Analysis/Input GAAP There are two approaches to eliminating developer fee income in financial statements that consolidate or combine the developer that earns the fee and a property that capitalizes the fee. First Approach: Elimination of All Inter-Company Profits Many accountants cite the guidance found in Accounting Research Bulletin (ARB) 51, Consolidated Financial Statements, which generally requires all inter-organization balances and transactions to be eliminated. This is done so that the resulting financial statements present the financial position and operating results of the reporting organization and all of its controlled entities as if they were a single enterprise. Such an enterprise cannot create profits through transactions with itself. ARB 51 also states that when eliminating intercompany profits on assets remaining within the consolidated group, the concept usually applied is elimination of the gross profit (or loss). The existence of minority (or noncontrolling) interests, such as limited partners, should not impact the amount of the gross profit to be eliminated. This is because of an underlying assumption that the consolidated statements represent the financial position and operating results of a single business enterprise. Such accountants also cite FAS 66, which illustrates several situations wherein a real estate seller should not recognize profit on a real estate transaction, including the following: the seller has an option to repurchase the property or guarantees the net tax benefits to the buyer, or the seller is a general partner in a limited partnership and the seller holds a receivable for a significant portion of the sales price, or the seller controls the limited partnership buyer. Often all three of these conditions are present in developer fee arrangements and SOP 92-1 states that the FAS 66 guidance for real estate sales should be followed when recognizing developer fees, as described in Topic 4a. Since the property incurring a developer fee capitalizes it as part of its property cost, the fee is included in the property s total assets and net equity. The developer also recognizes an asset (cash or receivable) and revenue for the fee as described in Topic 4a. The objective of eliminating the profit portion of the fee is to remove all profits recognized between entities within the consolidated group and to produce the same financial result as if a single business enterprise had constructed the real estate for its own use (and obtained noncontrolling equity as part of its financial structure). To avoid recalculating depreciation at the property level on only the consolidated group s cost portion of the fee, a more efficient way to accomplish the same result can be used. Deferring recognition of the
profit portion over the same 40-year life that the property uses to depreciate the property (including the capitalized developer fee) produces the same net effect. Once the profit portion of a developer fee has been deferred in consolidation, the remaining un-deferred portion of the fee represents only the developer s cost. SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects defines project costs that can be capitalized as those direct costs clearly associated with the acquisition, development and construction of a real estate project as well as allocated indirect project costs that clearly relate to a project under development or construction. The developer s costs would include such items as project managers salaries and benefits, allocated overhead and other costs incurred by the developer under the development services contract. Any costs charged to a project in addition to the developer fee are not included. The general and administrative expenses of a developer should be expensed as incurred. The resulting consolidated real property balances after eliminating the profit portion of developer fees should therefore reflect the same property cost that would have been capitalized had the development activity had been carried out by a single business enterprise. To accomplish this objective several steps are needed, including: A. Determine the estimated historical profit portion of developer fees and validate the estimate s accuracy annually for future reporting periods; B. Eliminate the historical developer fee profit from net assets at the beginning of the first consolidated reporting period, net of accumulated depreciation recorded by consolidated group organizations; C. Eliminate the current year development fee revenue, costs and defer recognition of the gross profit; and D. Amortize the deferred gross profit over the same period as the consolidated group organizations depreciate the property. A. Determine the estimated historical profit portion of developer fees and validate annually Organizations implementing the consolidation requirement for the first time will find it challenging to estimate how much of the developer fees capitalized by affiliated partnerships and corporations since the developer s inception represent gross profit needing to be eliminated. It is helpful to use historical records to determine what the percentage relationship was between the (direct and indirect) costs incurred to develop a sample of properties compared with the developer fee capitalized by those properties. Records that capture costs attributable to each development services agreement may not exist since developers often handle many projects simultaneously. In such cases only annual developer fee revenue and historical development department expenditures are available. Since most developments take many years to complete, a reasonable estimate will involve comparing annual developer fee revenue to direct and indirect development expenditures related to the development services performed for at least a fiveyear period. 2
Costs associated with capitalizing affiliates should not be included in this calculation since those costs are ultimately eliminated in consolidation. Developer fees may vary in amount from zero (e.g. for older HUD projects) to several million dollars (e.g. for newer TCAC projects). The sample of properties used to estimate an average profit portion for developer fees should represent a mix of property types similar to the mix in the entire portfolio of consolidated entities. For a larger developer with dozens of properties, a reasonable estimate of this profit will suffice, since obtaining an exact calculation is not practicable. Once an estimate of the profit portion of the developer fee is made (e.g. 30%), the estimate can be used until circumstances change. Monitoring an annual or rolling five-year average of this estimate will identify when it needs to be updated. A disclosure should be made in the financial statement notes regarding the nature of this estimate and its susceptibility to change. B. Eliminate the profit portion at the beginning of the first reporting period The inter-organizational developer fee gross profit remaining in the opening net assets of the consolidated financial statements, prior to elimination, is only that portion of the developer fee that has not yet been depreciated by the consolidated group entities. Generally developer fees are capitalized as part of a building, which has a 40-year estimated useful life for GAAP purposes. Using