through 55-26 (EITF Issue No. 90-8) include explicit examples with respect to the question of when it is appropriate to capitalize versus expense costs to treat environmental contamination.

1.7.6 Transactions with Related Parties

This section discusses three aspects of related party relationships:

1.7.6.1 Financing Provided by Related Parties

As outlined in Section 1.2.2.5 of this chapter, interest cost incurred during the development and construction period of a real estate project is capitalized and becomes part of project costs. That interest cost includes interest cost incurred on financing provided by a parent company or affiliate. The related interest income to the parent or affiliate is deferred to the extent of any ownership interest in the project or in the company; in subsequent periods, such deferred interest income is amortized to offset the company's amortization of capitalized interest cost, if the building is used in the company's operations, or recognized into income upon sale of the real estate property.

If a real estate project is financed by a parent company that does not charge interest, no interest cost may be capitalized at the subsidiary level, since the subsidiary does not incur any interest cost.¹⁸⁰ The capitalization of interest is nevertheless appropriate at the consolidated level; the amount to be capitalized at the consolidated level is determined by following the four-step approach outlined in Section 1.2.2.5 of this chapter.

1.7.6.2 Interest Capitalization on Investments Accounted for by the Equity Method

ASC 835-20-15-5 (paragraph 9(c) of FASB Statement No. 34) provides that assets qualifying for interest capitalization include investments (equity investments, loans, and advances) accounted for by the equity method while the investee has activities in progress necessary to commence its planned operations, provided that the investee's activities include the use of funds to acquire qualifying assets for its operations. The investor's investment in the investee, not the individual assets or projects of the investee, is the qualifying asset for purposes of interest capitalization. Interest capitalization on investments in equity method investees is illustrated in more detail in Chapter 6 (Section 6.5.8).

1.7.6.3 Purchase of Real Estate from Entity under Common Control

In real estate purchase transactions between unrelated parties, the purchaser of real estate generally records the real estate acquired at its purchase price. The purchase price represents the culmination of arm's-length bargaining and presumably is reflective of the fair value of the real estate property. An exception to this general rule is the acquisition of property from a party that is under common control with the buyer; parties under common control do not bargain at arm's length, because the shareholders are essentially self-dealing.

If companies under common control enter into transactions that are in the ordinary course of business, the agreed-upon purchase price is readily comparable to the price negotiated in similar transactions with unrelated parties. In these types of transactions, the purchaser is ordinarily not precluded from recording property acquired at its purchase price, if the agreed-upon purchase price is reflective of the market price. However, because of the special characteristics of real estate, the purchase of real estate from a party under common control is generally not comparable to similar transactions with unrelated parties. A step-up in basis by the acquirer is therefore not considered appropriate;¹⁸¹ rather, real estate purchased from an entity under common control is recorded at the transferor's carrying value at the time of transfer, irrespective of whether the property acquired meets the definition of a business.¹⁸² Any excess of consideration given over the transferor's carrying value is accounted for as a reduction in equity, often referred to as “dangling debit.” Authoritative literature does not address the accounting for dangling debits. Companies account for a dangling debit in one of two ways. They:

Concept of Common Control.

What transactions are considered common control transactions? The EITF discussed the definition of “common control” in EITF Issue No. 02-5, Definition of Common Control in Relation to FASB Statement No. 141. Paragraph 3 of EITF Issue No. 02-5¹⁸³ states:

The FASB staff understands that the SEC staff has indicated that common control exists between (or among) separate entities only in the following situations:

1.8 Financial Statement Presentation and Disclosure

1.8.1 Cash Flow Statement Presentation

Pursuant to Topic 230, Statement of Cash Flows (FASB Statement No. 95, Statement of Cash Flows), investing activities include acquiring and disposing of PP&E and other productive assets (i.e., assets held for or used in the production of goods or services by the entity). Operating activities include all transactions and other events that are not defined as investing or financing activities, which generally involve producing and delivering goods and providing services.¹⁸⁴

The classification of cash payments for real estate acquired or constructed depends on the intended use for the property. Cash paid to acquire or construct real estate that will be used as “productive asset,” such as rental property, is classified as investing cash outflows. However, if land was acquired by a real estate developer to be subdivided and sold, any cash payments to purchase that real estate would be classified as operating cash flows; the real estate acquired is akin to inventory in other businesses.¹⁸⁵

The three categories of operating, investing, and financing are not necessarily mutually exclusive (i.e., alternative classifications are acceptable in certain situations).¹⁸⁶ For example, if an office building is being constructed that is intended for sale after it has been leased up, a question may arise as to whether that property should be treated like inventory, with any cash payments to acquire and construct the asset being classified as operating cash flows, or whether it should be viewed as a productive asset, with any cash flows being classified as investing cash flow.

In instances in which a cash payment pertains to an item that could be considered either inventory or a productive asset, the appropriate classification depends on the activity that is likely to be the predominant source of cash flows for the item. ASC 230-10-45-22 (paragraph 24 of Statement No. 95) includes this example to illustrate that concept:

[T]he acquisition and sale of equipment to be used by the entity or rented to others generally are investing activities. However, equipment sometimes is acquired or produced to be used by the entity or rented to others for a short period and then sold. In those circumstances, the acquisition or production and subsequent sale of those assets shall be considered operating activities.

1.8.2 Segment Disclosures for Public Companies

Topic 280, Segment Reporting (FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information), requires that public companies report in their financial statements certain information about their reportable operating segments.

An operating segment is a component of a public entity that has these three characteristics:

Public real estate companies have to carefully evaluate whether they are required to report information about operating segments in their financial statements. For example, a homebuilder may manage its business based on geographic regions. If information related to geographic regions is regularly provided to the chief operating decision maker of the homebuilder, the homebuilder would likely be considered to have more than one operating segment.¹⁸⁸ In situations in which these operating segments do not have similar economic characteristics (e.g., they may have dissimilar operating margin percentages or trends), they do not meet the criteria for segment aggregation in ASC 280-10-50-11 (paragraph 17 of FASB Statement No. 131).

1.8.3 Other Presentation and Disclosure Requirements

Disclosures Related to the Capitalization of Interest.

ASC 835-20-50-1 (paragraph 21 of FASB Statement No. 34) requires these disclosures relating to interest cost, either in the income statement or in the notes to the financial statements:

Presentation and Disclosures Related to the Acquisition of Intangibles.

A company acquiring intangible assets (such as in-place leases in connection with the acquisition of income-producing properties) is subject to the financial statement presentation and disclosure requirements outlined in ASC 350-30-45-1 through 45-3 and ASC 350-30-50-1 through 50-5 (paragraphs 42 through 47 of Statement No. 142). Intangible assets need to be presented as a separate line item (or separate line items) in the balance sheet. Similarly, the aggregate amount of goodwill also needs to be presented as a separate line item in the balance sheet.¹⁸⁹

ASC 350-30-50-1 (paragraph 44 of Statement No. 142) includes these disclosure requirements in the period of acquisition:

ASC 350-20-50-1 and 50-2 (paragraph 45 of Statement No. 142) include these disclosure requirements for each period for which a balance sheet is presented:

Companies that report segment information in accordance with Topic 280 (FASB Statement No. 131) are required to provide the information about goodwill in total and for each reportable segment, as well as any significant changes in the allocation of goodwill by reportable segment. Additional disclosure requirements exist if a portion of the goodwill has not been allocated to a reporting unit.¹⁹⁰

Additionally, ASC 350-20-50-2 (FASB Statement No. 142) has specific disclosure requirements if a company recognizes an impairment loss related to intangible assets or goodwill.¹⁹¹

1.9 International Financial Reporting Standards

Two international accounting standards deal with PP&E: International Accounting Standard (IAS) 40, Investment Property, which applies to real estate held for investment purposes, and IAS 16, Property, Plant and Equipment, which applies to all other types of tangible, long-lived assets. The acquisition of a business, which often occurs when income-producing properties are acquired, is governed by International Financial Reporting Standard (IFRS) 3, Business Combinations.

