EITF Issue No. 09-D FASB Emerging Issues Task Force Issue No: 09-D Title: Application of Topic 946, Financial Services Investment Companies, by Real Estate Investment Companies Document: Working Group Report No. 1 * Date Prepared: January 11, 2010 FASB Staff: Yang (ext. 472)/Mills (ext. 317) EITF Liaison: Matt Schroeder Dates Issue Previously Discussed: None Previously Distributed EITF Materials: None Purpose 1. The purpose of this document is to summarize the discussion of this Issue at the 09-D Working Group meeting on December 14, 2009. The Working Group was assembled to provide feedback on whether (a) the issues in the Working Group Discussion Document represent the complete set of issues that should be addressed as part of this project, (b) the issues have been appropriately analyzed, and (c) the appropriate potential solutions to the issues have been identified. This Working Group Report also includes related Working Group recommendations. * The alternative views presented in this Working Group Report are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination, exposes it for public comment, and it is ratified by the Board. EITF Issue No. 09-D Working Group Report No. 1, p. 1
Background 2. Members of the Working Group represent accounting firms, preparers, industry associations, and the SEC who participated as an observer. Most of the Working Group members also were members of the AICPA Real Estate Funds Task Force, which assisted AcSEC in addressing implementation issues encountered by real estate investment companies relating to AICPA Statement of Position 07-1, Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies. Working Group Discussion 3. The Working Group discussed the following issues. Issue 1: When carrying real estate investments at fair value, how an entity should present the investments and investment income in the financial statements. 4. The Working Group focused on two distinct presentation methods, the investment company (net) method and the consolidation (gross) method. Under the investment company method as defined in Topic 946, an entity would report investments at fair value on one line in the balance sheet. In the statement of operations, the entity would report the investment income based on dividends distributed and interest accrued strictly following Topic 946. Under the consolidation method, an entity would include both assets and liabilities of its controlling entities in the balance sheets and include rental income and rental operating expenses in the statements of operations. 5. Most Working Group members believe that if a real estate investment entity functions the same as an investment company, the presentation should also be the same. They supported this view because it would align the accounting for all investment companies. If a real estate entity is an investment company, those members questioned why different presentation was warranted for real estate entities compared to other investment companies. EITF Issue No. 09-D Working Group Report No. 1, p. 2
6. However, some Working Group members believe that if real estate entities do not gross up their financial statements, investors will lose information on properties debt structures, earnings potentials, operating efficiencies, and so forth. Those are critical factors that investors would consider, especially when investing for current income rather than for long-term appreciation. As most of the real estate investees/properties are privately held entities, there is minimal or no public information available for the investors. 7. Some Working Group members stated that rather than requiring the consolidation method, such information could be provided in footnotes and supplemental schedules. They pointed out the difficult position that preparers constantly find themselves in when trying to apply operating company accounting, which was never contemplated in an investment company presentation. For example, real estate investment companies that apply the gross method do not report rental income using the straight line rent conventions required of real estate operating companies because it is believed that the resulting deferred rent receivables would overstate net asset value. There are numerous other accounting peculiarities that exist as a result of applying a consolidation approach in an investment company presentation that are often interpreted in different ways by preparers, thereby increasing diversity. Working Group members believe that the negative effects of increasing diversity under the consolidation method are more problematic than the potential issues that might be encountered in applying the net method and addressing the transparency issue through disclosure. 8. Working Group members who oppose gross presentation also point out that there is diversity in applying the consolidation method that results from the capital structure of underlying investees. Some entities measure the real estate assets at fair value but choose to measure the debt associated with those properties at amortized cost, in part because of the increased earnings volatility associated with the valuation of such liabilities. The resulting combination of measurements may not represent the fair value of the investments. EITF Issue No. 09-D Working Group Report No. 1, p. 3
