Timberland Financial Reporting
Jeff Mardis, CPA
Audit Partner
Sellers, Richardson, Holman & West, LLP
DUKE ENVIRONMENTAL LEADERSHIP PROGRAM // 2015
TIMBERLAND INVESTMENT
SPECTRUM
Investors can access the timberland investment market in multiple
ways:
CMBS and RMBS
Debt
Secured Debt
(first mortgages)
Investment grade
(AAA – BBB)
Unsecured Debt
(public debt/mezzanine debt)
Sub-inv. grade
(BB and lower)
Timberland
ownership
Equity
REITs and Publicly
Traded Companies
Indirect ownership through publicly
traded securities regulated by the
SEC
Direct Property
Investment
Direct fee or leasehold ownership
of timber and timberland properties
Private Investment
Fund
Indirect ownership through private
securities of an investment fund
that invests in timber and timberland
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TIMBERLAND INVESTMENT
SPECTRUM
Private Investment Fund
•
Characteristics
–
–
–
–
–
–
•
Acquire timber companies or timberland assets
Often created by Timber Investment Management Organizations (TIMOs)
TIMO management team/ third party manager operates properties
Fund typically has no employees
Finite life funds – closed end; indefinite life funds – open end
Multiple investors pooling money to invest with management team
Accounting
–
–
–
–
ASC 946 Financial Services-Investment Companies/AICPA Audit and Accounting Guide- Audits of
Investment Companies/NCREIF PREA Guidance
Fund level reporting represents aggregation of all investments
Investments carried at fair value
Operating Model
•
•
–
Non-Operating Model
•
•
•
–
–
•
Operating Model-Consolidate direct investments and controlled investees
Operating Model-Equity Method for non-controlled investees
Generally employ a “net” presentation
Authoritative GAAP does not specifically address when to consolidate another investment company
GAAP prohibits applying the equity method. Investment must be measured at fair value
Fair Value NAV should not be significantly different under either model
Cash distributions from investments received; recorded as income or return
of capital
Analyst view
–
–
Net asset value (provided)
Performance returns – financial highlights (provided)
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TIMBERLAND INVESTMENT
SPECTRUM
REITs and Publicly Traded Companies
• Characteristics
–
–
–
–
–
•
Accounting
–
–
–
–
–
–
•
Purchase/develop real estate
Own, operate properties or hire manager
Infinite life
Regulated by Securities and Exchange Commission (SEC)
Numerous investors – institutional and private
Historical cost-Generally Accepted Accounting Principles (GAAP)
Prohibited from applying Investment Company Accounting
Consolidation of controlling interest
Purchase price accounting for acquisitions
Impairment analysis
Straight-line rents
Analyst view
– Net asset value
– Earnings per share (EPS)
– Dividend Yield
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TIMBERLAND INVESTMENT
SPECTRUM
Direct Property Investment
•
Characteristics
– Acquire real estate assets through privately owned LLCs, LPs, Pension Separate
Accounts
– Often a very specific/defined investment goal
– Usually high net-worth investors or large institutional investors
•
Accounting
– Great diversity in reporting requirements
– US historical cost GAAP, investment company accounting, income tax basis,
Financial Accounting Standards Board (FASB) 35 or Governmental Accounting
Standards Board (GASB) 25
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TIMBERLAND INVESTMENT
SPECTRUM
Pension Separate Accounts
• Characteristics
 TIMO or other manager hired to invest on behalf of a single-defined benefit
pension plan (corporate; public employee)
 Acquires physical properties or timber deeds
 Property manager hired to manage property if investment manager is not
integrated
• Accounting




FASB 35 and GASB 25
Investments at fair value
Consolidation of controlled interests
P/L with full operations reflected
• Analyst view
 Net asset value (provided)
 Performance returns (supplemental)
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ASSESSMENT OF INVESTMENT
COMPANY STATUS
• An entity that is regulated by the Securities and
Exchange Commission under the Investment Company
Act of 1940 (the Act) automatically qualifies as an
investment company.
• Entities that are not regulated under the Act must have
certain fundamental characteristics and consider other
typical characteristics to determine whether they qualify
as investment companies. An entity should consider its
purpose and design when making the assessment.
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INVESTMENT COMPANY
FUNDAMENTAL CHARACTERISTICS
An investment company must have the following fundamental characteristics:
•
The entity obtains funds from one or more investors and provides the
investor(s) with investment management services.