1.9.1 IAS 16, Property, Plant and Equipment

IAS 16 provides a comprehensive model that deals with the acquisition, development, and construction costs of PP&E as well as with costs incurred subsequent to a property's acquisition or construction.

Recognition Criteria for Property, Plant, and Equipment.¹⁹²

An item of PP&E is recognized as an asset only if both of the following criteria are met:

Initial Measurement of Property, Plant, and Equipment.

PP&E that qualifies for recognition as an asset is measured at its cost, which is the amount of cash or cash equivalents paid and/or the fair value of other consideration given to acquire the asset at the time of acquisition or construction.¹⁹³ The recognition of costs ceases when the item is in the location and condition necessary for it to be capable of operating in the manner intended by management.

The cost of PP&E is comprised of:¹⁹⁴

Examples of costs that are not capitalizable as part of the cost of the asset:¹⁹⁶

The cost of a self-constructed asset is determined by applying the same principles as for an acquired asset. If an entity produces similar assets for sale in the normal course of business, the cost of the asset is usually the same as the cost of constructing an asset for sale, which is addressed in IAS 2, Inventories.¹⁹⁷

Interest Capitalization.

Borrowing costs that are directly attributable to construction are required to be capitalized as a component of the carrying amount of a self-constructed asset, assuming that the asset is a qualifying asset. An asset is a qualifying asset if the asset “necessarily takes a substantial period of time to get ready for its intended use or sale.”¹⁹⁸ IFRSs use the avoided cost model for the determination of whether borrowing costs are directly attributable to a qualifying asset. Borrowing costs that would have been avoided if the expenditure on the asset had not been made are deemed directly attributable to the construction of the asset.¹⁹⁹ In some situations, an entity may borrow funds for a specific assets, and the borrowing costs that directly relate to that asset can be readily identified. In other situations, such as when funding occurs within entities of a group, that determination may be more difficult; accordingly, an entity needs to exercise judgment.²⁰⁰

Exhibit 1.6 depicts guidelines set forth in IAS 23 for the capitalization of borrowing costs.²⁰¹

Exhibit 1.6 Capitalization of Borrowing Costs

Measurement after Initial Recognition.

Two models exist for measuring PP&E subsequent to initial recognition: (1) the cost model and (2) the revaluation model. The accounting policy a company selects—cost model or revaluation model—has to be applied to an entire asset class of PP&E.²⁰² A company's assets of similar nature and use in its operations form an asset class. Land, land and buildings, furniture and fixtures, and office equipment are examples of separate classes.²⁰³

Use of the Cost Model.

When using the cost model, PP&E is carried at its cost less accumulated depreciation and any accumulated impairment losses.²⁰⁴ The amount subject to depreciation is the difference between an item of PP&E and its residual value. Paragraph 51 of IAS 16 provides that “[t]he residual value and the useful life of an asset shall be reviewed at least at each financial year-end, and, if expectations differ from previous estimates, the change(s) shall be accounted for as a change in accounting estimate [i.e., prospectively] in accordance with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors.”

The residual value of an asset may increase or decrease in periods subsequent to an asset's initial recognition.

Use of the Revaluation Model.

Assets whose fair value can be measured reliably may be accounted for using the revaluation model. Paragraph 31 of IAS 16 provides that under the revaluation model, PP&E is carried at a revalued amount, which is its fair value at the date of revaluation less subsequent depreciation and impairment losses. To ensure that the carrying amount does not materially differ from that which would be determined using fair value at balance sheet date, revaluations have to be made with sufficient regularity. For items of PP&E that experience significant changes in fair value, annual revaluations may be necessary; for other items that experience only insignificant changes in fair value, a revaluation every three to five years may be sufficient.²⁰⁵ However, to avoid a selective revaluation of assets, a simultaneous revaluation of all of the assets of one class is required (or a revaluation of all of the items within a class on a rolling basis provided that the revaluation for the entire class is completed within a short period of time).²⁰⁶

If an asset's carrying amount is increased as a result of a revaluation, the increase is recognized in other comprehensive income (and accumulated under the heading of revaluation surplus), unless it reverses a revaluation decrease of the same asset previously recognized in profit or loss; in that case, any increase is recognized in profit or loss.²⁰⁷ If an asset's carrying amount is decreased as a result of a revaluation, the decrease is recognized in profit or loss, unless a credit balance exists in revaluation surplus with respect to that asset. In the case of a credit balance, the decrease is debited to equity (revaluation surplus).²⁰⁸ Revaluation surplus related to an asset is transferred to retained earnings. The revaluation surplus can either be transferred to retained earnings when the asset is retired or disposed of or the revaluation surplus can be amortized to retained earnings as the asset is being depreciated. Paragraph 41 of IAS 16 explains: “In such a case, the amount of the surplus transferred would be the difference between depreciation based on the revalued carrying amount of the asset and depreciation based on the asset's original cost. Transfers from revaluation surplus to retained earnings are not made through profit or loss.”

If an entity was to elect the revaluation model for asset classes that are depreciated, the entity would effectively report lower income than if the entity elected the cost model. This is because the revaluation amount is directly credited to revaluation surplus (i.e., it is not recorded in income), while the increase in the asset's carrying amount leads to higher depreciation expense in subsequent periods. As the amount accumulated in revaluation surplus is not “recycled” to income or loss at a later point in time, the overall impact on an entity's reported income is negative.

Costs Incurred Subsequent to Initial Recognition.

IAS 16 also provides accounting guidance for costs incurred after the property has been placed in service. IAS 16 differentiates between day-to-day servicing and costs for the replacement of (other than small) parts of an asset. The costs of day-to-day servicing, which may include labor, consumables, and small parts, are expensed as incurred. The costs of a replacement of parts of an item of PP&E are capitalized, assuming the recognition criteria outlined earlier are met. Any remaining carrying amount of the part replaced is derecognized.²⁰⁹

Similarly, costs of major inspections, such as inspections for aircrafts, are capitalized as part of the asset as a replacement, if the recognition criteria for PP&E are met. Any remaining carrying amount of a previous inspection is derecognized at that time.²¹⁰

Disclosures.

IAS 16 requires extensive disclosures for PP&E, including the measurement bases used for determining the gross carrying amount; depreciation methods used; useful lives or depreciated rates used; gross carrying amount and accumulated depreciation at the beginning and the end of the period together with a reconciliation; and information on impaired property.²¹¹

Additionally, paragraph 74 of IAS 16 requires these disclosures:

For items of PP&E that are stated at revalued amounts, these disclosures are required:²¹²

1.9.2 IAS 40, Investment Property

Scope of IAS 40.

IAS 40 provides accounting guidance for investment property. Investment property, which may be land, building, part of a building, or land and building, is defined as property held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for (1) use in the production or supply of goods or services or for administrative purposes or (2) sale in the ordinary course of business.²¹³

Additionally, a lessee may classify and account for property leased under an operating lease as investment property, if the property otherwise meets the definition of investment property, and the lessee uses the fair value model for all other investment property it holds.²¹⁴ Different from an accounting policy choice, this classification alternative is available on a property-by-property basis.

