NAREIT Submission to the AcSEC Cost Capitalization Task Force - Comments on July 2000 Draft SOP
August 15, 2000
Mr. Mark Simon
AICPA - Accounting Standards
1211 Avenue of the Americas, 6th Floor
New York, New York 10036
Re: Proposed Statement of Position; Capitalization of Certain Costs Related to Property, Plant and Equipment
The National Association of Real Estate Investment Trusts (NAREIT) has followed and directly supported the Accounting Standards Executive Committee's (AcSEC) process and deliberations with respect to its proposed Statement of Position (SOP), Capitalization of Certain Costs Related to Property, Plant and Equipment. NAREIT representatives have attended public AcSEC meetings at which this project has been discussed and provided the Project Task Force with NAREIT's views and concerns based on the materials discussed at these meetings. This letter raises certain questions about this project, especially its scope, and certain positions reflected in the July 24, 2000 draft of the SOP.
NAREIT is the national trade association for real estate investment trusts (REITs) and other publicly traded real estate companies. NAREIT members include over 200 REITs and other companies that develop, own, operate, and finance income-producing real estate, as well as those firms and individuals who advise, study, and service these businesses. Providing useful and relevant financial information related to investment property (property held for rental and/or capital appreciation), is of vital importance to the capital formation and investor relations activities of companies involved in these businesses. NAREIT has and will continue to actively support the development of accounting and reporting standards. Our goal is to responsibly advocate those standards that reflect the economic reality of acquiring, developing, owning and operating investment property. In this context, the accounting standards for capitalizing the cost of these assets are fundamental to producing useful financial reports for publicly traded real estate companies. These standards may have a more significant impact on the financial statements of NAREIT members than on the financial statements of companies that simply use property, plant and equipment in the production of products or delivery of services - property assets account for the great majority of member company assets and maintenance of these properties represents a significant annual cost. NAREIT representatives have reviewed all public documents related to this project and have attended all AcSEC meetings at which this project has been discussed. We are providing you with our views on the draft SOP at this stage for two reasons. First, we want to ensure that conclusions embedded in any public exposure draft are based on a full understanding of the related underlying business transactions and are practical from a cost/benefit perspective. Second, we would like to raise certain issues with tentative conclusions reached thus far.
We have reviewed the following materials related to this project:
October 22, 1988 letter from Lynn Turner to David Kaplan
February 3, 1999 prospectus of proposed SOP, Capitalization of Costs in Real Estate Assets not Within the Scope of FASB Statement No. 67
March 10, 2000 letter from Lynn Turner to David Kaplan regarding the expansion of the project beyond real estate assets
March 14, 2000 response from David Kaplan to Lynn Turner
May 21, 2000 Revised Prospectus of Proposed SOP, Capitalization of Certain Costs Related to Property, Plant and Equipment
May 24, 2000 AcSEC staff's cover letter forwarding the June 8 draft to AcSEC
June 8, 2000 draft SOP
July 14, 2000 AcSEC staff cover letter forwarding July 24 draft to AcSEC
July 24, 2000 draft SOP
From our review of these documents, it appears that the Securities and Exchange Commission (SEC) Staff's specific concerns focus on expenditures related to property, plant and equipment, including real estate, in operation. These concerns include:
diversity in accounting for capital maintenance costs,
the appropriateness of capitalizing certain kinds of these costs,
accounting for the net book value of components replaced, and
the practice of reserving for overhaul/turnaround costs. All of these concerns/issues relate to costs expended to maintain or enhance property, plant and equipment already in operation. We understand and appreciate these concerns and support the SEC Staff's and AcSEC's efforts to improve the accounting related to them.
Given the specific concerns set forth in the SEC Staff's correspondence, we do not understand why the scope of this project has been expanded to include accounting for costs of initial acquisition and construction. Certainly for the real estate industry, SFAS Nos. 34 and 67 provide clear guidance for accounting for these costs. Further, paragraph 4 of the revised prospectus states: "The project is expected to result in guidance that will affect all entities that make expenditures related to property, plant and equipment, if those costs are not covered under Statement 67."
