real estate jv losses, consolidation and recent gaap pronouncements babush, neiman, kornman &...
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Real Estate JV Losses, Consolidation and Recent GAAP Pronouncements
Babush, Neiman, Kornman & Johnson, LLP
www.bnkj.com
Jeffrey G Olson, CPA
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Topics Consolidation and equity method
of accounting ARB 51 (1959), SFAS No.94 (1987) APB 18 (1971) FASB FIN 46 (Jan. 2003)
Real estate JV losses - SOP 78-9 (1978)
Debt/equity instruments - SFAS 150 (May 2003)
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Real Estate Ownership Wholly-owned assets Corporate subsidiary Corporate JV Partnership (General or Limited) LLC Undivided interests or tenants in
common
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GAAP Accounting Consolidate
• SFAS No. 94 “majority owned” corporate subsidiaries or controlled general partnerships
• FAS FIN #46 is new
Equity Method - most unincorporated entities APB 18 generally Real estate entities specifically AICPA
SOP 78-9
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GAAP Accounting
Consolidation vs. Equity Method Financial statement effect is only presentation
Consolidate with minority interestsEquity method reduces investor’s share of net assets and
revenues/expenses to a single line each
No effect or difference on reported equity or net income of consolidating/investor entity
Can significantly effect gross balance sheet and ratios
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Real Estate Latest Activity Draft AICPA SOP - Accounting for
Investors’ Interest in Unconsolidated Real Estate Investments
Project draft originally dated 11-21-00 to have replaced SOP 78-9
AICPA rule making has changed -project turned over to FASB in early 2003
FASB has not picked it up as a current project - SOP 78-9 still applies
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SOP 78-9 Equity Method SOP 78-9 looks at control over a
“majority” ownership Unlike SFAS No. 94’s “majority”
ownership, non-corporate entities economics, ownership, and control rights may not have a clear “majority”
Where there is shared control, SOP 78-9 would have no one consolidate the JV
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JV Losses - GAAP & Tax Often depreciating an appreciating
real estate asset - noncash lossesGAAP or tax effects - partners may be
sensitive to who has to or can report these losses
Real economic or cash losses Generally no difference in how
allocated
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JV Losses - GAAP & Tax Generally allocated first to those
partners who have positive capital balances until everyone reduced to zero
Then JV allocates to partners with economic risk for additional losses via Other loans/advances Deficit restoration provisions Other guarantees or commitments Of support
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Practically speaking in REJV’sLP’s are rarely ever allocated
losses below zero capital account
General partner usually has debt guaranty, particularly on development loans
Losses in excess of invested capital -what happens?
Illustrations
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GAAPInvestors deemed unable to bear
losses otherwise JV allocates among other investors at risk
(under FAS 5 loss contingency concept) Investors “catch up” on subsequent income
allocations Exception for losses when return to profitability
is imminent and reasonably assured
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GAAP Ability to Bear LossesIs it probable an investor is
unable to bear his share of losses?
Look to: Fair value of his interest (cancels out
depreciation loss effects) Other evidence of economic commitment
Loans previously madeFinancial wherewithal and intent to fundCollateralized guarantees
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GAAP-Should Investor Record Allocated Losses?
Need consistent basis of accounting If deemed by other investors not able
to bear losses and losses not allocated Investor will continue to record
contractual losses (even if not allocated) unless formally relieved by agreement or operation of law
Can result in all investors as a group picking up more than 100% of JV level loss!
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GAAP Allocation Ratios JV agreement on P&L and
distribution allocations may be inconsistent
SOP 78-9 directs to use substance over form
Use liquidation accounting on capital to “push” the P&L allocation
Same for tax?
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Negative Capital- Tax Effects
If P&L & liquidating distributions are done correctly, less of a chance that some partners can be left with deficits while others have positive capital
May not always work out Interim sale of interestErrors
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FAS Financial Interpretation No. 46
New January 17, 2003 Interpretation of ARB 51 FIN 46 directed primarily toward:
Enron-type “off balance sheet” accounting
Securitization transactions and SPE’sR&D ventures/development stage
companiesMost synthetic lease transactions
Others will be caught however
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FIN 46 Variable Interest Entity (“VIE”) will be
consolidated by its primary beneficiary No more bastard subsidiaries (i.e.
“parentless”) Attacks accounting “form” transactions back
to economic substance - debt or accounting loss avoidance
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FIN 46Primary beneficiary/parent Entity who absorbs the majority of
losses, or losses and income May be a non-owner with other
contractual relationshipLeasesLoans and guarantorsService or development agreementsOther based on substance
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FIN 46
Variable Interest entity has either
Insufficient equity at risk (quantitative)
Holders of equity at risk lack characteristics of a controlling financial interest (qualitative)
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FIN 46 - Equity at Risk
GAAP defined equity only - need other subordinated capital or outside guarantees Below 10% must have pervasive evidence Above 10% not automatic - reference other similar businesses or entities Equity is less than expected losses
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FIN 46-Lack Controlling Financial Interests
If Equity Holders as a group lack any of the following:
Ability to make decisions on entity activities through voting rights (others have limits on absolute control rights)
Obligation to absorb losses (guarantees or through purchase commitments)
Right to receive residual returns or if those returns are capped
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FIN 46 -Lack of Controlling Financial InterestsLack of controlling financial
interest indicated by: Some investors with voting rights
disproportionate to their loss obligations and/or residual return rights
Substantial activities of the entity are for or on behalf of investor with disproportionately few voting rights
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Who/What Else May Be Affected
Certain real estate partnerships, depending on structure
Certain related party leasing transactions Certain homebuilder land and lots controlled
through contract Certain forward contracts and swaps with a
VIE Certain service contracts with a VIE
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SFAS 150
Financial instruments with characteristics ofboth debt and equity - May 2003
No more “mezzanine” presentations for these type items
Maditorily redeemable equity ESOP’s & other equity type plans with mandatory
buybacks - options, restricted or phantom stock, etc... Others generally outside real estate contexts
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SFAS 150 Affects
Liability recorded at fair value except forPhysically settled forward purchase
contractsMandatorily redeemable instruments
Lower equity/increase debt Effects on ratios, loan covenants,
etc...
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SFAS 150 Affects
Buy sell/agreements effecting
100% of equity creates madatorily
redeemable $0 equity, it is all a liability Separate line item presentation Note disclosure of CS/PIC/RE type
information