Real estate property may by comprised of a portion that is held to earn rentals or for capital appreciation and another portion that is held for use in the production or supply of goods or services or for administrative purposes. Portions of mixed-use property are accounted for separately, if they could be sold or leased separately under finance leases; otherwise, mixed-use property is considered investment property only if an insignificant portion is held for use in the production or supply of goods or services or for administrative purposes.²¹⁵

A property owner may provide ancillary services to occupants of a property. That property is nevertheless classified as investment property as long as the ancillary services are insignificant to the arrangement (e.g., security and maintenance for office buildings). The property is not considered investment property if the ancillary services provided are significant to the arrangement, such as guest services in an owner-managed hotel.²¹⁶ If not considered investment property, the property would be accounted for as owner-occupied property, and IAS 16 would apply.

Recognition Criteria for Investment Property.²¹⁷

The recognition criteria for investment property are the same as the recognition criteria for PP&E under IAS 16. Investment property is recognized as an asset only if both of these criteria are met:

The IASB's focus is the avoidance of a double recognition of assets. Paragraph 50 of IAS 40 provides, in part:

In determining the carrying amount of investment property under the fair value model, an entity does not double-count assets or liabilities that are recognized as separate assets or liabilities. For example:

No separate assets or liabilities are recognized for any in-place leases (i.e., in-place leases in which the investment property acquired is leased to lessees), whether the leases are at market, favorable, or unfavorable.²¹⁸ That is a distinct difference to the accounting under U.S. GAAP, described in Section 1.6.4 of this chapter.

Assets or liabilities are recognized, however, if investment property is acquired and the acquiree has operating leases in place in which it is the lessee under operating leases.²¹⁹

Initial Measurement of Investment Property.

Initially, investment property is measured at its cost. The types of costs that are capitalizable are the same as those for PP&E, discussed in Section 1.9.1 of this chapter. Any interest in property held by a lessee that is classified as investment property is recognized initially at the lower of the fair value of the property or the present value of minimum lease payments.²²⁰

Measurement after Initial Recognition.

After initial recognition, IAS 40 provides a choice between two accounting models, the fair value model and the cost model. As a general rule, the accounting policy selected has to be applied to all of a company's investment properties.²²¹ There are four exceptions to this general rule:

Under the fair value model, investment property is valued at fair value, with changes in fair value recognized in profit or loss.²²⁶ The cost model follows the guidelines established in IAS 16 for measurement subsequent to initial recognition.²²⁷ If the cost model is used, the fair value of investment property needs to be disclosed if it can be determined reliably, which is a rebuttable presumption pursuant to paragraph 53 of IAS 40.²²⁸ Accordingly, companies that hold investment properties are generally required to determine the fair value of these properties, regardless of the accounting policy adopted.

IAS 40 allows for a change in accounting policy only if it leads to a more appropriate presentation. A change from the fair value model to the cost model will generally not satisfy that requirement.²²⁹

Costs Incurred Subsequent to Initial Recognition.

Costs of day-to-day servicing are expensed as incurred.²³⁰ Costs of replacing parts of an existing investment property, such as interior walls, are capitalized at the time of replacement. The parts that are being replaced are derecognized at that time.²³¹ Under the fair value model, the fair value of the investment property may already reflect that the parts that are being replaced have lost their value, or it may be difficult to determine by what amount to reduce the fair value of the property as a result of the derecognition of the replaced parts. When it is not practical to determine the amount by which the fair value of the property should be decreased, a company may include the cost of the replacement in the carrying amount of the asset and then reassess the fair value, as would be required for additions not involving replacements.²³²

Change in Use.

When a company uses the cost model, a transfer between investment property, owner-occupied property, and inventory does not impact the carrying amount of the property transferred.²³³ A company that uses the fair value model accounts for a transfer between investment property, owner-occupied property, and inventory as follows:

Disclosures.

IAS 40 includes these disclosure requirements:²³⁷

Additional disclosures are required by paragraphs 76 through 79 of IAS 40, depending on whether the cost or the fair value model is used.

1.9.3 IFRS 3, Business Combinations

IFRS 3 provides guidance for business combinations. Business combinations was a joint project of the FASB and the IASB; accordingly, the considerations in Section 1.6.1 largely apply to IFRS 3.²³⁸ The definition of a business under IFRS 3 is the same as the definition of a business under U.S. GAAP; accordingly, many acquisitions of income-producing properties will be accounted for following the business combinations guidance.

At acquisition, an entity needs to determine whether it has acquired a business (accounted for by following business combinations guidance) or an asset/asset group.²³⁹

Initial Measurement of Assets and Liabilities.

When acquiring a business, an acquirer generally measures the identifiable assets acquired and the liabilities assumed at their acquisition-date fair values.²⁴⁰ There are, however, limited exceptions to the fair value recognition and measurement principles for the assets acquired and liabilities assumed; the key provisions are outlined below.²⁴¹

Contingent Liabilities.

IAS 37, Provisions, Contingent Liabilities and Contingent Assets, defines a contingent liability as²⁴²

“(a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or

(b) a present obligation that arises from past events but is not recognized because:

(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or

(ii) the amount of the obligation cannot be measured with sufficient reliability.” (Emphasis added.)

According to this definition, a contingent liability is—outside of business combinations—not recognized in the entity's financial statements. IFRS 3 establishes a requirement that an acquirer recognize as of the acquisition date a contingent liability assumed in a business combination if 1. it is a present obligation that arises from past events and (2) its fair value can be measured reliably.²⁴³ That is, the acquirer recognizes a contingent liability assumed in a business combination at the acquisition date even if it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation.²⁴⁴

Assets Held for Sale.

An acquired noncurrent asset (or disposal group) that is classified as held for sale at the acquisition date is measured at fair value less costs to sell in accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.

Subsequent Measurement of Assets and Liabilities.²⁴⁵

Generally, an acquirer measures and accounts for the assets acquired and liabilities assumed in accordance with applicable IFRS guidance.

Exceptions include these assets and liabilities:

Reacquired Rights.

A reacquired right is amortized over the remaining contractual period of the contract over which the right was granted.

Contingent Liabilities.

After initial recognition, a contingent liability recognized in a business combination is measured in accordance with IAS 39, Financial Instruments: Recognition and Measurement. Liabilities not within the scope of IAS 39 are measured at the higher of:

Contingent Consideration.

The accounting for changes in the fair value of contingent consideration depends on whether the change is the result of additional facts and circumstances that existed at the acquisition date and subsequently came to the acquirer's attention or whether such change results from events occurring after the acquisition date, such as meeting an earnings target or reaching a milestone on a research and development project.

If the change results from events after the acquisition date, the accounting is as follows:

If the change is a result of additional information, the accounting is as follows:²⁴⁶

Noncontrolling Interest.

In purchases in which an entity acquires less than 100% of the acquiree, other parties continue to have an equity interest in the acquiree (a noncontrolling interest). Any noncontrolling interest in the acquiree is measured either at fair value or at the noncontrolling interest's proportionate share of the acquiree's identifiable net assets.²⁴⁷ That is, the noncontrolling interest may (or may not) include goodwill attributable to the noncontrolling interest. This is in different from U.S. GAAP, which requires that the noncontrolling interest be measured at fair value.

Disclosures.²⁴⁸

IFRS 3 requires extensive disclosures to enable financial statement users to evaluate the nature and financial effects of:

1.10 Synopsis of Authoritative Literature (Pre-Codification References)

FASB Statement No. 34, Capitalization of Interest Cost.

FASB Statement No. 34 establishes standards for capitalizing interest cost as part of the historical cost of acquiring assets. To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use. Interest capitalization on inventories that are routinely manufactured is not permitted.

FASB Statement No. 58, Capitalization of Interest Cost in Financial Statements That Include Investments Accounted for by the Equity Method, an Amendment of FASB Statement No. 34.

FASB Statement No. 58 amends FASB Statement No. 34 to include investments (equity, loans, and advances) accounted for by the equity method as qualifying assets of the investor while the investee has activities in progress necessary to commence its planned principal operations, provided that the investee's activities include the use of funds to acquire qualifying assets for its operations.

