Real estate investment properties could be moving to fair value

No.2011-36 21 October 2011 To the Point FASB — proposed guidance Real estate investment properties could be moving to fair value The proposal would significantly affect the way many real estate entities account for their investments. What you need to know • The FASB proposed a new standard for entities that invest primarily in real estate properties and meetother criteria. • These “investment property entities” would be required to measure their real estate investment propertyat fair value, with changes in fair value recognized in net income. • They would present investment properties and related debt on their consolidated balance sheets and rental revenue and related expenses on their consolidated income statements. • Investment property entities would not apply the proposed lessor accounting model to leases of their investment properties. Overview The proposal1 by the Financial Accounting Standards Board (FASB) would change the way many entities that invest in real estate account for their investments. The proposal would require a real estate entity that meets the FASB’s investment property entity criteria to measure its investment properties at fair value, with changes in fair value recognized in net income. An investment property entity would present investment properties and related debt on its consolidated balance sheet. Rental revenueand operating expenses would be presented in the consolidated income statement. Investment property entities would not apply lessor accounting to leases oftheir investment properties. Investment property entities that control other investment property entities, entities that provide services to them or investment companies would consolidate Ernst & Young AccountingLink www.ey.com/us/accountinglink these entities. An investment property entity would not consolidate any other entities it controls but would measure those controlling financial interests atfair value with all changes in fair value recognized in net income. IFRS has an accounting model for investment properties, but it differs significantly from the FASB’s proposal. Background Today, the accounting for investments in real estate is diverse. Real estate investment trusts (REITs) generally carry real estate properties at cost less accumulated depreciation.Real estate funds follow a variety of fair value accounting approaches fortheir real estate properties, including following the investment company guidance in ASC 946, Financial Services — Investment Companies. Real estate funds that are investment companies account for all of their investments at fair value, but do not consolidate the underlying assets and liabilities of controlled entities. The International Accounting Standards Board (IASB), in earlier deliberations related to the joint FASB-IASB project on accounting for leases, tentatively decided that its proposed lease accounting model would not apply to lessors of investment property measured at fair value.IFRS provides an option to allow entities to measure investment properties at either fair value or historical cost under IAS 40. The option applies to all entities (i.e., there is no investment property entity concept under IFRS). The IASB decided that thefair value model would provide more useful and relevant information to financial statement users than the proposed lessor accounting model. In an attempt to address this potential inconsistency inlease accounting and to address existing diversity in the accounting for real estate investments, the FASB embarked on this project. Investment property entities The proposal would apply to entities that meet all of the following criteria: • Nature of the business activities — Substantially all of the entity’s business activities are investing in real estate property or properties. • Express business purpose — The express business purpose of the entity is to invest in real estate property or properties for total return including capital appreciation (for example, through disposal of the properties). • Unit ownership — Ownership in the entity is represented by units of investment. • Pooling of funds — The funds of the entity’s investors are pooled. • Reporting entity — The entity provides financial resultsabout its investing activities to its investors. When evaluating whether substantially all of an entity’s business activities are investing in real estate properties, the entity would consider real estate properties it holds directly or indirectly through controlling financial interests. Significant investments in other typesof assets, such as investments in mortgage notes, bonds, or noncontrolling interests in other entities (including noncontrolling interests in other investment property entities) wouldbe inconsistent with the “nature of business activities” criterion the FASB has proposed. An investment property entity could hold investments in other assets as long as those investments are not significant to the entity or are held only on a temporary basis. 