While the real estate industry has been stagnant over the past two years, the accounting profession has been quite active. The Financial Accounting Standards Board (FASB) issued FASB 121, effective this year. As another step toward fair value accounting, FASB 121 will alter they way some developers and owners of investment property determine the carrying value of real estate assets.
Under this new statement, entitled Accounting For The Impairment of Long Lived Assets And For Long Lived Assets To Be Disposed Of, an asset's carrying value, in certain cases, is no longer determined by its net realizable value but by the more stringent "fair" value litmus. For developers and asset owners with a marginal or non-performing asset, this may mean taking a large "write down" on their P & L statement.
Historical cost accounting, the recording of an asset at purchase price less depreciation, has been a tenet of accounting principles. Over the last few years, however, FASB began to move away from historical cost accounting toward fair value. The theory is that fair value, because it reflects the "real" value of an asset, provides a truer picture of financial position.
In 1993, FASB established fair value standards with the issuance of FASB 114, Accounting by Creditors for Impairment of a Loan. FASB 114 requires that a loan's impairment be based on the present value of future cash flows, the loan's observable market price, if one exists, or the current market price of the collateral, if the loan is collateral-dependent.
Previously, the holder of a troubled loan only needed to show that the outstanding principle balance would be recovered through future cash collections of either principal or interest, undiscounted. If these collection failed to recover the outstanding principal, then a write down was necessary, but only to the level of estimated aggregate cash collections over the lifetime of the loan. Now, to the extent that estimated future cash collections are insufficient, the loan must be written down to the present value of expected future cash flows.
FASB 121 will continue the fair value accounting trend started by FASB 114. The fair value principles now applied to real estate loan valuation will also be applied to development properties. A real estate asset is "impaired" if the sum of expected future cash flows from the asset is less than its cost basis, or measurement "trigger."
The fair value standard may greatly change the way real estate companies account for real estate assets, including assets held for sale. Before, real estate held for sale or development and sale, in short inventory, was carried on financial statements at the lower of costs or net realizable value (LCNRV). LCNRV is the selling price at which property can be sold in the condition intended to be sold, minus costs to complete the project, carry it and sell it.
FASB 121 is replacing LCNRV with the fair value "measurement trigger." To avoid triggering a write down to fair value, the sum of the expected future cash flows of a project (undiscounted and without interest charges) must be equal to, or more than, the total cost of the project. If not, the asset must be reported on financial statements at its fair value. For marginal or troubled assets, this could result in a write down that far exceeds those reserves which would have been required under LCNRV.
For example, a real estate development project, once completed, is expected to have a sale value of $10 million. $4 million in costs have been incurred, and estimated costs to complete, market and sell the project, including carrying costs, total $5.9 million, making the total project cost $9.9 million. This does not exceed the estimated sale value of $10 million, so the "fair value trigger" is not activated. But, if the total project cost was $10.1 million, project costs would exceed anticipated cash flows, and the trigger kicks in, requiring a write down to fair value.
For a project coming to market in a strong economy, the consequences of a fair market write down, if one is even triggered, may be trifling. But if the economy is weak, and real estate values have dropped since construction began, the fair market valuation may be more dramatic.
This is especially true for unfinished projects. Because active markets don't exist for partially completed real estate assets, the fair value of the unfinished project may well be below the costs incurred to date. Using the previous $10 million project, if the fair value of the unfinished project is $3.5 million, and the costs incurred are $4 million, then the fair value write down would be $500,000 ($4 million in costs incurred to date less the fair value of $3.5 million). By contrast, the LCNRV standard write down would be only $100,000.
The change from LCNRV to fair value may also have negative affects on lenders. Many lenders may have difficulty keeping pace with all the changes in accounting rules. Consequently, they may not accurately interpret the subtleties of an owner's financial data. The large write downs, which FASB 121 could trigger, may exacerbate this situation, causing some lenders to pass on projects which, though appearing less "valuable" on paper, may in reality be solid investment opportunities with healthy profit margins.