01/08/09

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Beware of the accounting GAAP

In a move to attract more stock listings to U.S. exchanges, the federal Securities and Exchange Commission voted on a new rule that may have unintended consequences for real estate companies stateside. And the ruling is of particular concern here in South Florida, where international developers regularly compete with American firms.

In November, the SEC voted unanimously to allow foreign companies to file financial results using international financial reporting standards (IFRS) — without reconciling the figures to U.S. generally accepted accounting principles (GAAP). The new SEC rule, which was officially published on December 21 and went into effect 60 days later, causes concern for some real estate players.

Most agree that the rule is well intentioned, but some accountants fear it could put U.S. public real estate companies at a significant competitive disadvantage with their foreign counterparts.

"My knee-jerk reaction is that the SEC ruling was a terrible oversight that could lead to a lot of misinformation and bad decisions," says Jahn Brodwin, partner-in-charge of Schonbraun McCann Group, a Manhattan-based real estate consulting firm.

"The accounting rules, quite frankly, weren't drafted with real estate companies in mind," he says. "But public companies are bound to them no matter what industry they are in."


An uneven trading field

There are several differences in the rules for revenue recognition under IFRS as compared to GAAP. These differences affect the carrying value of the underlying investments in real estate and real estate-related assets.

Under GAAP, real estate is carried at historical cost, whereas under IFRS it may be recorded at fair value. This difference results in significant issues when comparing operating results and that could make it appear that foreign entities are performing better than U.S. real estate firms because of the unrealized profit.

"This could give foreign entities an advantage in seeking investment dollars. Investors might better be able to gauge what their total return is from the standpoint of realizing unrealized appreciation in properties," says Stuart Eisenberg, national director of the real estate and hospitality practice at global accounting and financial consulting firm BDO Seidman LLP. "The IFRS is more transparent. The value per share can be more readily compared to the market price per share."


The new rule in action

As Brodwin sees it, the recent SEC rule changes ultimately impact every single real estate company in the United States.

Here is a hypothetical scenario: A U.S. company purchased a piece of real estate for $100,000 10 years ago. Over the decade-long period, the value of the real estate rose to $200,000. However, during that same decade the property also depreciated under U.S. tax laws. Again, hypothetically the GAAP recognizes $20,000 worth of depreciation over the 10-year period.

On the balance sheet of the U.S. company reporting under the GAAP, the asset purchased for $100,000 is now marked down to $80,000 even though it is actually worth $200,000. The scenario is much different for foreign companies reporting under the IFRS. The same piece of property with the same rising market value and same depreciation rate would be valued at $200,000 using IFRS measures. The foreign property, then, has a cumulative unrealized gain of $100,000.

"When an investor is looking at the U.S. reconciliation they say, 'I have $80,000 worth of assets.' But when they look at the foreign reconciliation it shows $200,000 worth of assets," Brodwin says. "It's the same building, and that's a big difference."


The trickle down effect

"The subjectivity involved in preparing real estate valuations could actually impact the reliability of the financial statements," Eisenberg says. Based upon the valuation methodologies used by two different appraisers — such as discounted cash flow analysis versus comparable sales analysis — the value of a property could vary widely.

Beyond financial statements and supplemental material, Eisenberg expects to see more disclosure from U.S. real estate companies. He suggests real estate companies offer additional data on the net asset value per share. This, he says, could help close the gap between the GAAP and IFRS, and offer shareholders a more transparent method of comparing U.S. and foreign filers.

That may only be a temporary solution, though. Beyond attracting more stock listings to U.S. exchanges, some say allowing foreign companies to file under the IFRS marks another step toward creating a global accounting standard. Indeed, there is discussion surrounding whether or not U.S. companies should be allowed to file under the IFRS so all parties would be reporting under the same format. That standard could mean getting rid of the GAAP for good.

SEC commissioners released a statement in August 2007 to gather comments about the possibility. The research is ongoing, as the SEC works to determine whether or not a standards change would ultimately benefit U.S. companies. The SEC has gathered about 2,000 comments to date, according to George Youngman, vice president of financial standards for the National Association of Real Estate Investment Trusts.

"We are moving in the direction of the IFRS longer-term. I have heard lots of numbers thrown out, but the consensus is that the U.S. should not totally adopt the IFRS for another five years, give or take," Youngman says. "The SEC may allow the choice to file under one or the other before that, but some people argue we shouldn't even allow the choice. It's still very much up in the air."

It may be up in the air, but Brodwin thinks the GAAP will ultimately give way. It's much easier to convert the GAAP to the IFRS, he says, than it is to covert the IFRS to the GAAP. That's one of the key reasons the SEC decided to allow foreign companies to file under the IFRS to begin with.


Making the transition

Equity One, a Miami-based REIT that owns, develops and operates shopping malls, is a good example of what could be in store for the future of public real estate firms.

An Israeli company, Gazit-Globe, is a significant shareholder in Equity One. For its first quarter 2007 earnings, Gazit-Globe requested that Equity One update a valuation of its investment property for financial reporting purposes using IFRS.

This is a model Brodwin says other U.S.-based real estate companies may want to adopt. He says, "This is where we are headed, so we need to get prepared."