Topic 4A: Developer Fee Recognition. Issue: Developer Fee Recognition for Unconsolidated Developers. Analysis/Input GAAP

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1 Issue: Developer Fee Recognition for Unconsolidated Developers Analysis/Input GAAP Revenue represents the actual or expected cash inflow from sales of an entity's core products or services. For transactions that are within the scope of specific GAAP pronouncements, revenue should be recognized in accordance with the criteria set forth therein. Regarding specific arrangements that are not explicitly addressed in any authoritative literature, revenue should be recognized when all of the following conditions are met: Persuasive evidence of an arrangement exists; Delivery has occurred or services have been rendered; and The price is fixed or determinable and collectability is reasonably assured. The basic fundamental criteria listed above should be applied when establishing accounting policy for developer fee revenue recognition. Although not specifically addressed in accounting guidance, the percentage of completion method is widely regarded as the method to use in determining when services have been rendered under development services agreements. The applicability and use of the percentage of completion method is described in AICPA Statement of Position 81-1 Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Each revenue recognition criteria and its pertinence to developer fee revenue recognition are discussed below. Persuasive Evidence of the Existence of an Arrangement In a typical development, the owner entity and the developer enter into a development services agreement, which memorializes the entity's arrangement with the developer to provide developmentrelated services in return for compensation (developer fee). The development services agreement typically describes the various responsibilities and functions that the developer is allowed to perform, describes specific functions that the developer is excluded from performing, identifies the total amount of developer fee, and provides a timetable of benchmarks that must be achieved before the owner entity can pay the developer fee. An executed development services agreement is considered persuasive evidence that an arrangement exists between the owner entity and the developer. Delivery Has Occurred or Services Have Been Rendered Revenue is earned for accrual purposes as the developer performs services during the development process. Development services typically relate to activities associated with deal structure, obtaining financing sources, oversight of development and construction, and other development related activities. As a result, the development process usually begins at some point prior to commencement of construction and ends at construction completion and/or the placed in service date of the development. The Price is Fixed or Determinable and Collectability is Reasonably Assured Since almost all, if not all, development services agreements identify the developer fee to be earned by the developer, the determination of price is relatively straightforward. On the other hand, determining

2 that collectability of the developer fee is reasonably assured can be very difficult, especially where collection of the fee is contingent upon the availability of future project cash flows. Evaluation of collectability is an ongoing process that should be performed on a project by project basis utilizing portfolio history and experience, underwriting data, asset management reporting, industry data, and any other relevant information. There is no "rule of thumb" with respect to assessing collectability and at best, it is ultimately a matter of judgment based on the information available. CFO Group Input The CFO Group organizations vary in each of their approaches to recognizing developer fee revenue. With respect to the services rendered criteria, the CFO Group organizations generally utilize either of the two following approaches: Recognize developer fee revenue as earned during the development period based on a specified percentage relating to services performed during the predevelopment phase of a project and the remainder of the developer fee recorded during the development period based on the percentage of completion method of accounting. Under this method, a portion of developer fee revenue is recognized at closing (as defined below) relating to services performed by the non-profit, which are inherent in the development process prior to the closing date. The specific portion varies based on the extent of services performed; however, the experience of some organizations has been that recognition at closing of up to 50% of total developer fees can be substantiated (though the typical range is between 20-30%). Closing is generally defined as that point in time at which an outside investor has at a minimum executed a letter of commitment with the owner entity and when all or most of the legal documents related to the project's construction financing are executed and funds become available for use. The remaining portion of developer fees not recognized at closing is recognized monthly over the remainder of the development period, beginning in the month of construction commencement, using the percentage of completion method. Organizations vary in defining the end of the development period. Some of the common benchmarks used include construction completion, full lease up, and receipt of Form Percentage of completion is generally measured as total construction costs incurred to date divided by total construction costs identified in the construction contract. Typically an allowance such as 10% of the total developer fee is reserved by the developer until the final milestones identified in the development services agreement are achieved, such as breakeven operations or receiving the IRS Form Recognize developer fee revenue on a basis that corresponds to the earnings benchmarks described in the development services agreement. 2

3 Under this method, developer fees are recognized in accordance with the earnings criteria described in the development services agreement. The earnings criteria typically are based in part on the progress of project construction/development and often provide that a specified portion of the developer fee is earned at closing. When using this method, it is important for the organization to test and document that revenue recognition closely approximates revenue recognition that would result from using percentage of completion. For organizations that consistently develop multiple projects, their recognition policy may allow for a sample of developments to be periodically tested and documented. The two methods described above either directly or indirectly incorporate elements of the percentage of completion method. In situations where the second method is used, the organization should adequately document that revenue recognition using that method closely approximates the results that would have been obtained under percentage of completion. Accordingly, use of either method is acceptable for recognizing developer fee revenue. Regardless of the method used, revenue recognition should be independent of the timing of collection of developer fees. The methods used by the members of the CFO group to evaluate the collectability of developer fees rely heavily on portfolio history and experience. Understandably, the members of the CFO Group tend to exercise a higher level of scrutiny around "deferred developer fees. Deferred developer fees are the portion of total developer fees payable over time from project operations. Many organizations recognize deferred developer fees only when collected. Other organizations do not make the distinction between developer fees that are deferred and those that are not. They instead recognize as revenue developer fees in total, whether paid during the development phase or expected to be paid from project operations. To the extent that developer fees remain unpaid, these organizations evaluate the collectability of developer fees receivable on an ongoing basis (at least annually) and when necessary, record an allowance for doubtful accounts to properly value the receivable. While the specific valuation methodologies used by each organization may differ, the underlying premise always involves prudent judgment by management in arriving at a valuation allowance that is documented and supportable. It is very important that organizations acquire and document a certain amount of history and experience to determine if all fees are collectible and what portion of developer fees, if any, to defer or reserve. Example 1 attached hereto illustrates a standard developer fee recognition model. The Developer s Maximum Exposure to Loss SOP 92-1 Accounting for Real Estate Syndication Income states that general partners in syndicated partnerships perform syndication activities including developing the property. SOP 92-1 states the developer fee income recognition should be consistent with the guidance for real estate sales accounting in FASB Statement No. 66 Accounting for Sales of Real Estate. That standard states that when a seller of real estate retains substantial risks or rewards of ownership, there is enough continuing involvement to preclude immediate recognition of a profit at the time of a sale. Thus, to be consistent with real estate 3