Should depreciation be included in calculating investment income? 9. The Working Group discussed how to calculate the income of a real estate investment property. Should depreciation, which is a non-cash item, be included in computing the income or treated as part of unrealized depreciation of the investment? 10. Some Working Group members pointed out that real estate investment companies do not include depreciation in calculating the investment income because they believe that depreciation is captured by the changes in fair value from period to period. The changes in fair value are generally presented below the investment income line in the unrealized appreciation or depreciation section of the statement of operations. Therefore, these entities do not separately compute depreciation or report depreciation in the financial statements and footnotes. 11. Some Working Group members believe that excluding depreciation from the calculation of the investee s earnings will result in higher investment income compared to the income of entities that include depreciation in earnings. Under the consolidation method, when depreciation is omitted, it understates operating expenses of the real estate properties and, as a result, overstates the investment income of the real estate investment funds. 12. While total returns from investments stay the same, different methods for recording investment income would be a problem for investors in open-ended funds who care about investment income. It may be less of a problem for high-risk close-ended fund investors who focus on total returns rather than income. When comparing investment income within the same industry or across a number of industries, investors may not understand that some differences in investment income are caused by including or excluding depreciation. And if they do understand, it is questionable whether they could re-compute the impact of depreciation on their own. 13. Working Group members also note that the depreciation expenses reflect an entity s own usage of assets in production or operations to generate revenue rather than changes in market factors, such as a decrease in demand for office space. Therefore, depreciation should be included in investment income. For example, assuming a commercial building has a useful life of EITF Issue No. 09-D Working Group Report No. 1, p. 4
70 years over which there is no other change in its market factors, the building s value would decreases to 0 (assuming no residual value) at the end of its 70-year life. The consolidation method would not include depreciation in operating expenses but instead would show the decrease in the building s value as unrealized depreciation. Opponents argue that this distorts the fact that the decrease in value would never be recouped or recovered when the building is sold or otherwise disposed of. Other Working Group members believe that depreciation expense is merely an allocation of cost among periods, and does not represent actual usage of assets under a cost model nor a change in fair value under a fair value model. Accordingly, as the presentation is primarily a fair value model, there was support for the view that depreciation should be excluded from investment income and included within the change in unrealized appreciation. 14. Working Group members who support the exclusion of depreciation note that International Accounting Standard 40, Investment Property, does not require calculation of depreciation under the fair value method. Moving depreciation from one line to another line only changes the geography of the statement of operations, but would not add any value to the investors. Proponents also believe that requiring entities to compute depreciation would be costly as those entities will have to change their systems and policies. Recommendation 15. The Working Group recommends that if a real estate investment company qualifies to carry its investments at fair value under Topic 946, financial statement presentation requirements in Topic 946 should be applied. Although investment companies are not required to consolidate operating companies, disclosure regarding debt at the investee level should be required for majority-owned investments. 16. The majority of the Working Group believes that for real estate investment companies that carry real estate investments at fair value, depreciation should be included when computing investment income of an investee. Some Working Group members support excluding depreciation from investment income. EITF Issue No. 09-D Working Group Report No. 1, p. 5
17. The Working Group also recommends that if the Task Force decides to include depreciation in the computation of investment income, it should consider the transition issues and allow extra time for entities to change their systems. Issue 1a: Accounting for fee simple properties owned by investment companies. 18. Fee simple properties are properties that are owned directly by an entity. The diversity discussed in financial statement presentation also exists for fee simple investments. The decisions to be made by the Task Force should help resolve most of the diversity in practice, but the question remains whether such fee simple investment properties owned by an investment company should follow the same rules as other real estate investments, such as investments held through equity of another entity or investments in a special purpose entity. 19. Some Working Group members believe that regardless of the ownership form (fee simple or through an entity), the properties held by real estate investment companies should be treated consistently and thus that fee simple properties should be carried at fair value using the investment company (net) presentation. Working group members highlighted the fact that it is rare for real estate investment companies to own real estate properties directly, but it may occur. They believe that the net presentation would put the fee simple investments on an equal footing with the same or similar investments that are made through 100 percent owned legal entities because investment companies do not consolidate investments in controlled, non-investment companies. They also indicated that if fee simple ownership were to result in different accounting application for a property, there might be structuring opportunities; for example, entities that prefer to exclude depreciation from calculating investment income might choose to own the real estate investment properties directly in order to gross up the rental revenue and the rental operating expenses but exclude depreciation from investment income. This issue was first observed in practice after AcSEC reached its initial conclusions on the application issues of Topic 946, which are similar to the ones discussed in Issue 09-D. 20. Working Group members who support gross presentation believe that gross presentation provides investors with information about earnings and operations as well as how the fee simple EITF Issue No. 09-D Working Group Report No. 1, p. 6
