By David Taube and George Yungmann

Recent capital market events have resulted in the scrutiny of virtually every aspect of public company financial reporting—perhaps none more so than the accounting and disclosure of off-balance sheet (OBS) activities. Well before these events, participants in the real estate industry have been attentive to financial reporting associated with OBS activities, particularly joint ventures (JV) reported on the equity method of accounting.

Although the industry long ago began using JV arrangements as a source of capital for a wide range of purposes, the associated benefits provided by JVs have led to a significant increase in their use since the mid 1990s. As a result, JV arrangements have become an integral part of the business model of many real estate companies, and financial statement preparers and users have worked toward achieving a satisfactory level of transparency.

Real estate companies have used OBS joint venture arrangements in most cases to provide access to lower-cost capital for acquisitions and new developments, while avoiding the issuance of additional public equity. A property disposition into a JV allows a company to retain part of the benefits of mature properties while accessing a portion of the asset's increased market value.

Related benefits of joint ventures for acquisition and disposition purposes include geographic or property diversification. Development JVs allow a company to not hold non-revenue producing assets and shift a portion of construction and lease-up risk to a development or financial partner. Also, a minority interest position in a portfolio may provide an investor a qualitative informational advantage if the balance of the venture becomes available for acquisition.

Company Requirements

Although investors have generally penalized companies with complex OBS activities, real estate companies have for the most part been unscathed since they already provide much of the relevant data that investors seek to assess the impact these activities have on the company. Real estate companies provide disclosures about joint venture arrangements required by generally accepted accounting principles (GAAP), and many provide supplemental disclosures.

Financial reporting guidance for these activities is contained in the American Institute of Certified Public Accountants' (AICPA) Statement of Position (SOP) 78-9, Accounting for Investments in Real Estate Ventures, and in Accounting Principles Board (APB) Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, which states:

"When investments in unconsolidated subsidiaries are, in the aggregate, material in relation to financial position or results of operations, summarized information as to assets, liabilities and results of operations should be presented in the notes or separate statements should be presented for such subsidiaries, either individually or in groups, as appropriate."

The foregoing also applies to investments in common stock of corporate JVs. SOP 78-9 also refers a financial statement preparer to Statement of Financial Accounting Standards No. 95, Statement of Cash Flows, for the form and content of cash flow data to be disclosed.

Investor, Analyst Needs

Due to the complexity associated with the financial reporting, investors and analysts need sufficient data regarding a company's interests in its JV arrangements in order to evaluate the impact on the company's profitability and financial position. These disclosures should provide analysts with sufficient information to evaluate the prospective cash inflows and outflows related to the JVs.

Data that would enhance an analyst's or investor's understanding about JV arrangements include a description about ownership structure and significant terms and conditions. Some of the terms may include, but would not be limited to: the company's stated legal share of the venture, effective economic interest in earnings, funds from 0perations, cash flow and equity of the venture, control provisions, term/duration of the venture, contingent capital obligations, revenue splits, fee allocations, preferences, earn outs, exit conditions, permissible outs and recourse provisions.

Financial statement data would include the total joint venture and company pro-rata share of:

• Balance sheet:

- investment property (net)
- mortgage debt
- other assets and liabilities
- partners'/shareholders' equity

• Income statement:

- revenues
- expenses (operating, depreciation & amortization, interest)
- gain or loss on sale of properties
- net income

An analyst also would want information about a company's receipt of cash flows from a JV representing dividends or other forms of distributions. Other financial data about the total JV and the company's pro-rata share would include: straight-line rents in excess of (less than) contract rents, capital expenditures (including tenant improvements and leasing commissions, and non-tenant costs), and contingent liabilities.

Fundamental data about the properties included in joint ventures also are important—location, size, leasing statistics and occupancy. This property specific information becomes even more crucial when looking at JVs established for development due to the uncertainties associated with construction and leasing. Finally, the existence of related party transactions should be fully disclosed.

Making the Rules

Even before the recent spotlight on OBS activities, private-sector rule makers around the world have been focused on setting accounting standards for JVs. In the U.S., both the AICPA and the Financial Accounting Standards Board (FASB) have ongoing projects on their agendas to address JV accounting. In addition, the International Accounting Standards Board is considering a project similar to the FASB project. The outcome of these standards projects could have an impact on how real estate companies, as well as the ventures in which they invest, are required to report and disclose financial information about JVs.

The AICPA is working on a proposal that would clarify and expand the real estate venture financial reporting guidance contained in SOP 78-9. The proposal would specify when the equity method of accounting is to be used and the method of calculating the impact on an investor's earnings.

The FASB has initiated a rulemaking effort dealing with new basis accounting (reporting assets transferred in the creation of JVs at current value) for JVs and similar combinations. In addition, the FASB has resumed its long-term project on consolidations by concentrating its efforts on accounting and reporting for "special purpose entities." When these issues are resolved, more OBS arrangements could be reported on-balance sheet.

Prior to the recent scrutiny over financial reporting, the real estate industry understood the business advantages of using JV arrangements and providing relevant data to enhance the level of transparency. Regardless of the official financial reporting requirements that may be proposed and adopted, it will remain critical for companies to provide users with a full understanding of the financial impacts of JV investments.

Taube

David M. Taube is director, financial standards and George L. Yungmann is vice president, financial standards for NAREIT.

Yungmann