We have noted that, in AcSEC's discussions and in the Task Force's May 24, 2000 cover letter to the draft SOP, certain conclusions of AcSEC may require amendment of SFAS 67. These changes would result from AcSEC's current conclusion that the SOP's capitalization-versus-expense guidance would be based on paragraphs 6 and 7 of SFAS No. 91 and similar guidance in SOP 98-1. A model based on these references may yield dramatic changes in accounting for the initial acquisition or development costs of real estate. We agree with Appendix A, paragraph 46 of the July 24, 2000 draft SOP which indicates that "diversity in practice is minimal" with respect to SFAS 67. We are not aware of significant diversity in practice in applying SFAS 34 and 67 to the acquisition and development of investment property, and therefore see no need to amend SFAS 67.
We believe the purpose of the proposed SOP should be to achieve this same kind of consistency with respect to appropriately accounting for capital maintenance costs - not to amend standards that have served the needs of our industry's financial statement consumers well for over twenty years. In addition, unless standard setters are prepared to completely abandon SFAS 67, it seems counter productive to establish accounting standards that would measure the cost of similar real estate assets differently based on whether they are used by the owning entity (costs not covered by SFAS No. 67) or leased to others.
In paragraph 7, the SOP should explicitly indicate that it does not apply to costs covered by FASB Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects.
Relationship of the SOP to Newly Promulgated International Accounting Standards
We understand that there may be issues with specific practices associated with accounting for capital maintenance expenditures - and these need to be resolved. At the same time, the depth and detail to which certain of the AcSEC discussions have gone appear very inconsistent with more profound directions being taken with respect to accounting for investment property.
We have listened to discussions about separating the cost of removing a component replaced so that only the cost of the new component and its installation would be capitalized. Even a member of the Project Task Force offered that this might be impracticable. We also heard a proposal that would require the cost of a replacement component to be expensed unless the cost of the component was identified separately at time of development or acquisition,
With respect to more profound changes in accounting standards, International Accounting Standard (IAS) No. 40, Investment Property, requires disclosure of the fair value of investment property either in the financial statements or in accompanying notes. To achieve this measurement and disclosure, it views an investment property as an integrated operating entity - not as an amalgamation of hundreds of components. IAS No. 40 also addresses the accounting for "subsequent expenditure." This standard forms part of the core set of international accounting standards. As a member of the International Organization of Securities Commissions (IOSCO) and a vocal advocate for global accounting standards and capital markets, the SEC is evaluating the set of core standards and the framework in which they can be effective. To require owners/operators of investment property to dramatically move in a direction counter to the more profound, albeit, long term, direction of accounting standards seems inappropriate and unnecessary. We believe that accounting changes that require detailed componentization of the costs of investment property will result in the real estate industry's financial reporting and accounting systems being whipsawed as the US moves toward acceptance of even the core set of international accounting standards.
Specific Comments on July 24, 2000 Draft SOP
Our remaining comments are in order of and referenced to specific paragraphs in the July 24, 2000 draft SOP.
Paragraph 16 - Accounting for all distinguishable components of PP&E as separate assets
This proposed accounting implicitly eliminates the use of the composite depreciation method - currently an acceptable accounting method widely used in practice. Under the composite method of depreciation, groups of assets or components of assets with different service lives are depreciated over the weighted useful lives of the individual assets of the group or components. If a component is retired before or after the average useful life, any resulting gain or loss is charged/credited to accumulated depreciation. This practice is justified because individual components will be retired both before and after the average useful life. The composite method of depreciation results in appropriate financial reporting at reasonable cost.
In addition, the composite or group method of depreciation is referred to and considered acceptable in current accounting literature, including the:
AICPA Industry Audit Guide; Audits of Airlines;
SFAS No. 19, Appendix B; and
AICPA Industry Audit Guide; Audits of Agriculture Producers and Agricultural Cooperatives.
The composite method of depreciation also is described in many accounting texts.
Further, based on AcSEC discussions, we believe that there is some misconception that composite depreciation lives have not been responsibly calculated. While some companies may not have focused on this measurement in specific detail, others have based the composite weighted average useful lives on empirical underlying data with respect to the useful lives of components.