•
The entity commits to its investor(s) that its business purpose and only
substantive activities are investing the funds solely for returns from capital
appreciation, investment income or both.
•
The entity or its affiliates do not obtain or have the objective of obtaining
returns or benefits from an investee or its affiliates that are not normally
attributable to ownership interests or that are other than capital appreciation
or investment income.
•
An entity that does not have all of the fundamental characteristics would not
be an investment company.
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INVESTMENT COMPANY
FUNDAMENTAL CHARACTERISTICS
An investment company also has the following typical characteristics:
•
It has more than one investment.
•
It has more than one investor.
•
It has investors that are not related parties of the parent (if there is a parent)
or the investment manager.
•
It has ownership interests in the form of equity or partnership interests.
•
It manages substantially all of its investments on a fair value basis.
•
An entity that does not have one or more of the typical characteristics could
conclude that it is an investment company, but it would have to apply
judgment and determine, considering all facts and circumstances, that its
activities continue to be consistent with those of an investment company.
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INVESTMENT COMPANY
ACCOUNTING
• Key accounting requirements:
– Statement of Net Assets
– Investments recorded at fair value (follow
other GAAP for other assets and liabilities)
– Schedule of investments and financial
highlights
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INVESTMENT COMPANY
ACCOUNTING
– Unrealized gain/loss vs. realized gain/loss:
• Both are presented below the line on the financial
statements, such as after net investment income (investment
income minus expenses)
• Unrealized relates to any changes in fair value of the
investment from one reporting period to the next
• Realized gain/loss relates to the sale of the investment-it
reverses any previously recognized unrealized gain/loss
• Realized gain varies by investments and accounting basis
DUKE ENVIRONMENTAL LEADERSHIP PROGRAM // 2015
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SAMPLE STATEMENT OF NET
ASSETS
Assets
Investments
Timberlands
$
Investments in timberland joint ventures
Total investments
Cash and cash equivalents
Other assets
Total assets
$
Liabilities
Accrued expenses
Accounts payable
Deferred tax liability
Total liabilities
Net Assets
$
5,498,082
$
9,032,674
41,413,979
40,886,012
46,912,061
49,918,686
1,553,359
68,007
3,016,360
101,132
53,036,178
48,533,427
$
585,090
72,753
1,060,531
1,718,374
70,067
129,634
1,831,748
2,031,449
46,815,053
$51,004,729
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SAMPLE STATEMENT OF
OPERATIONS
Revenue
Timber sales
Equity in income of joint ventures
Interest income
Other income
Total revenue
$
1,523,685
77,612
1,601,297
$
169,303
1,287,512
83,847
5,000
1,545,662
Expenses
Depletion
Harvesting expense
Real estate and other taxes
Property management
Account management
Professional fees and other
Total expenses
76,818
552,708
84,460
713,986
150,757
13,714
10,069
31,919
776,605
125,188
1,108,252
Net investment income
887,311
437,410
Net realized gain
Net proceeds received from sales of real estate investments
Less: Cost basis of real estate investments sold
Realized gain from sales of real estate investments
Less: Reversal of previously recorded unrealized gain on sale
Net (loss) gain realized from sales of real estate investments
Realized gain on joint ventures
Net realized gain
4,569,603
3,221,271
1,348,332
1,358,729
(10,397)
219,761
209,364
20,030,921
15,811,792
4,219,129
4,142,974
76,155
38,410
114,565
Unrealized gain on real estate investments held
8,181,980
6,869,007
Net increase in net assets resulting from operations
$
9,278,655
$
7,420,982
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INVESTMENT COMPANY
FINANCIAL REPORTING ISSUES
• Schedule of Investments
– Percent net assets for each category and total
cost for each category
– Disclose the name, value and type of each of
the following:
• Each investment constituting more than 5% of net
assets
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SAMPLE FOOTNOTE DISCLOSURES (FAIR
VALUE POLICY)
•
In accordance with ASC 820, Fair Value Measurement, the Partnership has
established and documented processes and methodologies for determining the fair
values of forestland investments on a recurring basis. This value is based on
exchange prices in a hypothetical orderly transaction at the measurement date
between market participants to sell the asset or transfer the liability in the market in
which the reporting entity would transact for the asset or liability, this is, the principal
or most advantageous market for the asset or liability. The financial instrument’s
categorization within the valuation hierarchy is based upon the lowest level of input
that is significant to the fair value measurement.
•
The three levels of valuation hierarchy are defined as follows:
•
Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for
identical assets or liabilities in active markets.
