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Accounting Alternatives for Construction and Real Estate Companies
For more than a decade, private companies have wrestled with costly, complicated accounting standards required by U.S. Generally Accepted Accounting Principles (GAAP). In response to these challenging guidelines, the Financial Accounting Standards Board (FASB) established the Private Company Council (PCC) on May 30, 2012. Since its establishment, the PCC has worked closely with the FASB, users of financial statements, and stakeholders to create alternative accounting solutions for privately held companies. The PCC’s recommendations carefully consider user-relevance and cost-benefit calculations.
In early 2014, the PCC issued three Accounting Standards Updates regarding alternative accounting methods for the following:
- Derivative and hedging instruments
- The application of the consolidation of variable interest entities (VIEs) under common control leasing arrangements
These updates apply to all entities, with the exception of public business entities, nonprofits, and employee benefit plans. Financial institutions are also excluded from the accounting alternative for derivatives and hedging instruments. These recent updates are particularly relevant to the construction and real estate industries.
Accounting for goodwill and intangible assets
Goodwill is currently carried on the balance sheet until written off due to impairment. The current impairment method of writing off goodwill requires costly annual valuation and causes confusion on the income statement. Furthermore, sureties normally do not give credit for such intangible assets when computing tangible net worth or other key indicators.
The PCC has suggested an alternative accounting method for goodwill to address concerns related to the complexity and the annual cost of testing for impairment under the current guidance. This alternative allows for the straight-line amortization of goodwill over 10 years or less, and simplifies the test for impairment of goodwill. Impairment testing is only required when a triggering event has occurred that indicates that the fair value of the entity may be below its carrying amount.
This alternative accounting method provides construction and real estate companies with an avenue to methodically and reasonably amortize these assets — reducing the potential for having to recognize significant impairment losses, as well as eliminating the cost of annual impairment testing.
Accounting for derivatives and hedging instruments
This alternative accounting method offers a simplified hedge accounting approach for “plain-vanilla” swap arrangements that convert variable-rate borrowing into fixed-rate borrowing. Under this approach, the income statement charge for interest expense related to the swap is similar to the amount that would result if the entity had directly entered into a fixed-rate borrowing agreement. The company also has the option to measure the swap at the settlement value instead of its fair value. The main difference between these two methods is that the settlement value does not take into consideration nonperformance risk, which makes the calculation simpler. In essence, it is the present value of the remaining estimated cash flows of the swap.
Although such financing arrangements are less frequent in the construction and real estate industries, they are becoming more common.
Guidance for VIEs with common control leasing arrangements
VIEs are prevalent in the construction and real estate industries. Buildings purchased to house property management, corporate headquarters, or shop operations are often organized as a separate company with common control and are subsequently leased back to the operating company for tax, legal-liability, and estate-planning purposes.
The PCC’s new method simplifies the accounting for these leasing arrangements — a private company lessee is not required to consolidate the lessor’s financial statements under VIE rules if the lease meets four characteristics:
- Both entities must be under common control
- A leasing arrangement exists between the entities
- All of the activity between the two entities is related to the leasing arrangement
- The lessee explicitly guarantees or provides collateral for the leased asset
Instead of consolidating, the lessee would only need to make additional disclosures, including the amount and key terms of resulting liabilities and a qualitative description of circumstances that would expose the lessee to a loss as a result of the lease.
Sureties have expressed mixed feelings to this new alternative. Some state that consolidation of lessor entities under common control provides useful information, whereas others state that the required robust disclosures that include the terms and the arrangement between the two entities should be sufficient.
Many contractors, real estate companies, and their accountants have struggled with accounting for goodwill, swaps, and VIEs. The new PCC accounting method alternatives help simplify the issues and provide clearer and more valuable information to the financial statement users.