by George Yungmann and David Taube
By the time this article is published, the American Institute of Certified Public Accountants (AICPA) is expected to have issued an exposure draft (ED) of proposed rules governing which costs related to property, plant and equipment (PP&E), including real estate, should be capitalized and which should be expensed in GAAP financial statements. In addition, this proposal would require very detailed accounting for PP&E components and, implicitly, eliminate the composite method of depreciation. The Securities and Exchange Commission (SEC) and many auditors believe that the lack of uniformity in the capitalization of costs is a pervasive financial reporting problem. Based on the latest draft of the proposal, these new rules would have a negative effect on Funds From Operations (FFO) as well as GAAP net income for most companies. The AICPA intends that these rules would become effective beginning in 2002.
This article summarizes the pitfalls and potential benefits of the proposal, but more importantly, it calls for action on the part of NAREIT's membership. To be successful in advocating certain changes to the proposal, NAREIT membership must broadly respond. NAREIT's Cost Capitalization Task Force will complete a comment letter in response to the ED within weeks after its issuance. This comment letter will be posted in the member only section of www.nareit.com under accounting issues. Each NAREIT member will be asked to submit an individual comment letter to the AICPA. The Task Force's comment letter could be used as a basis for these individual responses. In addition, the Task Force and staff will be available to assist members in the development of individual comment letters.
Although this proposal is drafted to apply to all PP&E, initially it would not impact costs of developing real estate for rental or sale. These costs are governed by the Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standard (SFAS) No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects. In connection with the proposal, the AICPA intends to recommend to the FASB that SFAS 67 be amended to reflect guidance in the proposal. Should the FASB agree with this recommendation, it would be required, under its due process procedures, to expose any amendment for public comment. This could be a lengthy process. Therefore, the impact of the AICPA proposal on real estate development costs may not be effective for some time after the effective date of the proposal, if at all.
The Potential Negative Impacts of the Proposal
As drafted, the new rules would have a negative impact on FFO and GAAP net income of real estate companies as a result of:
- Greater expensing of capital maintenance costs
- Greater expensing of indirect and overhead costs associated with capital maintenance programs
- Expensing of the remaining net book value of replaced PP&E or PP&E components
- Significantly increased bookkeeping for many companies as a result of the requirement to maintain very detailed records of cost and accumulated depreciation for PP&E components
Limitation on Capitalization
The proposed rules generally would limit 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 may be subject to capitalization 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 would be required to be expensed.
Indirect and Overhead Costs
Indirect costs and certain overhead costs that have previously been capitalizable would be expensed. For example, costs of "executive management" could not be capitalized—even when an executive manager is directly involved with capital maintenance programs or 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 capital maintenance 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.
This limitation would have a more significant negative impact on companies with internal development and construction management staffs if SFAS 67 is amended by the FASB to conform to the AICPA proposal.
Expense Remaining Net Book Value
The current draft requires that the remaining net book value of PP&E or a component replaced be calculated and the amount expensed. This would represent a major change for most NAREIT member companies. 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 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. For example, if the treads on an escalator are replaced, the remaining net book value of the 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. In addition, many NAREIT member companies 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 and no accounting is done for PP&E components that are replaced. The detailed cost accounting requirements of the proposal may implicitly prohibit companies from using the group or composite method of depreciation at any level.
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 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 method of making this calculation, as required by the proposal, would generally result in higher expense write-offs.
Could There be Benefits of 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 be enhanced if the final AICPA guidance 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 provide an opportunity for the industry to use GAAP net income as its primary performance indicator. This would, of course, mirror the reporting of the rest of corporate America.
George L. Yungmann is vice president, financial standards and David M. Taube is director, financial standards for NAREIT.