Level 2 – inputs to the valuation methodology include quoted prices for similar assets
and liabilities in active markets, and inputs that are observable for the asset or
liability, either directly or indirectly, for substantially the full term of the financial
instrument.
Level 3 – inputs to the valuation methodology are unobservable and significant to the
fair value measurement.
•
•
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SAMPLE FOOTNOTE DISCLOSURES
(FAIR VALUE POLICY)
•
The Partnership invests primarily in diversified commercial forestlands for which quoted prices
falling within the categories of Level 1 and Level 2 inputs are not available. Therefore, the
Partnership values all of its investments at fair value, as determined in good faith by the General
Partner (Level 3 inputs, as further described below). Due to the inherent uncertainty in the
valuation process, the General Partner’s estimate of fair value may differ significantly from the
values that would have been used had an active market existed, and as such, the differences
could be material. In addition, changes in the market environment and other events that may
occur over the life of the investments may cause the gains or losses ultimately realized on these
investments to be different than the valuations currently assigned. There is no single standard for
determining fair value in good faith, as fair value depends upon circumstances of each individual
investment. In general, fair value is the amount that the Partnership might reasonably expect to
receive upon the current sale of the property.
•
For the period during which a forestland investment is acquired, it is initially recorded at the
appraised value established by an independent third party appraisal. This valuation incorporates
various methodologies including, but not limited to, the cost approach, income approach, and
comparable sales approach. An independent appraiser will establish the reported forestland fair
value at the end of every three-year cycle following acquisition. For periods between third party
independent appraisals, the General Partner determines forestland investment fair value. Factors
considered by the General Partner in determining the interim estimates of fair value include,
among others, the following: the most recent appraised value, the growth of the timber, volumes of
timber harvested, pricing changes in relevant timber markets, and adjustments to land values.
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SAMPLE FOOTNOTE DISCLOSURES
(UNOBSERVABLE INPUTS)
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INVESTMENT COMPANY
FINANCIAL REPORTING ISSUES
• ASC 946 Financial Services-Investment Companies and
AICPA Audit and Accounting Guide- Audits of Investment
Companies require disclosure of financial highlights for
the following:
– Net investment income ratio – net investment
income/average net assets
– Expense ratio – total expenses/average net assets
– Internal rate of return (IRR) – the implied discount
rate calculated based on a series of cash flows and
residual values as of the beginning and end of
the investment period
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INVESTMENT COMPANY
FINANCIAL REPORTING ISSUES
• Financial highlights
– Ratios calculated for each class of investor (excluding
the manager)
– Net investment income ratio and expense ratio are
calculated prior to the effects of any incentive
allocation
– If incentives are structured as fees, include in
calculation of expense ratio
– All incentives should be reflected in the disclosure of
financial highlights to avoid inconsistencies in ratio
presentations based solely on structuring of fees
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SAMPLE FOOTNOTE DISCLOSURES
(FINANCIAL HIGHLIGHTS)
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INVESTMENT COMPANY
ACCOUNTING
• FASB Accounting Standards Codification (ASC) 820
provides a framework that clarifies the fair value
measurement objective within GAAP and its application
under the various pronouncements that require (or
permit) fair value measurements.
• Determining “fair value”
– One likely reason for diversity in fair value methods is the
varying nature of investments, which are both traditional and
non-traditional.
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INVESTMENT COMPANY
VALUATION DRIVERS OF TIMBERLAND ASSETSLEVEL 3 FAIR VALUE MEASUREMENT
• Timber Component:
– Net biological growth- Biological growth of the timber resource
including in-growth less harvest removals.
– Timber price changes- Species pricing for the compositional
makeup of the underlying timber resource.
• Land Component:
– Generally the CPI is used as a proxy for land value changes due
primarily to the absence of any other significant measurement
tool. CPI is often a basis for appraiser’s assumptions on
valuation of the underlying dirt value.
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HOW IS GROWTH RECOGNIZED?
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Investment Company
Measurement of Value Change-Timberland Property
• Assumptions:
1. $10 Million Timberland Property at acquisition on
December 31st 2012.
2. 30% allocated value to the land ($3M) and 70% to the
timber resource ($7M).
3. Biological Growth including in-growth: 6% Annually
4. Annual Harvest Rate: 50% of net biological growth
5. 2013 Price Changes on a blended species basis: 8%
6. 2013 CPI: 3%
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INVESTMENT COMPANY
MEASUREMENT OF VALUE CHANGE-TIMBERLAND
PROPERTY (CONTD.)