We are very concerned that this AICPA SOP can eliminate an accounting method that has solid basis in both accounting literature and practice. Moreover, the prescribed component depreciation method is impracticable and is not justified on a cost/benefit basis. We do not believe that the Project Task Force or AcSEC have adequately considered the effort and cost that would be required to apply this accounting method. Paragraph 42 of the draft discusses disclosures and suggests that, with respect to buildings, income-producing property should be sub-categorized into tenant improvements, integral equipment and the building shell. It further suggests that a range of useful lives should be disclosed for each category. We are concerned that the discussion in this paragraph implies significantly fewer components than actually exists. There are hundreds of replaceable components in a single investment property. While it is possible to account for the cost of these hundreds of components, we do not believe that the result provides significantly more useful information than the composite method of accounting for groups of components.
Further, with respect to component asset accounting, we do not believe that the cost of multi-million and even billion dollar acquisitions can be reasonably assigned to replaceable components (e.g., a motor in major mechanical equipment, the interior façade of a bank of elevators, the hundreds of appliances in a large apartment project, etc.). We also do not believe it is practicable to allocate the current net book value of hundreds of billions of dollars associated with existing investment property assets to all replaceable components. This would be a massive undertaking with minimal useful result.
Based on the above reasons, we urge AcSEC to reconsider its proposal that implicitly disallows the use of the composite method of accounting for investment property. Disclosures could be expanded to provide financial statement users a better understanding of capital expenditures, as well as depreciation methodology and measurement.
Paragraphs 17 through 25 - Costs of Acquisition and Construction
As stated above, we strongly believe that SFAS 67 has provided appropriate accounting guidance for acquisition and development costs of investment property and that there is minimal observed diversity in practice. Investment property should therefore be exempted from the application of these paragraphs.
Paragraphs 26, 27, 34, 51 and 57 - Costs Related to In-service Assets and Planned Major Maintenance Activities
The accounting proposed in these paragraphs, combined with the Task Force's elimination of the criteria for capitalization included in Paragraph 23 of the June 8, 2000 draft SOP, represents a dramatic change in GAAP. Paragraph 27 of the current draft SOP states: "costs incurred during the in-service stage, including costs of normal, recurring or periodic repairs and maintenance activities, should be charged to expense as incurred unless the costs are incurred for a replacement of PP&E or component of PP&E"(emphasis added). If taken literally, this standard eliminates the concept of deferred costs in accounting for betterments, improvements, refurbishments, rearrangements and other forms of major, long-term maintenance activities. At the June AcSEC meeting there was a discussion about accounting for "treatments" that may extend the original useful life of an asset. By a vote of 9-4, AcSEC concluded that, "costs incurred to extend the expected useful life of PP&E should be capitalized provided the costs extend the life beyond that originally expected assuming the entity performs normal, ongoing maintenance on that PP&E." Our understanding was that these were costs that may not represent tangible PP&E (new or replacement components) but costs that met the criteria for capitalization as set forth in paragraph 23 of the June draft SOP.
Possibly contrary to the position discussed above, AcSEC concluded by a vote of 9-4 that planned major maintenance activities should be capitalized only to the extent that the costs are for the replacement of specific PP&E items. AcSEC recognized that this conclusion is inconsistent with the proposal of the IASC's Standing Interpretations Committee (SIC) Interpretation SIC 23, Property, Plant and Equipment - Major Inspection or Overhaul Costs. This interpretation provides for the capitalization of all of the overhaul costs. We do not understand why new U.S. GAAP, especially at this level of detail, should be inconsistent with new IASC standards at a time when the global accounting profession, including the SEC, FASB and AICPA, are committed to financial standards harmonization.
Further, the concept of deferred costs is well established in U.S. GAAP. A full discussion is contained in FASB Concepts Statement No. 6, Elements of Financial Statements (the Statement), paragraphs 246 through 250. We do not believe the July draft (paragraph 51) provides a full discussion of the relevant sections of the Statement. The Statement clearly establishes the basis for deferring costs that, "do not by themselves qualify as assets" but may provide future economic benefit. Much of the cost of long-term maintenance programs related to physical assets provide economic benefit beyond the period in which they are incurred and should, therefore be capitalized and amortized over the periods benefited.