FASB Statement No. 62, Capitalization of Interest Cost in Situations Involving Certain Tax-Exempt Borrowings and Certain Gifts and Grants, an amendment of FASB Statement No. 34.

FASB Statement No. 62 amends FASB Statement No. 34 to require capitalization of interest cost of restricted tax-exempt borrowings less any interest earned on temporary investment of the proceeds of those borrowings from the date of borrowing until the specified qualifying assets acquired with those borrowings are ready for their intended use and to proscribe capitalization of interest cost on qualifying assets acquired using gifts or grants that are restricted by the donor or grantor to the acquisition of those assets.

FASB Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects.

FASB Statement No. 67 provides accounting guidance for the capitalization of costs associated with the acquisition, development, and construction of real estate projects and with the allocation of costs to individual components of a project. It also addresses the accounting for costs to sell or rent real estate projects.

FASB Statement No. 141 (revised 2007), Business Combinations.

FASB Statement No. 141(R) replaces FASB Statement No. 141. FASB Statement No. 141(R) retains the requirement in FASB Statement No. 141 that the acquisition method of accounting (referred to as purchase method in FASB Statement No. 141) be used when accounting for business combinations. Significant changes to the provisions in FASB Statement No. 141 include the separate recognition of acquisition-related costs, measurement of the noncontrolling interest in the acquiree at fair value, recognition of assets acquired and liabilities assumed arising from contractual contingencies, and recognition of gain from a bargain purchase.

FASB Statement No. 142, Goodwill and Other Intangible Assets.

FASB Statement No. 142 addresses the financial accounting and reporting for acquired goodwill and other intangible assets. It provides guidance for the accounting of intangible assets that are acquired individually or with a group of other assets upon their acquisition. The Statement also addresses how goodwill and other intangible assets should be accounted for subsequent to their recognition in the financial statements.

FASB Statement No. 143, Accounting for Asset Retirement Obligations.

FASB Statement No. 143 provides accounting guidance for legal obligations associated with the retirement of tangible long-lived assets that result from the acquisition, development, construction, and/or normal operation of long-lived assets and for the associated asset retirement costs. FASB Statement No. 143 does not provide guidance for obligations of lessees in connection with leased property that meet the definition of either minimum lease payments or contingent rentals.

FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations.

FIN 47 clarifies that the term “conditional asset retirement obligation” as used in FASB Statement No. 143 refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement is conditional on a future event that may or may not be within the control of the company. FIN 47 also clarifies when a company would have sufficient information to reasonably estimate the fair value of an asset retirement obligation.

FSP FAS 141(R)-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies.

FSP FAS 141(R)-1 amends FASB Statement No. 141(R). The FSP provides:

EITF Issue No. 85-27, Recognition of Receipts from Made-Up Rental Shortfalls.

Issue.

A real estate developer sells a recently constructed office building to a syndication. For the payment of a fee, the developer enters into a master-leaseback arrangement with the seller, under which it leases the vacant space at a market rate for a two-year period. How should the syndication account for the fee it pays to the seller and the rent it receives from the seller?

Consensus/Status.

The Task Force reached a consensus that payments to and receipts from the seller should be treated by the syndication as adjustments to the basis of the property. This consensus also applies to a property that is fully rented at the time of sale if the seller agrees to make up any decrease in rentals resulting from lease terminations during a specified period after the sale.

EITF Issue No. 89-13, Accounting for the Cost of Asbestos Removal

A property owner may incur costs to remove or contain asbestos in compliance with federal, state, or local laws.

Issues.

The issues are:

Consensuses/Status.

The Task Force reached these consensuses:

The consensuses do not apply to asset retirement obligations that are within the scope of FASB Statement No. 143.

EITF Issue No. 90-8, Capitalization of Costs to Treat Environmental Contamination.

Issue.

A company incurs costs to remove, contain, neutralize, or prevent existing or future environmental contamination. Should environmental contamination treatment costs be capitalized or expensed?

Consensus/Status.

The Task Force reached a consensus that, in general, environmental contamination treatment costs should be charged to expense. They may be capitalized if recoverable, but only if one of these criteria is met:

The consensus does not apply to obligations for environmental contamination treatment costs that are within the scope of FASB Statement No. 143.

EITF Issue No. 93-5, Accounting for Environmental Liabilities.

Incorporated in and effectively nullified by SOP 96-1.

EITF Issue No. 95-23, The Treatment of Certain Site Restoration/Environmental Exit Costs When Testing a Long-Lived Asset for Impairment

Issue.

Should cash flows associated with environmental exit costs that may be incurred if a long-lived asset is sold, is abandoned, or ceases operations be included in the undiscounted expected future cash flows used to test a long-lived asset for recoverability under FASB Statement No. 144?

Consensus/Status.

The Task Force reached a consensus that whether environmental exit costs should be included in the undiscounted expected future cash flows used to test a long-lived asset for recoverability under FASB Statement No. 144 depends on management's intent with respect to the asset. EITF Issue No. 95-23 provides examples for situations in which cash flows for environmental exit costs should be excluded from the FASB Statement No. 144 recoverability test.

EITF Issue No. 97-11, Accounting for Internal Costs Relating to Real Estate Property Acquisitions.

Issue.

Many companies incur internal costs related to a real estate property that are incurred for the purpose of, but prior to, obtaining that property. Can internal preacquisition costs be capitalized as part of the cost of a real estate property acquisition?

Consensus/Status.

The Task Force reached a consensus that internal costs of preacquisition activities incurred in connection with the acquisition of a property that will be classified as nonoperating at the date of acquisition, that are directly identifiable with the acquired property, and that were incurred subsequent to the time that acquisition of that specific property was considered probable (i.e., likely to occur) should be capitalized as part of the cost of that acquisition. If the entity subsequently determines that the property will be classified as operating at the date of acquisition, such costs should be charged to expense, and any additional costs should be expensed as incurred.

Internal costs of preacquisition activities incurred in connection with the acquisition of a property that will be classified as operating at the date of acquisition should be expensed as incurred. If the entity subsequently determines that the property will be classified as nonoperating at the date of acquisition, previously expensed costs should not be capitalized as part of the cost of that acquisition.

EITF Issue No. 98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business.

Nullified by FASB Statement No. 141(R).

EITF Issue No. 99-9, Effect of Derivative Gains and Losses on the Capitalization of Interest.

Issue.

Should the interest rate used in capitalizing interest pursuant to the provisions of FASB Statement No. 34 be the effective yield after gains and losses on the effective portion of a derivative instrument that qualifies as a fair-value hedge of the fixed interest rate date, or should it be the original effective rate of the fixed-rate debt?

Consensus/Status.

The Task Force reached a consensus that amounts recorded in an entity's income statement as interest costs should be reflected in the capitalization rate under FASB Statement No. 34. Those amounts could include amortization of the adjustments of the carrying amount of the hedged liability if an entity elects to begin amortization of those adjustments during the period in which interest is eligible for capitalization. The ineffective portion of the fair-value hedge should not be reflected in the capitalization rate.

FASB Statement No. 133 prohibits the capitalization of the gain or loss on the hedging instrument in a cash-flow hedge. The FASB Staff believes that, when the variable-rate interest on a specific borrowing is associated with an asset under construction and capitalized as a cost of that asset, the amounts in accumulated comprehensive income related to a cash-flow hedge of the variability of that interest should be reclassified into earnings over the depreciable life of the constructed asset, since that depreciable life coincides with the amortization period for the capitalized interest cost on the debt.

EITF Issue No. 02-17, Recognition of Customer Relationship Intangible Assets Acquired in a Business Combination.

Issues.