• What is the value of this timberland property as of 12/31/2013?
• Increase in value of the timber component is 3% for net biological
growth which added $210,000 in value for the year.
• With incremental timber volume resulting in the higher timber value
and 8% for improved pricing throughout the year being applied,
2013 price changes added $576,800 in market value for the year.
• The land component increased at the 3% inflation rate which added
another $90,000 for the land.
• The overall increase for the 2013 year would be $876,800.
• The fair value of the timberland property as of 12/31/2013:
$10,876,800.
• 2013 Annual Rate of Appreciation for the Property is 8.77%.
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INVESTMENT COMPANY
FINANCIAL REPORTING ISSUES
• IRR is required to be disclosed instead of
total return as previously required under the
guide if the following criteria are met by the
investment company:
– Have limited lives
– Don’t continuously raise capital
– Operating strategy is to return proceeds from
dispositions to investors
– Limited opportunities for investors to withdraw
prior to termination of the entity
– Acquiring market-traded securities and
derivatives are not routine
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WHAT IS A REIT?
• Real estate investment trust (REIT) – a
corporation, business trust or association that
makes a tax election by filing form 1120-REIT
after meeting the required criteria
• REITs were created in 1960 by the US Congress
to allow individual or smaller investors to
participate in investing in real estate (a sort of
real estate mutual fund)
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REIT REQUIREMENT CRITERIA
•
•
•
•
Organizational
Operational
Distribution
Compliance
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REIT – ORGANIZATIONAL
REQUIREMENTS
• Ownership:
– Not closely held – must be owned by a minimum
of 100 shareholders
– No more than 50% of shares may be held by 5 or
fewer individuals (5/50 Rule)
• Structure: managed by a board (one or more
trustees or directors) with freely transferable
shares or certificates (public entity)
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REIT – OPERATIONAL
REQUIREMENTS
• Quarterly asset test: at least 75% of the value of the
REIT’s total assets represented by real estate assets
(real property, mortgages on real property, CMBS,
RMBS)
• Annual income test: at least 75% of gross income
derived from one or more sources, including rents
from
real
property,
mortgage
interest
or
dividends/gains from REIT shares (good income vs.
bad income)
• Taxable REIT subsidiary (TRS): not more than 25% of
the value of the REIT’s assets represented by one or
more TRSs
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REIT – DISTRIBUTION
REQUIREMENTS
• Annual distribution test: during the taxable year
must pay out (includes actual and certain deemed
distributions) at least 90% of REIT taxable income to
shareholders. May pay out 100% of REIT taxable
income to avoid corporate level tax.
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REIT – COMPLIANCE
• Failure to meet these tests can result in penalties or
disqualification, which may result in the REIT
incurring corporate taxes or potentially losing REIT
status
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REIT-ADVANTAGES
• Two Major Structural Advantages of the REIT:
1. Allows for the utilization of leverage without
generating UBTI (unrelated business taxable
income) for tax-exempt investors. This provides
the potential for incremental returns.
2. Provides safe harbor rules for the disposition of
real estate assets whereby a “facts and
circumstances” test is applied in the partnership
taxation arena.
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REIT FINANCIAL REPORTING
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REIT FINANCIAL REPORTING
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REIT FINANCIAL REPORTING
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REIT FINANCIAL REPORTING
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THE REIT MARKET
Home financing
8%
Commercial
financing 1%
Timber 5%
Office
10%
Industrial 4%
Office/ind mix 7%
Health care
11%
Shopping
centers 7%
Self-storage
6%
Retail 13%
Lodging/resorts 5%
Diversified 7%
Apartments
13%
Manufactured homes 1%
Free standing
retail 2%
Source: NAREIT
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CASE OF BLUE DEVIL TIMO
Considering the organization of a new investment
vehicle.
A couple of institutions have expressed an interest in
establishing separate accounts with Blue Devil TIMO.
Some of the existing investors have expressed
interest in participating in a new fund.
The Investment Committee has requested that you
evaluate the proposed structural options of the new
investment vehicle along with the financial reporting
issues that may impact the selection of the type of
fund investment vehicle to pursue.
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BLUE DEVIL TIMO CASE TEMPLATE
• First choice for new fund type-Separate Account vs.
Commingled Fund? _____________
• Criteria drivers for this choice?
– A. ___________________
– B. ___________________
– C. ___________________
• Accounting Method- Fair Value Reporting or Lower
of Cost or Market?
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