Also with respect to deferred costs, paragraph 51 of the July draft states, "AcSEC believes further that costs incurred to restore PP&E to its original operating condition (emphasis added) do not provide a future benefit; rather those costs remedy the effects of having used the PP&E in the past." This seems illogical. If these expenditures restore the PP&E to its original operating condition, doesn't this lead to the conclusion that the expenditure will benefit future periods equal to the originally estimated useful life? Further, doesn't this lead to a conclusion that the useful life should be restarted at the time the expenditure is made?
The SOP's guidance for accounting for major, long-term maintenance costs should allow for capitalization of costs which provide future economic benefit even if they do not represent physical components - consistent with the Concept Statement No. 6. Such guidance also would be consistent with SIC 23. Therefore, we believe that the criteria for capitalizing costs contained in the June draft SOP should be included in the final SOP.
Paragraph 39 and Appendix C - Measuring the Net Book Value of an Item of PP&E Replaced
The guidance in these sections of the draft is simply not logical. If a composite depreciable life of a PP&E asset is 40 years and a component having a 15 year life (reflected in the weighted average life used) is replaced at the end of 10 years, the applicable accumulated depreciation is 10/15 times the original cost - not 15/40 times the original cost. While the weighted average life of the PP&E asset is 40 years, the short-lived component has been depreciated over its 15-year useful life. This is especially appropriate where the composite depreciation rate assumed multiple generations of short-lived assets in calculating the weighted average life. To measure the accumulated depreciation related to a replaced, short-lived component using the full weighted average life does not result in an accurate measure of the book value of the component. Paragraph 39, line 16 of the July 24 draft SOP should read: "expected useful life being used to depreciate the PP&E component."
Paragraph 41 - Contractually Recoverable Capital Expenditures
AcSEC discussed the accounting for capital costs recoverable under the terms of tenant leases. We believe the discussion provided an incomplete understanding of many lease agreements requiring these reimbursements. The discussion focused on the accounting where there is a direct relation between a capital expenditure and a tenant. To illustrate, a question was asked as to whether a tenant with 2 years to run on its lease in year X is required to reimburse the landlord for its full share of a capital expenditure made in year X having a useful life of 5 years.
Our experience with multiple-tenant buildings indicates that the majority of lease arrangements call for the reimbursement of capital expenditures in the context of an annual pool of reimbursable costs. This pool might include the full cost of certain capital expenditures, the depreciation of certain assets, the amortization of deferred long-term maintenance costs or a combination of these costs. Each tenant reimburses the landlord for its share of the annual pool of costs - not directly for specific expenditures. There may be little or no connection between the useful life of a reimbursable capital expenditure and the length of a lease that requires reimbursement of such cost. Therefore, any tenant could reimburse the landlord for the periodic write-off of costs incurred prior to the effective date of the tenant's lease or, conversely, not reimburse the landlord for costs that are written-off beyond the termination date of the tenant's lease.
AcSEC's consensus is that reimbursable capital expenditures should be capitalized and the contracted reimbursement should be recorded as deferred revenue. This accounting seems overly complex where a calculation would be required to compare the remaining lease terms of all leases with the useful life of the capital expenditure to measure the deferred revenue. Further, to accrue the entire reimbursement equal to the full capital expenditure may reflect potential reimbursements not covered by executed leases.
We suggest that AcSEC accept the "netting method" set forth in the July draft or, as an alternative, provide that the expenditure be capitalized and depreciated/amortized over its expected useful life with reimbursements being accrued when billable.
In conclusion, NAREIT supports this project toward enhancing the accounting practices with respect to capital maintenance costs. Since this project may impact the measurement of depreciation, we also would support the profession's evaluation of methods used to depreciate investment property assets. Representatives of NAREIT would be pleased to discuss the issues raised in this letter with the Project Task Force or with AcSEC. We believe such a discussion would further enhance the quality and appropriateness of the SOP. You can reach me at (202) 739-9432 or email@example.com or my associate David Taube at (202) 739-9442 or firstname.lastname@example.org.
George L. Yungmann
Vice President, Financial Standards
David B. Kaplan, AcSEC Chair
Mark V. Sever, AcSEC Incoming Chair
R. Scott Blackley, SEC, Officer of Chief Accountant
Timothy S. Lucas, FASB, Director of Research and Technical Activities