FASB Statement No. 141 requires that intangible assets be recorded apart from goodwill, if they arise from contractual or legal rights (the contractual-legal criterion), or if they are capable of being separated or divided from the acquired entity (the separability criterion). The EITF addresses three issues relating to the application of FASB Statement No. 141.

Consensus/Status.

The Task Force reached consensuses, and the EITF Abstract includes examples of the application of these consensuses.

EITF Issue No. 03-9, Determination of the Useful Life of Renewable Intangible Assets under FASB Statement No. 142, Goodwill and Other Intangible Assets

Issues.

Four issues are addressed in that EITF Abstract, relating to the determination of the useful life of intangible assets (Issues 1 through 3) and to the recognition of an intangible asset apart from goodwill (Issue 4).

Consensuses/Status.

No consensuses were reached. EITF Issue No. 03-9 was removed from the EITF agenda. At the recommendation of the Task Force, the FASB added this issue to the FASB agenda and has issued proposed FSP FAS 142F.

EITF Issue No. 03-17, Subsequent Accounting for Executory Contracts That Have Been Recognized on an Entity's Balance Sheet.

Issues.

The issues are:

Consensuses/Status.

The issue has been removed from the EITF agenda.

EITF Issue No. 04-1, Accounting for Preexisting Relationships between the Parties to a Business Combination.

Issues.

The EITF addresses the accounting for preexisting relationships between the parties to a business combination. The issues are:

Consensuses/Status.

The Task Force reached these consensuses:

EITF Issue No. 04-2, Whether Mineral Rights Are Tangible or Intangible Assets.

Issues.

The issues are:

Consensuses/Status.

EITF Topic No. D-108, Use of the Residual Method to Value Acquired Assets Other Than Goodwill.

FASB Statement No. 141 requires that intangible assets that meet the recognition criteria be recorded at fair value. The SEC staff does not believe that the application of the residual method to the valuation of intangible assets can be assumed to produce amounts representing the fair values of those assets. Accordingly, the SEC staff believes that a direct value method, rather than the residual method, should be used to determine the fair value of all intangible assets other than goodwill.

AICPA Statement of Position 93-7, Reporting on Advertising Costs.

SOP 93-7 provides guidance on the accounting, reporting, and disclosure of advertising costs in financial statements. It requires that the costs of advertising be expensed either as incurred or at the first time the advertising takes place, except for direct-response advertising (1) whose primary purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising and (2) that results in probable future economic benefits. For direct-response advertising that may result in reported assets, the SOP addresses how such assets should be measured initially, how the amounts ascribed to such assets should be amortized, and how the realizability of such assets should be assessed.

AICPA Statement of Position 96-1, Environmental Remediation Liabilities.

SOP 96-1 is divided into two parts. Part 1 provides an overview of key environmental laws and regulations. Part 2 provides guidance on the accounting, presentation, and disclosure of environmental remediation liabilities that relate to pollution arising from some past act, generally as a result of the provisions of Superfund, the corrective-action provisions of the Resource Conservation and Recovery Act, or analogous state and non-U.S. laws and regulations. Following the general guidance of FASB Statement No. 5, SOP 96-1 provides that a liability be accrued if (1) it is probable that an asset has been impaired or a liability has been incurred and (2) the amount of the loss can be reasonably estimated. For purposes of measuring environmental remediation liabilities, the measurement should be based on enacted laws and adopted regulations and policies. Discounting the liability to reflect the time value of money is considered appropriate only if certain conditions are met.

If there is more than one party involved, SOP 96-1 provides that the environmental remediation liability recorded by a company should be based on an estimate of the company's allocable share of the joint and several remediation liability. The amount of an environmental remediation liability should be determined independently from any potential claim for recovery, and an asset relating to the recovery should be recognized only when realization of the claim for recovery is deemed probable.

AICPA Statement of Position 98-5, Reporting on the Costs of Start-up Activities.

SOP 98-5 provides guidance on the financial reporting of start-up costs and organization costs; the costs of start-up activities and organization costs are to be expensed as incurred. The SOP defines start-up activities as one-time activities relating to opening a new facility, introducing a new product or service, conducting business in a new territory, conducting business with a new class of customer or beneficiary, initiating a new process in an existing facility, or commencing some new operation. Start-up activities include activities related to organizing a new entity (organization costs).

AICPA Proposed Statement of Position, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment.

The proposed SOP provides guidance on accounting for PP&E, which is based on these principles:

SEC Staff Accounting Bulletin Topic 5Y,²⁴⁹Accounting and Disclosures Relating to Loss Contingencies.

SAB Topic 5Y addresses these questions:

Interpretive Responses.

SEC Staff Accounting Bulletin Topic 10F, Presentation of Liabilities for Environmental Costs.

SAB Topic 10F addresses questions relating to recognition and presentation of liabilities for environmental costs for rate-regulated enterprises.

International Accounting Standard 16, Property, Plant, and Equipment.

IAS 16 prescribes the accounting for PP&E, including their recognition, measurement, and derecognition; it provides guidance with respect to depreciation charges and impairment losses, and disclosures relating to PP&E. The Standard allows for the use of the cost model or the revaluation model.

International Accounting Standard 23, Borrowing Costs.

IAS 23 provides guidance related to the accounting for borrowing costs, setting forth criteria that require capitalization of borrowing costs.

International Accounting Standard 40, Investment Property.

IAS 40 prescribes the accounting—and related disclosures—for investment property—that is, real estate property—held by the owner or by the lessee under a finance lease to earn rentals or for capital appreciation or both, rather than for (1) use in the production or supply of goods or services or for administrative purposes; or (2) sale in the ordinary course of business.

International Financial Reporting Standard 3, Business Combinations.

IFRS 3 (revised in 2008) provides guidance related to the accounting for business combinations. The project “Business Combinations” was a joint project of the FASB and the IASB and resulted in a common definition of what constitutes a business and in standards that are very similar.

Notes

1. Accounting Standards Codification (ASC) 970-10-15-3 (FASB Statement (FAS) No. 67, paragraph 2(a)).

2. ASC 970-10-20 (FAS 67, Appendix A, paragraph 28).

3. Land option deals may pose special accounting issues, as discussed in Section 1.7.3 of this chapter.

4. ASC 970-340-25-3 (footnote 3 of FASB Statement No. 67) states that “probable” in this context means “likely to occur.” Paragraph 13 of the proposed Statement of Position (SOP), Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, uses that same threshold for the capitalization of preacquisition costs.

5. ASC 970-340-25-3(b) (FAS 67, paragraph 4).

6. ASC 970-340-25-3(c) (FAS 67, paragraph 4(c)).

7. ASC 970-340-25-4(b) (FAS 67, paragraph 5).

8. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 24.

9. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph A29.

10. The Other Assets and Deferred Costs subsection of Topic 970 (Emerging Issues Task Force (EITF) Issue No. 97–11) does not address the accounting for costs incurred for acquisitions of real estate properties that will be used in a company's own operations, other than for sale or rental.

11. ASC 970-340-25-5 (EITF Issue No. 97-11).

12. ASC 970-340-25-3(a) (FAS 67, paragraph 4(a)).

13. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 19.

14. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, footnote 4.

15. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraphs 20 and 21.

16. ASC 970-10-20 (FAS 67, paragraph 28).

17. Special issues may arise if seller and buyer of a real estate property enter into an arrangement under which the seller agrees to lease (or lease up) the property. ASC 970-360-25-1 (EITF Issue No. 85–27) addresses the accounting for such arrangements, which may, in substance, be adjustments to the purchase price of the property.

18. See Section 1.7.1 of this chapter.

19. ASC 970-360-35-1 (FAS 67, paragraph 14).

20. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 34.

21. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 34.

22. See also Section 1.7.5 for further discussion regarding environmental remediation costs.

23. ASC 970-360-20 (FAS 67, Appendix A, paragraph 28).

24. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 26.

