By George Yungmann and David Taube
Investors trying to decipher the key metric for measuring real estate companies got a hand recently from NAREIT’s Board of Governors. The board took a step affirming net income computed under generally accepted accounting principles (GAAP) as the primary earnings measure for real estate companies when it unanimously agreed to findings and recommendations of the association’s Best Financial Practices Council.
The board agreed that relevant financial items (not including gains or losses from sale) from investment property held for sale, sold or otherwise transferred and now reported in results of discontinued operations are to be included in consolidated funds from operations (FFO). The need for this modification to the guidance contained in NAREIT’s FFO White Paper resulted from the Financial Accounting Standards Board’s (FASB) interpretation of Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets as it relates to dispositions of investment property.
Based on the FASB’s February 2002 interpretation, most dispositions of investment property will be reported in the GAAP income statement as discontinued operations. Under the former definition of FFO, this would have resulted in the FFO from properties held for sale or sold being excluded from reported FFO. Further, since discontinued operations reporting is required for all periods presented in the financial statements, previously reported FFO would have been required to be revised for most dispositions. As a result of the board’s actions, Statement 144 will have no impact on the FFO operating performance metric–mirroring the impact on “bottom line” GAAP net income.
The following summarizes the findings and recommendations made by the Best Financial Practices Council and adopted by the board of governors:
- NAREIT recognizes and emphasizes that GAAP net income is the primary earnings measure for real estate companies.
- NAREIT welcomes the efforts of analysts and others to increasingly rely upon and utilize net income, as defined by GAAP, in their analysis of the real estate industry and individual companies.
- NAREIT believes that FFO remains a useful supplemental earnings measure for a variety of reasons, including the treatment of depreciation and gains and losses on property sales under GAAP.
- NAREIT believes that, consistent with the intended purpose of FFO and past practice, items previously included in the calculation of FFO from income-producing properties, whether currently in use, held for sale, sold or otherwise transferred, should be presented as part of FFO for current periods as well as prior periods presented.
- NAREIT recommends that full disclosure be made of amounts reported in results of discontinued operations. These disclosures should identify FFO, gains/losses and other items included in results of discontinued operations.
Implications of Statement 144
Although the action of NAREIT’s leadership neutralizes the impact of Statement 144 on bottom-line FFO, investors and analysts should be aware of the statement’s impact on GAAP income statements. Statement 144 requires that the financial results from most investment property held for sale, sold or otherwise transferred must be classified as discontinued operations in the applicable financial reporting period.
Further, financial results from these properties must be reclassified from continuing operations to discontinued operations for all prior periods presented in financial statements. The outcome is that many financial results of recycling capital through transfers of properties and certain merchant building activities will be reported as discontinued operations.
As with other accounting standards, the new rules do not contain a bright line that clearly distinguishes sales of property that must be reported as discontinued operations. In some cases, disposition activities may continue to be reported as continuing operations. Investors and analysts will need to understand which property transactions are reported in continuing operations and which are included in results of discontinued operations.
Reporting Correctly
To minimize confusion, a working group comprised of the Best Financial Practices Council and select company financial executives are working to ensure that implementation of Statement 144 is being applied correctly. Particularly, that no property disposition is characterized as a discontinued operation that is not required to be shown as such under the statement. The group has discussed these issues with representatives of a number of audit firms and with FASB staff.
Although few property dispositions will be exempt from discontinued operations reporting, investors and analysts should take note of these exceptions. The sale of a property developed under a build-to-suit contract or a project that is sold immediately upon completion even though not developed under a build-to-suit contract would not be reported as a discontinued operation. One of the critical factors in determining whether a transaction is required to be reported as a discontinued operation is the degree to which rental revenues from the property have been reported in the income statement. The sale of properties that are operated, even for very short periods, would probably be reported as discontinued operations. Further guidance on this new accounting standard is available in the Accounting Issues section of NAREIT’s web site (www.nareit.com).
In addition, to provide enhanced transparency with respect to the financial results of property sales, NAREIT’s Best Financial Practices Council is developing a model disclosure for reporting the various elements contained in results of discontinued operations. This model will also be available in the Accounting Issues section of www.nareit.com.
George L. Yungmann is vice president, financial standards and David M. Taube is director, financial standards for NAREIT.
