Real Estate JV Losses, Consolidation and Recent GAAP Pronouncements

1. Real Estate JV Losses, Consolidation and Recent GAAP Pronouncements Jeffrey G Olson, CPA Babush, Neiman, Kornman & Johnson, LLP www.bnkj.com

2. 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)

3. Real Estate Ownership • Wholly-owned assets • Corporate subsidiary • Corporate JV • Partnership (General or Limited) • LLC • Undivided interests or tenants in common

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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 • Other loans/advances • Deficit restoration provisions • Other guarantees or commitments • Of support

10. 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?

11. 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 reasonablyassured

12. 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

13. 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!

14. 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?

15. 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

16. 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

17. 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

18. 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

19. 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)

20. 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

21. FIN 46-Lack Controlling Financial Interests If Equity Holders as a group lackany 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

22. 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

23. Who/What Else May Be Affected • 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

24. 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

25. 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...

26. SFAS 150 Affects Buy sell/agreements effecting 100% of equity creates madatorily redeemable • $0 equity, it is all a liability • Separate line item presentation • Note disclosure of CS/PIC/RE type information