4 sales accounting, a portion of developer fees should be deferred and recognized over the period during which a developer bears a substantial risk of loss. For example, a developer that guarantees funding a property s operating deficits for the first three years should defer recognizing that portion of its developer fee equal to its maximum risk of loss under such an arrangement, if operating deficit funding is not recoverable. FAS 66 illustrates projecting a 1/3 vacancy rate until there is reasonable assurance that future rent receipts will cover operating expenses and debt service. The existence of a Section 8 contract would mitigate the need for a one-third vacancy rate assumption. Other variables which impact the projection of a developer s maximum exposure to loss include: the speed of the rent-up process, occupancy rates of similar properties in the area and the size of the property s operating reserve available to fund such deficits Similarly, a developer that guarantees construction cost overruns without a right of reimbursement would reduce its fee by the amount of an overrun as soon as it is estimable. Example 2 attached hereto illustrates how the maximum exposure to loss affects developer fee recognition. CFO Group Input The members of the CFO Group have rarely encountered a situation where the developer needed to defer recognizing any material portion of their developer fee as a result of the maximum exposure to loss calculation. In some cases it is the general partner, rather than the developer, that issues the guaranty. In other cases, the operating reserve is large enough to absorb any estimated losses and while there may be temporary cash flow shortages at a property, the property should be able to repay any advances under the deficit guaranty eventually. While many portfolios have troubled properties, there is not necessarily a correlation between the initial few years of operations and the period in which operating subsidies may be necessary. Furthermore, developers may choose to subsidize operations of properties in their portfolios even when no deficit guaranty exists. The CFO Group suggests that developers establish a policy for calculating their maximum exposure to loss on each new development including documenting the substantial risks of loss considered, any mitigating factors which reduce those risks and their conclusions regarding the amount of developer fee to be deferred, if any. This documentation will be useful when discussing revenue recognition issues with the external audit firm each year. Conclusion While processes may differ between organizations, the fundamental bases for determining developer fee revenue recognition are similar: 1) developer fee arrangements are evidenced by written, executed agreements that identify the developer fee; 2) organizations apply the percentage of completion method, or an approximation of that method, to determine the extent that services have been rendered; and 3) organizations utilize available data to periodically evaluate developer fee collection. 4

5 A method that corresponds to or approximates the percentage of completion method, as adjusted for continuing exposure to loss when necessary, would be the best practice for the industry. Individual circumstances within various organizations may warrant other practices and would be acceptable if based on sound logic and the basic premises of GAAP revenue recognition principles. APPLICABLE AUTHORITATIVE PRONOUNCEMENTS Statement of Position 81-1 Accounting for Performance of Construction-Type and Certain Production-Type Contracts Statement of Position 92-1 Accounting for Real Estate Syndication Income SFAS 66 Accounting for Sales of Real Estate Acknowledgements STRENGTH MATTERS gratefully acknowledges the work of staff from Novogradac and Company LLP, The Reznick Group, and Lindquist, von Husen & Joyce LLP and the following individuals that contributed to this paper: Allison Clark, The John D. and Catherine T. MacArthur Foundation, Chicago, IL Vince Dodds, Mercy Housing, Inc., Denver, CO Caroline Horton, AEON, Minneapolis, MN Joe Kasberg, National Church Residences, Columbus, OH Michael Kurtz, Common Ground, New York, NY Jeff Reed, Community Housing Partners Corporation, Christiansburg, VA Harry Thompson, Community Preservation & Development Corporation, Washington, DC D Valentine, BRIDGE Housing, San Francisco, CA Mary White Vasys, Vasys Consulting Ltd, Chicago, IL Laura Vennard, Preservation of Affordable Housing, Inc., Boston, MA Last Updated April 4, 2010 DISCLAIMER This paper contains certain recommended financial reporting best practices for nonprofit affordable housing organizations that develop and own affordable housing in the United States. This paper was developed by a working group comprised of chief financial officers from certain leading nonprofit affordable housing organizations active in the networks of NeighborWorks America, Housing Partnership Network and Stewards of Affordable Housing for the Future, as well as representatives of socially responsible lenders, working in conjunction with representatives from Novogradac and Company LLP, The Reznick Group, and Lindquist, von Husen & Joyce LLP, three independent public accounting firms. This publication should not be construed as accounting or other advice on any specific facts or circumstances. The contents of this paper are intended for general informational purposes only, and you are urged to consult your accountants and other professional advisors concerning your specific situation and any financial reporting or accounting questions you may have. For further information, contact info@strengthmatters.net. 5

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