investments are being financed. Other members indicated that most real estate investments are either non-leveraged or financed by non-recourse debt (meaning only the property itself is pledged, not the general assets of the fund); in both cases, the net presentation would reflect the maximum exposure of the investments. Recommendation 21. The Working Group recommends that fee simple investments by real estate investment companies should be measured at fair value by applying the investment company (net) method for financial statement presentation. Issue 2: Whether an entity that is not in the scope of Topic 946 can carry real estate and other non-financial investments at fair value by analogy to Topic 946 or on the basis of industry practice. 22. The Working Group agreed that the major groups of institutional real estate investors could be categorized as follows: a. Pension funds or separately-managed accounts of pension funds b. Insurance separate accounts c. Real estate investment companies d. Real estate operating companies, including many Real Estate Investment Trusts (REITs) 1 e. Other funds or separately-managed accounts that have some attributes of the above but don t completely meet the definition of any of the above categories. 23. In practice, most REITs measure real estate investments at amortized cost while other entities (including investment companies, pension funds, and insurance separate accounts) measure real estate investments at fair value. Some entities that are not investment companies or 1 In order for a company to qualify as a REIT in the U.S., it must comply with certain ground rules specified in the Internal Revenue Code. These include: investing at least 75 percent of total assets in real estate; deriving at least 75 percent of gross income as rents from real property or interest from mortgages on real property; and distributing annually at least 90 percent of taxable income to shareholders in the form of dividends. EITF Issue No. 09-D Working Group Report No. 1, p. 7
pension funds analogize themselves to investment companies or pension funds and, therefore, measure real estate investments at fair value. 24. The Working Group agreed that determining which entities are (or should be) eligible for carrying real estate at fair value is challenging. For example, a. The current investment company guide, which now resides under Topic 946, Financial Services Investment Companies (originally issued as AICPA Audit and Accounting Guide, Investment Companies), requires investment companies to carry investments at fair value. However, while it contains guidance for all entities, it lacks specific guidance on determining whether a real estate investment fund would meet the definition of an investment company without the clarification of the scope provided by SOP 07-1. b. Some real estate investment funds are not pension funds or investment companies but they are predominately owned by pension funds (for example, they might be 95 percent owned by a pension fund and 5 percent owned by an affiliate of the professional investment adviser to the fund) or investment companies. In those cases, it is not clear whether by analogy those real estate investment funds can carry the real estate investments at fair value in order to meet the information requirements of their investors (although they may meet the relatively vague definition of an investment company currently contained in Topic 946). 25. The Working Group agreed that determining which entities should be eligible to carry real estate at fair value is a broader issue than what they believe the scope of Issue 09-D should include. A broader project would potentially involve reconsidering parts of Topic 960, Plan Accounting Defined Benefit Pension Plans, Topic 944, Financial Services Insurance, and Topic 946, and their relationship to the scope of investment companies. Some Working Group members believe that the scope portion of SOP 07-1 provides useful guidance regarding the definition of an investment company and the related scope of Topic 946; therefore, the scope portion should be made effective. Some Working Group members thought that a broad project EITF Issue No. 09-D Working Group Report No. 1, p. 8