25. ASC 970-720-25-3 (FAS 67, paragraph 7).

26. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 31.

27. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 34.

28. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 26.

29. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 27.

30. ASC 970-720-25-3 (FAS 67, paragraph 7).

31. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 28.

32. ASC 970-340-25-8 (FAS 67, paragraph 6); depending on the real estate property: The term “ready for its intended use” encompasses both “ready for use” and “ready for sale” [ASC 835-20-20 (FAS 34, paragraph 6, footnote 3)].

33. ASC 970-340-25-8 (FAS 67, paragraph 6, footnote 4).

34. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 31.

35. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph A37.

36. Proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment, paragraph 31.

37. ASC 360-10-30-1; ASC 835-20-05-1 (FAS 34, paragraph 6).

38. ASC 835-20-10-1 (FAS 34, paragraph 7).

39. ASC 835-20-25-7 (FAS 34, paragraph 19; FAS 144, paragraph 20).

40. ASC 835-20-30-10 (FAS 62, paragraph 3).

41. ASC 835-20-15-5 (FAS 34, paragraph 9).

42. ASC 835-20-15-6 (FAS 34, paragraph 10).

43. ASC 835-20-15-8 (FAS 34, paragraph 11).

44. ASC 835-20-25-3 (FAS 34, paragraph 17).

45. ASC 835-20-25-6 (FAS 34, paragraph 58).

46. ASC 835-20-25-4 (FAS 34, paragraph 58).

47. ASC 835-20-25-5 (FAS 34, paragraph 18).

48. ASC 835-20-30-2 (FAS 34, paragraph 12).

49. ASC 835-20-30-6 (FAS 34, paragraph 15).

50. ASC 835-20-20 (FAS 34, paragraph 1).

51. ASC 835-20-30-3 (FAS 34, paragraph 13).

52. The accounting for costs of amenities is further discussed in Section 1.7.1.

53. ASC 970-360-30-1 (FAS 67, paragraph 11).

54. ASC 970-360-30-1 (FAS 67, paragraph 11).

55. ASC 970-360-35-1 (FAS 67, paragraph 14).

56. ASC 970-360-30-1 (FAS 67, paragraph 11).

57. ASC 970-360-30-1 (FAS 67, paragraph 11).

58. ASC 970-340-35-1 (FAS 67, paragraph 12).

59. ASC 970-360-35-2 (FAS 67, paragraph 15).

60. ASC 970-360-40-1 (FAS 67, paragraph 13).

61. ASC 970-340-25-13 (FAS 67, paragraph 17).

62. ASC 970-340-25-14 (FAS 67, paragraph 17).

63. ASC 970-340-25-13 and 25-14 (FAS 67, paragraph 18).

64. ASC 970-340-40-1 (FAS 67, paragraph 19).

65. ASC 340-20-35-2 (SOP 93-7, paragraph 46).

66. ASC 970-340-25-15 (FAS 67, paragraph 19).

67. ASC 970-340-25-16 and 25-17, 970-340-35-2, 970-340-40-2, and 970-605-25-1 through 25-2 (paragraphs 20 through 23 of FASB Statement No. 67) do not apply to real estate rental activity, in which the predominant rental period is less than one month [ASC 970-10-15-9 (FAS 67, paragraph 2)].

68. ASC 970-10-15-8(b) (FAS 67, paragraph 2(b)).

69. ASC 840-20-25-17 and 25-19 (FAS 13, paragraph 5(m)).

70. ASC 970-340-25-16 (FAS 67, paragraph 20).

71. ASC 970-340-40-2 (FAS 67, paragraph 21).

72. ASC 970-340-25-16 (FAS 67, paragraph 20).

73. ASC 970-340-25-12 (FAS 67, paragraph 10).

74. The accounting treatment of incidental operations under IFRS differs from the accounting treatment under U.S. GAAP. Paragraph 21 of International Accounting Standard (IAS) 16 provides, in part: “Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognized in profit or loss and included in their respective classifications of income and expense.”

75. See also discussion in Section 1.5.1 of this chapter.

76. ASC 970-605-25-2 (FAS 67, paragraph 22).

77. ASC 970-340-35-2 (paragraph 21 of FASB Statement No. 67) provides, in part: “Capitalized rental costs directly related to revenue from a specific operating lease shall be amortized over the lease term. Capitalized rental costs not directly related to revenue from a specific operating lease shall be amortized over the period of expected benefit.”

78. FAS 67, paragraph 38 (not codified).

79. Section 1.7.2 discusses the accounting for start-up costs.

80. Statement No. 141(R) is applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period on or after December 15, 2008. Earlier application is not permitted (FAS 141(R), paragraph 74, not codified).

81. The definition of a business in Securities and Exchange Commission (SEC) Regulation S-X, Rule 11-01(d) differs from the definition of a business in Topic 805 (Statement No. 141(R)); accordingly, SEC registrants have to undertake a separate analysis under Rule 11-01(d) when evaluating the reporting requirements of SEC Regulation S-X.

82. ASC 805-10-20 (FAS 141(R), paragraph 3(d)).

83. ASC 805-10-55-5 (FAS 141(R), paragraph A5).

84. ASC 805-10-55-4 (FAS 141(R), paragraph A4); before the effective date of Statement No. 141(R), inputs, processes, and outputs were required for a business. Thus, the acquisition of an entity in the development stage, such as the acquisition of a shopping mall under development, did not constitute a business, whereas it may meet the definition of a business under current guidance.

85. ASC 805-10-55-7 (FAS 141(R), paragraph A7).

86. ASC 805-10-55-5 (FAS 141(R), paragraph A5).

87. ASC 805-10-55-6 (FAS 141(R), paragraph A6).

88. EITF Issue No. 98-3, nullified by Statement No. 141(R), provided examples (Exhibit 98-3A, Examples 2 and 3) related to the determination of whether a transfer of hotels and restaurants constituted a business.

89. The purchase of real estate also includes the acquisition of equity interests in a real estate entity.

90. The costs to issue debt or equity securities as part of a business combination are recognized in accordance with other applicable guidance.

91. ASC 805-10-20 (FAS 141(R), paragraph 3(k)).

92. An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows; (b) a particular entity can obtain the benefit and control others' access to it; and (c) the transaction or other event giving rise to the entity's right to or control of the benefit has already occurred (Concepts Statement (CON) No. 6, paragraph 26; CON 5, paragraphs 63 and 64).

93. ASC 350-30-25-4 (FAS 142, paragraphs 9 (footnote 7) and B37).

94. ASC 805-20-55-25 (FAS 141(R), paragraph A41).

95. Or a well-known anchor tenant, such as a high-end retailer, may act as a magnet for other tenants.

96. Either at their fair values (business combinations) or at their relative fair values (acquisition of asset/asset group)

97. ASC 820-10-20 (FAS 157, paragraph 5).

98. ASC 820-10-35-10 (FAS 157, paragraph 12).

99. Before the effective date of Statement No. 141(R) in 2009, Statement No. 141 provided specific guidance regarding the valuation of plant and equipment: That guidance suggested the use of current replacement cost to determine the value at which plant and equipment acquired in a business combination should initially be recorded and that the replacement cost of used PP&E should be estimated by determining the replacement cost new less accumulated depreciation [FAS 141, paragraph 37(f); 37(d)(1) (not codified)].