a spreadsheet listing all consolidated properties by date placed in service, the accumulated depreciation of the developer fee profit can be calculated as of the beginning of the first consolidated reporting period. There is no need to eliminate this depreciated portion of the developer fee profit since the consolidated accumulated net asset opening balance reflects prior year recognition of both the fee and the depreciation expense, netting to zero. However, the remaining un-depreciated portion of the developer fee profit must be removed from the consolidated entity s beginning net asset balance through an elimination entry. The amount removed from net assets is deferred and amortized over the remaining depreciable life of each property. Two approaches for presenting the amount of deferred profit on developer fees are available: either reducing the consolidated property asset account balance (since the analysis above indicates that such balance is otherwise overstated by this inter-organizational gross profit), or reporting the balance as deferred developer fee revenue (a liability). C. Eliminate the current year activity Since the objective is to report development activity as if conducted by a single business enterprise, current year developer fee income should also be eliminated during consolidation. Similarly, current year direct and indirect development expenses associated with earning the developer fee should be eliminated. Such expenses are reflected in the cost portion of the developer fee capitalized by the affiliates. 3
It is unlikely that the net of these two eliminating entries will represent the expected gross profit percentage in any given year, due to timing issues arising from the developer s policy for recognition of developer fees as well as due to the imperfect nature of the estimated profit percentage. Nevertheless, the net of this elimination entry should also be added to the deferred developer fee account. Once newly developed property is placed in service, amortization of the estimated deferred gross profit begins. Until that time, the deferred developer fee account will also contain some balances attributable to projects still in development. D. Amortize the deferred developer fee gross profit The amortization of each property s deferred developer fee gross profit should match the estimated useful life that the entity which capitalized that fee uses to depreciate its property. The same spreadsheet listing all properties by date placed in service can be used to track the annual amortization of the deferred developer fee gross profit. Two approaches also exist for recognizing each year s amortization of such deferred revenue and selection of the appropriate choice will depend on which approach was selected for reporting the deferred profit on the balance sheet. If the deferred revenue is reported as a reduction of the property account balance, the amortization of that deferred revenue should reduce consolidated depreciation expense. Conversely, if a deferred revenue liability is reported, the amortization of that balance should result in developer fee income. Under either approach the consolidated effect is to match the developer s recognition of developer fee profits with the affiliate s recognition of depreciation expense on such inter-organizational profits. Also, under either approach the consolidated effect is to capitalize the direct and indirect development costs, as described in SFAS 67, that were incurred by the consolidated entity other than through interorganizational transactions. When allocating net income between controlling and noncontrolling interests, eliminating entries are often allocated so as to produce no impact on the noncontrolling share of equity. Thus, limited partnership interests as reported to investors will equal the amount of noncontrolling equity on the consolidated financial statements. An illustration of this approach, based on the same facts as Example 1 in Topic 4a appears as Example 1 for this topic. Second Approach: Treat developer fee as a partial real estate sale to the limited partner Other accountants cite the sections of SOP 92-1 and FAS 66 that describe partial sales of real estate. Such sections illustrate accounting for the transfer of real estate from a partner to a partnership in which it holds a partial interest, as long as certain forms of continuing involvement or control are not maintained. Gain on sale of real estate is to be recognized by a seller (developer) based on the 4
proportion of the outside interests in the buyer (limited partnership). Such accountants maintain that paragraph 34 of FAS 66, which states that when the seller controls the buyer no profit shall be recognized, does not apply to general partners who control limited partnerships. Such accountants make a distinction between the developer fees paid out of capital contributions from investment limited partners versus deferred developer fees to be paid out of project operations. To the extent that developer fees are paid by investors, they are recognized as income and not eliminated. Unpaid fees are removed from the depreciable property balance and any corresponding depreciation expense is reversed. An illustration of this approach, based on the same facts as Example 1, appears as Example 2 for this topic. CFO Group Input The CFO group includes proponents of both approaches, although the majority uses the first method (eliminating all intercompany transactions). A comparison of the resulting net assets for each method in Examples 1 and 2 reflect an immaterial difference. However different fact patterns could produce a larger disparity. Neither method will always produce more net assets for the reporting entity, since the impact of the second method (recognizing a developer fee to the extent of cash received) on net assets will vary depending on the magnitude of the deferred portion of the fee. Although the second method results in a quicker recognition of the entire developer fee (since the deferred developer fee will always be paid within 15 years whereas the first method amortizes the profit portion of the fee over 40 years), some members of the CFO group were concerned that the second method appears to contradict paragraph 34 of FAS 66: If the seller owns a noncontrolling interest in the buyer, the seller should recognize profit in proportion to the outside ownership of the buyer. If the seller owns a controlling interest in the buyer, no profit should be recognized until it is realized through either (1) sale to an independent party or (2) profits from continuing operations. Additionally, some members of the CFO group prefer the first method because it is consistent with the approach used for elimination of developer fees earned from non-partnership affiliates. Whichever method is selected, it is important that organizations disclose their accounting policy for developer fee recognition and eliminations in their financial statement notes. 5
APPLICABLE AUTHORITATIVE PRONOUNCEMENTS ARB 51, Consolidated Financial Statements SFAS 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects 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 16, 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. 6
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