2 21 October 2011 To thePoint – Real estate investment properties could be moving to fair value Ernst & Young AccountingLink www.ey.com/us/accountinglink To be an investment property entity, an entity’s express business purpose would be to invest in real estate for total return, including an objective to realize capital appreciation. An entity would demonstrate this objective by formulating exit strategies for the disposition of its investments, for example through property sales. The proposal does not specify a time frame for plans to dispose of properties. Disposal of real estate properties through the liquidation of the entity would not constitute an exit strategy for purposes of meeting thiscriterion. Also, an entity that has an express business purpose ofinvesting in real estate propertiesfor use in the production or supply of goods or services, rental income only or to develop for sale in the ordinary course of business would not be an investment property entity. Real estate entities would face challenges in moving to fair value and presenting more detailed information about their underlying investments. Proposed accounting for investment property entities Investment property entities would initially measure real estate investment properties upon acquisition at their transaction prices, including fees, taxes and other transaction costs.Investment property entities would subsequently measure their real estate investment properties at fair value and recognize all periodic changes in fair value in net income. The fair value of real estate investment properties would be calculated including the expected cash flows under any in-place lease contracts. Investment property entities would not apply the lessor accounting provisions of the leases proposal.2 Instead, they would recognize rental revenue when lease payments are received or as the lease payments become receivable in accordance with the contractual terms of the related leases. Investment property entities would not separately account for intangible assets related to in-place leases (e.g.,favorable or unfavorable lease terms) in acquired properties as the value of the leases would be included in the fair value of the properties recognized. An investment property entity would present investment properties and related debt on its consolidated balance sheet and rental revenue and related expenses on its consolidated income statement. All non-investmentproperty assets of an investment property entity(which would have to be either not significant or held only temporarily) and all liabilities of the investment property entity would be accounted for in accordance with other relevant US GAAP. Inarelated project,the FASBproposedrevisingthe definitionof an investment companyand modifyingsome ofthe guidancefor investment companies.3 Anentity thatisaninvestment propertyentity would not beaninvestment companyand vice versa.Ifanentity meetsthe criteriafor bothaninvestment companyandan investment property entity, itwould beaninvestment propertyentity. Underthe investment company proposal,investment companies would in most cases continue to measuretheirinvestmentsatfairvalue. The FASB’s proposalwould alsorequire aninvestment companytoconsolidate an investment propertyentity(andretainthe accountingfor theinvestment property entityinconsolidation) when the investment companyholdsa controlling financial interestinthe investment propertyentity. 3 21 October 2011 To thePoint – Real estate investment properties could be moving to fair value Ernst & Young AccountingLink www.ey.com/us/accountinglink How we see it The proposal would createbig operational challenges for real estate entities that do not currently measure their real estate properties atfair value. Investment property entities would have to gather and analyze data related to their operations and make valuation assumptions. It might also be challenging to track and present detailed information about the underlying investment properties held in entities that would be consolidated under the proposal. Effective date and transition The FASB has not yet suggested an effective date. The proposed changes are significant, and affected entities would need sufficient time to educate users of their financial statements and to develop the systems and processes necessary to implement the proposed standard. Upon transition, an investment property entity would recognize a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. The FASB tentatively decided not to permit retrospective application because doing so would require determining fair value for prior periods. Next steps Because the proposal represents a significant change from current practice, we encourage real estate entities to determine how they would be affected and to express any concerns to the FASB. Comments are due5 January 2012. Endnotes: 1 ProposedAccountingStandardsUpdate, RealEstate— Investment PropertyEntities 2 See ourTo the Point,Operatingleaseaccountingsurvivesfor some realestatelessors (SCORENo. BB2198),forfurtherdetails. 3 SeeProposedAccountingStandardsUpdate, Financial Services— InvestmentCompaniesand ourTo the Point, Redefininginvestment companiesandhowtheyaccount forinvestments (SCORENo. BB2201),forfurtherdetails. Ernst&Young Assurance|Tax|Transactions|Advisory ©2011Ernst&YoungLLP. AllRightsReserved. SCORENo.BB2200 About Ernst& Young Ernst&Youngisa globalleaderinassurance,tax,transactionandadvisoryservices.Worldwide,our 152,000peopleareunitedbyoursharedvaluesandanunwaveringcommitmentto quality.Wemakea differencebyhelpingourpeople,ourclientsandourwidercommunitiesachievetheirpotential. 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