100. ASC 820-10-55-25 (FAS 157, paragraph A6).

101. Adapted from ASC 820-10-55-30 and 55-31 (FAS 157, paragraphs A10 and A11).

102. See Chapter 3, Section 3.8.2, for presentation and disclosure requirements.

103. ASC 805-20-30-22 (FAS 141(R), paragraph 33).

104. An exception to the fair value measurement principle is provided for reacquired rights: Reacquired rights, such as a right to use the acquirer's trade name, for example, are measured on the basis of the remaining contractual term of the related contract regardless of whether market participants would consider potential renewals in determining its fair value. [ASC 805-20-30-20]

105. FAS 141, paragraphs B172 and B41 (not codified).

106. This section assumes that an acquirer purchases 100% of a business; the accounting for situations in which an acquirer purchases less than 100% of a business is more complex. Accounting implications for acquisitions in which parties unrelated to the acquirer hold noncontrolling interests in the entity acquired are discussed in Chapter 6, Section 6.4.1.

107. For business combinations with an acquisition date before 2009 (for entities with a December 31 year-end), any excess of the fair value of the net assets acquired over the consideration transferred was “reallocated” to assets that were acquired in the purchase transaction, following the allocation method for negative goodwill, described in paragraphs 44 and 45 of Statement No. 141: “That excess shall be allocated as a pro rata reduction of the amounts that otherwise would have been assigned to all of the acquired assets . . . except (a) financial assets other than investments accounted for by the equity method, (b) assets to be disposed of by sale, (c) deferred tax assets, (d) prepaid assets relating to pension or other postretirement benefit plans, and (e) any other current assets. If any excess remains after reducing to zero the amounts that otherwise would have been assigned to those assets, that remaining excess shall be recognized as an extraordinary gain.”

108. In other situations, a “bargain purchase” may be the result of applying the guidance in Topic 805 (Statement No. 141(R)). For example, Topic 805 permits the recognition of contingent liabilities only if the recognition criteria in the Business Combinations guidance are met. Contingent liabilities may be present for which the recognition criteria are not met; the risks related to these contingent liabilities, however, may have been reflected in the purchase price and thus have given rise to a “bargain purchase.”

109. ASC 350-30-25-2 (FAS 142, paragraph 9).

110. ASC 805-20-S99-3 (EITF Topic No. D-108, Use of the Residual Method to Value Acquired Assets Other Than Goodwill).

111. Tenant relationships in a hotel or resort may result from relationships with the owners of gift stores or the operators of amenities and from relationships with recurring customers established through frequent-stay programs, conventions, and conferences, for example.

112. ASC 350-30-35-6 (FAS 142, paragraph 12).

113. ASC 350-30-35-8 (FAS 142, paragraph 13).

114. EITF Issue No. 03-9, paragraph 5 (not codified): “The Task Force noted that the useful life—the period over which an intangible asset is expected to contribute to an entity's cash flows—for amortization purposes should be consistent with the estimated useful life considerations used in the determination of the fair value of that asset.”

115. ASC 805-10-25-23 (paragraph 59 of Statement No. 141(R)) provides with respect to acquisition-related costs (transaction costs): “Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finder's fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer shall account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities shall be recognized in accordance with other applicable GAAP.”

116. Before the effective date of FAS 141(R), acquisition costs incurred in a business combination were capitalized.

117. FASB Staff Position (FSP) FAS 141(R) amended the guidance in Statement No. 141(R). See Section 1.10, “Synopsis of Authoritative Literature.” for a brief description of the changes.

118. ASC 970-340-25-10 (FAS 67, paragraph 8).

119. ASC 970-340-25-9(a) (FAS 67, paragraph 8(a)).

120. ASC 970-340-25-9 (FAS 67, paragraphs 8(b) and 9).

121. ASC 970-340-25-11 (FAS 67, paragraph 9).

122. ASC 720-15-20 and 720-15-15-2 (SOP 98-5, paragraph 5).

123. ASC 720-15-25-1 (SOP 98-5, paragraph 12).

124. ASC 720-15-15-2 (SOP 98-5, paragraphs 30 and 31).

125. ASC Section 720-15-55 (SOP 98-5, paragraphs 44 and 45).

126. ASC Section 720-15-55 (SOP 98-5, paragraphs 8, 44).

127. The costs of using long-lived assets that are allocated to start-up activities (e.g., depreciation of computers) are within the scope of the guidance for start-up costs [ASC 720-15-15-4(f) (SOP 98-5, paragraph 8)].

128. The costs of using intangible assets that are allocated to start-up activities are within the scope of Subtopic 720-15 (SOP 98–5) [ASC 720-15-15-4(f); (SOP 98–5, paragraph 8)].

129. AcSEC believes that start-up costs incurred in connection with existing contracts (whether incurred in anticipation of follow-on contracts or not) are contract costs related to a specific source of revenue subject to the accounting prescribed in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 98-5, paragraph 39 (not codified)).

130. Adapted from ASC 720-15-55-8 through 55-10 (Example 3) (SOP 98–5, paragraph 44 (Illustration 3)).

131. If the deposit is nonrefundable, the option holder also absorbs expected losses of the entity.

132. ASC 810-10-15-14(b)(3) (FASB Interpretation (FIN) No. 46(R), paragraph 5(b)(3)).

133. Except for interests that are insignificant or have little or no variability [ASC 810-10-25-55 (FIN 46(R), paragraph 12)].

134. ASC 810-10-25-57 (FIN 46(R), paragraph 13; FSP FIN 46(R)-1).

135. A silo in a VIE is treated as a separate VIE. Therefore, in the discussion that follows, no distinction has been made between an option holder that has an interest in a VIE and an option holder that has an interest in a silo of a VIE.

136. In June 2009, the FASB issued Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R). The provisions of Statement No. 167 are effective as of the beginning of each reporting entity's first annual reporting period that begins after November 15, 2009, with earlier application prohibited (FAS 167, paragraph 4). Before that amendment, the consolidation criteria of FIN 46(R) provided that an option holder would have to consolidate the land option entity (silo) if the option holder and its related parties were to absorb a majority of the entity's expected losses, receive a majority of the entity's expected residual returns, or both.

137. FASB Statement No. 167 is effective as of the beginning of the reporting entity's first annual reporting period that begins after November 15, 2009. Earlier application is prohibited [ASC 810-10-65-2 (FAS 167, paragraph 4)].

138. ASC 310-10-30-5 (Accounting Principles Board (APB) Opinion No. 21, paragraph 12).

139. ASC 310-10-30-5 (APB 21, paragraph 12).

140. ASC 835-30-10-1 (APB 21, paragraph 13).

141. ASC 835-30-25-12 (APB 21, paragraph 13).

142. ASC 835-30-35-2 (APB 21, paragraph 15).

143. The term “asset retirement obligation” refers to an obligation associated with the retirement of a tangible long-lived asset. The term “asset retirement cost” refers to the amount capitalized that increases the carrying amount of the long-lived asset when a liability for an asset retirement obligation is recognized [ASC 410-20-20 (FAS 143, footnote 1)].

144. ASC 410-10-20 (FAS 143, footnote 2).

145. ASC 410-20-55-44 (Case D) (FAS 143, Appendix C, Example 4); the “lease of land” for the exploitation of timber is not within the scope of Subtopic 840-10 (FASB Statement No. 13) (ASC 840-10-15-15 (FAS 13, paragraph 1)).