may be better addressed by the FASB and/or the FASB and the IASB jointly rather than by the EITF. Therefore, the Working Group agreed that the scope of this project should be limited to presentation and, potentially, to disclosure for entities that are investment companies (with one exception discussed in the paragraph that follows). 26. The Working Group believes that a clarification of the scope of Topic 946 is warranted. Paragraph 946-10-15-3 states: The guidance in this Topic does not apply to real estate investment trusts, which have some of the attributes of investment companies but are covered by other generally accepted accounting principles (GAAP). 27. Working Group members pointed out that some may interpret paragraph 946-10-15-3 to preclude any entity structured as a REIT for tax purposes from being an investment company. However, others interpret the paragraph to mean that those REITs that have other than insignificant non-investment operations (for example, property development or management activities) or otherwise meet the definition of an investment company are not precluded from applying Topic 946. This view was based on the belief that the intent of the scope exclusion noted in paragraph 23 was that at the time that guidance was written, REIT s generally were structured as operating entities and, accordingly, did not meet the criteria to be considered an investment company under the Investment Company Guide. 28. Working Group members believe that the definition of an investment company should be applied in a principled manner and that the tax structure of the entity should not be the determining factor in whether an entity is within the scope of Topic 946. Entities structured as REITs should be allowed to analyze their underlying characteristics to decide whether they would meet the definition of an investment company under Topic 946. Therefore, the Working Group agreed that the clarification or removal of the reference scope exception for REITs in Topic 946 is necessary. That treatment would be consistent with the decision reached by AcSEC as noted in paragraph A25 of SOP 07-1. EITF Issue No. 09-D Working Group Report No. 1, p. 9
29. The Working Group also discussed the potential impact on REITs, especially those that might be required to change from the cost method to the fair value method based on the Task Force s decision. Those members are concerned with potentially requiring a REIT to change its accounting twice within a short time period pending the outcome of the Board s other projects. Some Working Group members note that REITs do not have a problem with using amortized cost because they provide investors with fair value information in the footnote and supplemental schedules anyway. Some members note that an alternative could be to provide a fair value option to REITs until the Board s other related projects have been completed. Other Working Group members note that few if any of the publicly traded REITs would meet the definition of an investment company and therefore the impact of clarifying the REIT scope exception would be limited only to real estate investment companies that utilize the REIT tax structure. 30. The Working Group was concerned about making significant changes to the scope by identifying which entities can carry real estate investments at fair value given the uncertainty surrounding the effect that the Boards' joint projects (such as consolidations, leases and financial statement presentation) may have on REITs and other entities. For example, the joint project on leases is considering adopting IAS 40 to allow a fair value option for real estate investment properties. Some Working Group members recommend that consideration be given to providing a fair value option for real estate held for investment in order to both achieve greater comparability among reporting entities and proceed toward convergence with IFRS. Recommendation 31. The Working Group recommends the following: a. That the Task Force not address the scope issue as to what entities would qualify as investment companies under Topic 946, except for the scope exception for REITs. b. That the Task Force either remove the exception for REITs from Topic 946 or clarify it. c. That under existing U.S. GAAP, an entity should measure its real estate investment at amortized cost unless permitted by authoritative guidance to recognize the investment at fair value. EITF Issue No. 09-D Working Group Report No. 1, p. 10
32. Some Working Group members recommend that consideration be given to providing a fair value option for real estate held for investment in order to both achieve greater comparability among reporting entities and proceed toward convergence with IFRS. Interaction with IASB and other Board projects 33. Several Working Group members expressed concern about potentially making entities change accounting twice. For example, if the Task Force were to conclude that all investment companies must follow Topic 946 strictly, some entities may have to change presentation methods. Those same entities might be subject to another change as a result of the Boards' joint consolidations project or financial statement presentation project (for example, if those projects were to modify the consolidation requirements and the financial statement presentation of Topic 946). Other members commented that both the IASB and the FASB might decide to exclude investment companies from the above changes due to specialized industry practices used by investment companies. Others noted that the joint leases project also has the potential for affecting real estate investment companies. 34. Working Group members noted that these joint projects are not expected to be completed until late 2010 or early 2011. They would prefer to standardize the presentation of real estate investments under current U.S. GAAP rather than wait for the Boards to finish the other projects. Transition 35. The Working Group did not specifically discuss any transition issues. Some Working Group members observed that given the current diversity in practice and manner in which various entities are rationalizing use of fair value accounting for real estate investments, a transition period would be necessary to provide real estate investment entities with adequate time to evaluate the effect of any changes resulting from Task Force decisions. Some Working Group members observed that transition issues could become complicated. EITF Issue No. 09-D Working Group Report No. 1, p. 11