Industry Insights

On October 21, 2011, the Financial Accounting Standards Board (FASB) issued an exposure draft of a proposed accounting standard on accounting for investment property entities (IPE). The proposed Accounting Standards Update (ASU) would change the way many entities investing in real estate account for their investments. A real estate entity meeting FASB’s defined IPE criteria would be required to measure its investment properties at fair value, with changes in fair value recognized in net income. This would be a significant change for entities currently reporting such investments at historical cost. Other proposed changes also may be significant to entities reporting under fair value today.

Background

FASB is looking to address diversity in accounting for real estate investments by certain real estate entities and potential inconsistency in lease accounting.

Accounting for investments in real estate today is diverse. Real estate investment trusts (REITs) generally carry real estate properties at historical cost less accumulated depreciation, while real estate funds follow a variety of fair value accounting approaches for their properties. Entities considered investment companies under ASC 946, Financial Services – Investment Companies, such as real estate funds, account for real estate investment properties at fair value but do not consolidate the underlying assets and liabilities of controlled entities.

FASB and the International Accounting Standards Board (IASB) decided in earlier deliberations related to the joint lease accounting project that the proposed lease accounting model would not apply to lessors of investment property measured at fair value. This would result in significant differences in the scope of entities applying the proposed lessor accounting model under U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). Entities reporting under International Accounting Standard 40, Investment Property, and electing to measure all of their investment property at fair value would be scoped out of the proposed lessor accounting model. Before FASB issued the IPE proposal, there was no guidance in U.S. GAAP similar to what is currently in IFRS; the proposed ASU could help align the scopes of FASB’s and IASB’s proposed lessor accounting requirements.

IPE Criteria

Under the proposed ASU, an entity meeting all of the following criteria would be considered an IPE:

• 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 properties for total return, including capital appreciation, e.g., through disposal of its real estate 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 to benefit the investors of professional investment management.
• Reporting entity:  The entity provides financial results about its investing activities to its investors.

An IPE is not prohibited from investing in other assets. An entity can hold assets such as loans, securities and derivatives—regardless of whether they are related to real estate—provided those investments are not significant to the entity. Investments in mortgage receivables and mortgage-backed securities are not considered investments in real estate properties for purposes of IPE determination.

Certain property types are considered explicitly incompatible with the express business purpose criterion. Such property types would be those typically including significant customer service, e.g., owner-operator hotels and nursing homes, and those developed for “sale in the ordinary course of business upon completion," e.g., land development, condo conversions or home builders.

An entity investing in real estate properties should first evaluate the criteria to qualify as an IPE and apply the guidance if met. An entity not meeting the proposed IPE criteria still may be within the scope of the proposed investment company ASU. Entities not meeting the IPE definition should assess whether they meet the definition of an investment company.

Specific facts and circumstances for each entity and property type should be considered when determining whether the IPE criteria are applicable.

Measurement of Investment Properties

IPEs would initially measure real estate investment properties upon acquisition at their transaction price, including fees, taxes and other transaction costs. This differs from the requirement in ASC 805, under which transaction costs must be expensed in a business combination. IPEs would subsequently measure their real estate investment properties at fair value and recognize all changes in fair value through the income statement.

Other Investments

An IPE would apply the equity method of accounting in ASC 323 only to an investment in an operating entity providing services to the IPE for which it has significant influence, e.g., property management services. An IPE would measure all investments otherwise qualifying for the equity method, e.g., an investment in an IPE or an investment company, at fair value, recognizing all changes in fair value through income statements.

An IPE consolidating another IPE or investment company, as defined in ASC 946, would retain the IPE’s or investment company’s specialized accounting. All other controlling financial interests in entities would not be consolidated, but rather measured at fair value with all changes recognized through income statements.

Investments in loans, debt securities and other cost method investments would be accounted for under other relevant U.S. GAAP.

Recognition of Rental Revenue

IPEs would recognize rental revenue when lease payments are received or as the lease payments become receivable in accordance with the lease terms, rather than on a straight-line basis. FASB said requiring rental revenue recognition on a straight-line basis would require adjusting the investment property’s fair value to avoid double counting, because the fair value of an investment property would include the effects of future rent increases or concessions.

Presentation & Disclosure

An IPE would be required to present separately within its income statement all of the following related to its investment properties:  rental revenues, rental operating expenses and changes in fair value recognized in earnings. An IPE also would be required to separately present the fair value of investment properties held and any associated debt in its balance sheet.

Effective Date & Transition

The proposed ASU does not specify an effective date; a date will be set after considering comment letter feedback on the proposed ASU. Comment letters are due by January 5, 2012.

Early application would be prohibited. An entity considered an IPE as a result of the proposed IPE would report the effect of applying the amendments as a cumulative effect adjustment to retained earnings as of the beginning of the adoption period.

For more on this proposed ASU, contact your BKD advisor.