146. ASC 840-10-20; ASC 840-10-25-5 (FAS 13, paragraph 5(j)(i)).

147. ASC 410-20-15-3(e) (FAS 143, paragraph 17).

148. FAS 143, paragraph A2 (not codified).

149. ASC 410-20-25-4 (FAS 143, footnote 4).

150. ASC 410-20-25-6 (FIN 47, paragraph 4).

151. ASC 410-20-25-5; ASC 410-20-35-2 (FAS 143, paragraph 11).

152. ASC 410-20-35-1 (FAS 143, paragraph 10).

153. ASC 410-20-35-2 (FAS 143, paragraph 11).

154. ASC 410-20-35-3 – 35-5 (FAS 143, paragraph 15).

155. ASC 410-20-35-5 and 35-8 (FAS 143, paragraphs 14 and 15).

156. ASC 410-20-25-7 (FIN 47, paragraph 3).

157. Adapted from ASC 410-20-15-3(b) (FASB Statement No. 143, paragraph A13).

158. ASC 410-20-50-1 (FAS 143, paragraph 22).

159. ASC 410-30-10-1 (SOP 96-1, paragraph 99).

160. ASC 410-30-25-3 (SOP 96-1, paragraphs 107 and 109).

161. ASC 410-30-25-6 (SOP 96-1, paragraph 109).

162. ASC 410-30-30-8 (SOP 96-1, paragraph 121).

163. ASC 410-30-25-7 (SOP 96-1, paragraph 110).

164. ASC 410-30-25-8 (SOP 96-1, paragraph 111; FIN 14, paragraph 3).

165. ASC 410-30-25-9 (SOP 96-1, paragraph 113).

166. ASC 410-30-30-1 (SOP 96-1, paragraph 133).

167. ASC 410-30-30-10; 410-30-55-1 and 55-2 (SOP 96-1, paragraphs 124–127).

168. ASC 410-30-30-15; ASC 410-30-35-4 (SOP 96-1, paragraph 129).

169. ASC 410-30-35-12 (SOP 96-1, paragraph 132).

170. ASC 450-20-S99-1 (SEC Staff Accounting Bulletin (SAB) Topic 5Y, Question 1).

171. ASC 410-30-35-8 (SOP 96-1, paragraph 140).

172. ASC 410-30-50-4 (SOP 96-1, paragraphs 151 and 152).

173. ASC 450-20-S99-1 (SAB Topic 5Y, Questions 1 and 2).

174. ASC 410-30-50-1 through 50-17 (SOP 96-1, paragraphs 155–169).

175. ASC 410-30-25-22 (SOP 96-1, paragraph 147).

176. ASC 410-30-25-16 – 25-19 (EITF Issue No. 90-8).

177. For example, that could include costs incurred for the removal of asbestos [ASC 410-30-55-26 (EITF Issue No. 90-8)].

178. ASC 410-30-25-21 (SOP 96–1, paragraph 147).

179. Adapted from EITF Issue No. 90-8, Exhibit 90-8A, Example 4 (not codified).

180. ASC 835-20-30-6 (FAS 34, paragraph 15).

181. Similarly, a seller is precluded by ASC 360-20-40-47 (paragraph 34 of FASB Statement No. 66) to recognize profit from the sale of real estate to parties that are controlled by the seller.

182. ASC 805-50-30-5 (paragraph D9 of FASB Statement No. 141(R)) states: “When accounting for a transfer of assets or exchange of shares between entities under common control, the entity that receives the net assets or the equity interests shall initially measure the recognized assets and liabilities transferred at their carrying amounts in the accounts of the transferring entity at the date of transfer. If the carrying amounts of the assets and liabilities transferred differ from the historical cost of the parent of the entities under common control, for example, because push-down accounting had not been applied, then the financial statements of the receiving entity shall reflect the transferred assets and liabilities at the historical cost of the parent of the entities under common control.”

183. EITF Issue No. 02-5 has not been codified.

184. ASC 230-10-20 (FAS 95, paragraph 21).

185. ASC 970-230-45-1 (FAS 102, paragraph 25).

186. FAS 95, paragraph 86 (not codified).

187. ASC 280-10-50-1 (FAS 131, paragraph 10).

188. ASC 280-10-50-6 (paragraph 13 of FASB Statement No. 131) describes a scenario in which a public entity produces reports in which its business activities are presented in different ways. “If the chief operating decision maker uses more than one set of segment information, other factors may identify a single set of components as constituting a public entity's operating segments, including the nature of the business activities of each component, the existence of managers responsible for them, and information presented to the board of directors.”

189. ASC 350-30-45-1 (FAS 142, paragraphs 42 and 43).

190. ASC 350-20-50-1 (FAS 142, paragraph 45).

191. ASC 350-20-50-2 (FAS 142, paragraph 47).

192. IAS 16, paragraph 7.

193. IAS 16, paragraph 6.

194. IAS 16, paragraph 16.

195. This is similar to the requirement under Topic 410-20 (FASB Statement No. 143) to capitalize asset retirement cost.

196. IAS 16, paragraphs 19 and 20.

197. IAS 16, paragraph 22.

198. IAS 16, paragraph 22; IAS 23, paragraphs 5 and 9.

199. IAS 16, paragraph 10.

200. IAS 16, paragraph 11.

201. IAS 23, paragraphs 10–15.

202. IAS 16, paragraph 29.

203. IAS 16, paragraph 37.

204. IAS 16, paragraph 30.

205. IAS 16, paragraph 34.

206. IAS 16, paragraphs 36 and 38.

207. IAS 16, paragraph 39.

208. IAS 16, paragraph 40.

209. IAS 16, paragraphs 12 and 13.

210. IAS 16, paragraph 14.

211. IAS 16, paragraphs 73 and 78.

212. IAS 16, paragraph 77.

213. IAS 40, paragraph 5.

214. IAS 40, paragraph 6.

215. IAS 40, paragraph 10.

216. IAS 40, paragraphs 11 and 12.

217. IAS 40, paragraph 16.

218. IFRS 3 provides a comparison of IFRS 3 and FASB Statement No. 141, which states, in part: “The revised IFRS 3 requires the acquirer to take into account the terms of a lease in measuring the acquisition-date fair value of an asset that is subject to an operating lease in which the acquirer is the lessor. This is consistent with the guidance in IAS 40 Investment Property.”

219. IFRS 3, paragraphs B28–B30; in the author's view, the same criteria should be applied for the separate recognition of intangibles related to operating leases, whether the acquisition of investment property is the acquisition of an asset/asset group or whether it is the acquisition of a business.

220. IAS 40, paragraph 25.

221. IAS 40, paragraph 30.

222. IAS 40, paragraph 32A.

223. IAS 40, paragraph 34.

224. IAS 40, paragraph 53.

225. IAS 40, paragraphs 53–56.

226. IAS 40, paragraph 35.

227. IAS 40, paragraph 56.

228. IAS 40, paragraph 79(e); additional disclosures are required if a company cannot determine the fair value of the investment property reliably.

229. IAS 40, paragraph 31.

230. IAS 40, paragraph 18.

231. IAS 40, paragraph 19.

232. IAS 40, paragraph 68.

233. IAS 40, paragraph 59.

234. IAS 40, paragraph 60.

235. IAS 40, paragraph 61.

236. IAS 40, paragraph 63.

237. IAS 40, paragraph 75.

238. The revised guidance for business combinations, IFRS 3(R), is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after July 1, 2009. Earlier application is permitted (IFRS 3, paragraph 64). This section's references to IFRS 3 refer to the guidance in IFRS 3 as revised in 2008.

239. IFRS 3, paragraph 3.

240. IFRS 3, paragraph 18.

241. Other exceptions to the recognition and/or measurement principles:

242. IAS 37, paragraph 10

243. IFRS 3, paragraph 23.

244. IFRS 3, paragraph 23.

245. IFRS 3, paragraphs 54–58.

246. IFRS 3, paragraphs 45–50.

247. More specifically, the choice of acquisition date fair value or the proportionate share of the acquired entity's identifiable net assets is limited to noncontrolling interest components that entitle the owners to a proportionate share of the net assets of the subsidiary. Other components of noncontrolling interest, such as equity components of convertible bonds, warrants, and options over own shares, are measured using the measurement basis required by IFRS (2009-2010 Annual Improvements Project).

248. IFRS 3, paragraphs 59–63 and B64–B67.

249. SAB 92.