Limitation on Capitalization

The proposed rules generally would restrict capitalization only to those costs that directly relate to specific tangible PP&E or PP&E components. For example, improvements such as resurfacing parking lots or roofs and major, long-term painting could be capitalized only if the company accounts for these improvements as separate components and expenses any remaining net book value of the previous resurfacing or painting. In addition, the cost of removing any replaced component must be expensed under the proposed rules. Also, this limitation would eliminate the practice of capitalizing the full basket of costs, both direct and allocated, associated with a major, long-term maintenance project. Only those costs directly related to new or replacement physical components could be capitalized.

Indirect and Overhead Costs Would be Expensed

Indirect costs and certain overhead costs that previously have been capitalizable would be expensed. For example, costs of a chief executive officer could not be capitalized—even when she/he is directly involved with the acquisition or development of PP&E. Other overhead costs that would not be capitalizable include costs of support functions such as corporate accounting and legal, human resources, information systems, marketing, purchasing and office management.

Further, for employees who are directly involved in the development or acquisition of PP&E, only payroll and payroll benefit-related costs of such employees would be capitalized. Currently, most real estate companies capitalize all costs of these employees including space and equipment rental, travel associated with a project, telephones, computer support and administrative support.

If Statement 67 is amended by the FASB to conform to the AICPA proposal (as proposed in the FASB ED) this limitation on the capitalization of indirect and overhead costs would have a more significant negative impact on companies with internal development and construction management staffs.

Expense Remaining Net Book Value of PP&E

The ED requires that the remaining net book value of PP&E, or of a replaced component, be calculated and the amount expensed. For example, if the treads on an escalator are replaced, the remaining net book value of the old treads would need to be calculated and expensed. The same thing would be true of a large elevator motor, a single HVAC unit or any one of hundreds of PP&E components that make up an investment property.

This would represent a major change for virtually all REITs. Currently, in accordance with the composite or group method of depreciation, property assets are grouped into several major asset categories by useful life. Upon replacement of property or a component, the costs of the new asset are capitalized but the net book value of the replaced asset is not written off.

Increase in Detailed Bookkeeping

The proposal's requirement to track separately the cost and accumulated depreciation of PP&E components and to calculate the remaining net book value (original cost less accumulated depreciation) of replaced PP&E components will result in a significant increase in detailed bookkeeping for most real estate companies. Many REITs use the composite method of depreciation at some level of PP&E. They might account for their real estate assets using broad categories, such as land, buildings, mechanical equipment, personal property and tenant improvements. In most cases, each of these categories is depreciated as a group.

Further, under the group or composite method of depreciation, the remaining net book value of components replaced generally is not calculated and charged to expense. The detailed cost accounting requirements of the proposal may implicitly prohibit companies from using the group or composite method of depreciation at any level.

Making the Transition

The proposal provides two alternatives for transitioning to component accounting. The first alternative would require real estate companies to allocate the current net book value of its properties to replaceable components at the date of adopting the new proposal. In order to satisfy the need to track the net book value of each replaceable component, this allocation would result in accounting for potentially hundreds of components for any given property. The publicly traded real estate industry would be faced with allocating well over $300 billion of net asset book value to thousands of components and tracking the net book value of those components.

The second alternative would allow a company to adopt component accounting prospectively by requiring a calculation of the net book value of a replaced component at time of replacement. The second method of making this calculation, as required by the proposal, would generally result in a higher remaining net book value to be expensed.

Could There Be Benefits from This Proposal?

The proposal would require the industry to focus more rigorously on accounting for fixed assets, capital maintenance expenditures and depreciation expense. Financial reporting for investment property assets and their depreciation may even be enhanced if the final SOP would:

• Require grouping costs of investment property into more precise useful-life categories
• Allow for the use of the composite/group depreciation method within each group and
• Allow for the use of more realistic depreciable lives and, possibly, residual values.

Further, if the depreciation expense resulting from this new accounting were deemed to be realistic, it would facilitate the industry's use of GAAP net income as its primary performance indicator.

Commenting Deadline

Because of the dramatic changes in accounting for costs under the proposals and their potentially significant negative impact on the earnings of real estate companies, we would urge the management of each real estate company and companies working in real estate-related fields to familiarize themselves with the proposals, consider their impacts and submit a comment letter to AcSEC and the FASB. The deadline to submit comments is October 15, 2001. NAREIT's Cost Capitalization Task Force, Best Financial Practices Council and staff have completed a draft of NAREIT's comment letter and are available to assist companies in developing individual comment letters. It will also be important to share the industry's views with representatives of the major accounting firms who sit on the AcSEC.

These proposals have a great deal of momentum and are generally supported by the FASB, SEC and the major accounting firms. Therefore, modifying them will only result from significant constituent input.