Real Estate JV Losses, Consolidation and Recent GAAP Pronouncements

Babush, Neiman, Kornman & Johnson, LLP

www.bnkj.com

Jeffrey G Olson, CPA

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)

Real Estate Ownership Wholly-owned assets Corporate subsidiary Corporate JV Partnership (General or Limited) LLC Undivided interests or tenants in

common

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

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

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

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

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

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

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

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

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

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!

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?

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

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

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

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

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)

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

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

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

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

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

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...

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