Real Estate JV Losses,
Consolidation and Recent
GAAP Pronouncements
Jeffrey G Olson, CPA
Babush, Neiman, Kornman & Johnson, LLP
www.bnkj.com
Topics

Consolidation and equity method
of accounting
 ARB 51 (1959), SFAS No.94 (1987)
 APB 18 (1971)
 FASB FIN 46 (Jan. 2003)

Real estate JV losses - SOP 78-9
(1978)
 Debt/equity instruments - SFAS
150 (May 2003)
Real Estate Ownership

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



Wholly-owned assets
Corporate subsidiary
Corporate JV
Partnership (General or Limited)
LLC
Undivided interests or tenants in
common
GAAP Accounting

Consolidate
• SFAS No. 94 “majority owned”
corporate subsidiaries or controlled
general partnerships
• FAS FIN #46 is new

Equity Method - most unincorporated
entities
 APB 18 generally
 Real estate entities specifically AICPA
SOP 78-9
GAAP Accounting
Consolidation vs. Equity Method
 Financial
statement effect is only presentation
 Consolidate
with minority interests
 Equity method reduces investor’s share of net
assets and revenues/expenses to a single line
each
 No
effect or difference on reported equity or
net income of consolidating/investor entity
 Can significantly effect gross balance sheet
and ratios
Real Estate Latest Activity
Draft AICPA SOP - Accounting for
Investors’ Interest in Unconsolidated
Real Estate Investments

Project draft originally dated 11-21-00 to
have replaced SOP 78-9
 AICPA rule making has changed -project
turned over to FASB in early 2003
 FASB has not picked it up as a current
project - SOP 78-9 still applies
SOP 78-9 Equity Method

SOP 78-9 looks at control over a
“majority” ownership
 Unlike SFAS No. 94’s “majority”
ownership, non-corporate entities
economics, ownership, and control
rights may not have a clear “majority”
 Where there is shared control, SOP
78-9 would have no one consolidate
the JV
JV Losses - GAAP & Tax

Often depreciating an appreciating
real estate asset - noncash losses


GAAP or tax effects - partners may be
sensitive to who has to or can report
these losses
Real economic or cash losses
 Generally no difference in how
allocated
JV Losses - GAAP & Tax

Generally allocated first to those
partners who have positive
capital balances until everyone
reduced to zero
 Then JV allocates to partners
with economic risk for additional
losses via


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Other loans/advances
Deficit restoration provisions
Other guarantees or commitments
Of support
Illustrations

Practically speaking in
REJV’s



LP’s are rarely ever allocated
losses below zero capital
account
General partner usually has
debt guaranty, particularly on
development loans
Losses in excess of invested
capital -what happens?
GAAP
Investors deemed unable to bear
losses otherwise

JV allocates among other investors at
risk (under FAS 5 loss contingency
concept)
 Investors “catch up” on subsequent
income allocations
 Exception for losses when return to
profitability is imminent and reasonably
assured
GAAP Ability to Bear Losses
Is it probable an investor is
unable to bear his share of losses?
Look to:

Fair value of his interest (cancels out
depreciation loss effects)
 Other evidence of economic
commitment
 Loans
previously made
 Financial wherewithal and intent to
fund
 Collateralized guarantees
GAAP-Should Investor
Record Allocated Losses?

Need consistent basis of accounting
 If deemed by other investors not
able to bear losses and losses not
allocated


Investor will continue to record
contractual losses (even if not
allocated) unless formally relieved by
agreement or operation of law
Can result in all investors as a group
picking up more than 100% of JV level
loss!
GAAP Allocation Ratios

JV agreement on P&L and
distribution allocations may be
inconsistent
 SOP 78-9 directs to use
substance over form
 Use liquidation accounting on
capital to “push” the P&L
allocation
 Same for tax?
Negative Capital- Tax
Effects

If P&L & liquidating distributions
are done correctly, less of a
chance that some partners can
be left with deficits while others
have positive capital
 May not always work out


Interim sale of interest
Errors
FAS Financial Interpretation
No. 46

New January 17, 2003
 Interpretation of ARB 51
 FIN 46 directed primarily toward:
Enron-type “off balance sheet”
accounting
 Securitization transactions and SPE’s
 R&D ventures/development stage
companies
 Most synthetic lease transactions


Others will be caught however
FIN 46
Variable Interest Entity (“VIE”) will be
consolidated by its primary beneficiary
 No more bastard subsidiaries (i.e.
“parentless”)
 Attacks accounting “form” transactions back

to economic substance - debt or accounting
loss avoidance
FIN 46
Primary beneficiary/parent

Entity who absorbs the majority of
losses, or losses and income
 May be a non-owner with other
contractual relationship
 Leases
 Loans
and guarantors
 Service or development agreements
 Other based on substance
FIN 46
Variable Interest entity has
either

Insufficient equity at risk
(quantitative)
 Holders of equity at risk lack
characteristics of a controlling
financial interest (qualitative)
FIN 46 - Equity at Risk
 GAAP defined equity only - need
other subordinated capital or outside
guarantees
 Below 10% must have pervasive
evidence
 Above 10% not automatic reference other similar businesses or
entities
 Equity is less than expected losses
FIN 46-Lack Controlling
Financial Interests
If Equity Holders as a group lack
any of the following:

Ability to make decisions on entity
activities through voting rights (others
have limits on absolute control rights)
 Obligation to absorb losses
(guarantees or through purchase
commitments)
 Right to receive residual returns or if
those returns are capped
FIN 46 -Lack of Controlling
Financial Interests
Lack of controlling financial
interest indicated by:
 Some
investors with voting rights
disproportionate to their loss
obligations and/or residual return
rights
 Substantial activities of the entity
are for or on behalf of investor
with disproportionately few voting
rights
Who/What Else May Be
Affected

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Certain real estate partnerships,
depending on structure
Certain related party leasing transactions
Certain homebuilder land and lots
controlled through contract
Certain forward contracts and swaps
with a VIE
Certain service contracts with a VIE
SFAS 150
Financial instruments with characteristics of
both debt and equity - May 2003
No more “mezzanine” presentations for these type
items
 Maditorily redeemable equity
 ESOP’s & other equity type plans with mandatory
buybacks - options, restricted or phantom stock, etc...
 Others generally outside real estate contexts

SFAS 150 Affects

Liability recorded at fair value
except for

Physically settled forward purchase
contracts
 Mandatorily redeemable instruments

Lower equity/increase debt
 Effects on ratios, loan covenants,
etc...
SFAS 150 Affects
Buy sell/agreements effecting
100% of equity creates madatorily
redeemable


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$0 equity, it is all a liability
Separate line item presentation
Note disclosure of CS/PIC/RE type
information