Global convergence is coming to financial accounting standards

By Dees Stribling

The wheels of regulatory change grind slowly, but steadily. Each and every day, various committees of accountants are working toward fundamental changes in the way companies keep their books, which may profoundly affect the way investors evaluate REIT financials. In an age of global capital flows, shouldn’t the world have one global accounting standard?

“On both sides of the Atlantic, there’s a commitment to the convergence of U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS),” says Hans Bruggink, director of reporting practices at the European Public Real Estate Association (EPRA). “However, it will be a slow process.”

The goal of convergence is to iron out the differences between U.S. GAAP and IFRS, leading to the use of one universal accounting standard for economies around the world. According to Ray Milnes, national industry sector leader-real estate, KPMG LLC, either the two standards will converge, or U.S. companies will eventually be allowed to use IFRS standards.

Either change would represent a migration of U.S. companies to international standards, but it will be a slow process, Milnes says. “Some U.S. companies want to use IFRS, and a movement to allow it will pick up some steam in the years ahead.”

Whatever happens, it’s going to involve a considerable learning curve for investors, especially non-accountants who aren’t familiar with IFRS, notes Bruggink. “For investors used to U.S. GAAP,financial statements using international standards will seem more complicatedand difficult to read at first, but that will pass.”

Where there’s uncertainty, there’s also a measure of fear. “The standards are a work in progress, and naturally there’s some trepidation about it,” says Ben Neuhasen, national director of accounting at BDO Seidman LLP, the American arm of the accounting agency BDO International. “There’s a cost involved in a major switch, and aversion to doing things differently. However, over the long-term, using one set of standards will make it easier to compare investments worldwide.”

A Tale of Two Standards

For many years, the matter of accounting standards has been settled in the United States, Neuhasen says. U.S. Generally Accepted Accounting Principles (GAAP) have been exactly that, generally accepted. They are formulated by the Financial Accounting Standards Board (FASB) with regulatory oversight by the Securities and Exchange Commission (SEC) for those companies listed on U.S.-based exchanges.

With the creation of the European Union, pan-European accounting standards were formulated under the aegis of the International Accounting Standards Board (IASB), based in London. The European Parliament and the Council of the European Union decided in 2005 that all publicly traded companies based in the EU would be required to prepare their consolidated accounts using IFRS.

In recent years, there has been considerable movement on convergence of U.S. GAAP and IFRS, notes Neuhasen. In 2002, IASB and FASB agreed to work towards reducing differences between the two sets of standards. A few years later, the two bodies issued a memorandum of understanding including topics on which they would seek convergence by 2008, such as government grants, joint ventures, impairment and income tax.

In August 2007, SEC commissioners released a statement discussing the possibility of allowing U.S. issuers to report under IFRS instead of U.S. GAAP. The SEC is continuing its research to ensure the effect of this change on U.S. markets will be positive. “This could be the first step toward convergence, but there are still a number of ways this could play out,” Neuhasen says, adding that unknown factors could affect REIT valuations.

Milnes is more optimistic that U.S. companies will embrace the international standards. “My sense is that U.S. companies would like that choice,” he says. “If the SEC allowed it, I think you’d see a number of companies using IFRS even before the convergence process want any further.”

The Death of FFO?

Milnes calls the IFRS requirement to record investment properties at fair value the most important single difference between U.S. and international accounting standards, at least for REITs. “Under IFRS, investment properties are reported at fair value either in the financial statements or in notes to one statement, so, for many companies, there would be no depreciation relative to book value,” he says. “REITs, through FFO calculation, reverse out depreciation. However, it’s cleaner not to have depreciation in the first place.”

Eventually, FFO might become an obsolete measure of REIT performance, because there’s no need for it under IFRS, explains Milnes. “When people speak of the value of a REIT, book value under U.S. GAAP isn’t meaningful, and properties don’t depreciate the way GAAP accounting says they should,” he says. “IFRS allows fair value, and that takes away depreciation. It would eliminate the need to calculate FFO, since that’s designed to take out the impact of depreciation.”

Another accounting issue that will affect real estate owners is lease treatment under proposed revisions of both GAAP and IASB accounting standards. The operating lease, popular in real estate, is in danger of being effectively abolished. In its place, leases would function as capital leases, which assign the risks and rewards attendant with ownership to the lessee.

“FASB and IASB are jointly considering requirements that operating leases be treated similarly to capital leases,” says Chris Dubrowski, director of professional practice for Deloitte & Touche. “There’s approximately $1 trillion of operating leases in force, so that would be a major change.”

If the operating lease concept is eliminated, tenants will be required to record the present value of remaining lease payments as a liability on their books, Dubrowski says. Those who lease numerous locations will have considerable additional liabilities on their books that previously didn’t exist.

“A practical effect could be that tenants push for short-term leases, because a two-year lease won’t be a big liability compared to a five-year lease under the capital lease model,” he says. “That will impact property valuation.”

As for landlords, the changeover would be more complicated and have a stronger impact on their valuation, including REITs, Dubrowski notes. “For example, a shopping center investment would have to be bifurcated,” he says. “One part would be the present value of the lease receivables, while the other would be the residual value of the real estate. The landlord would recognize interest income from the lease receivable instead of rental income from the tenant, no simple matter for those landlords with hundreds or thousands of tenants.”

Despite the prospect of increased accounting complexity, however, Dubrowski expects the change to evolve slowly. In the meantime, the real estate industry has time to make its voice heard during the process. “It’s definitely something that landlords and investors need to monitor,” he says.

“Far more than simply monitoring activities in the international financial standards arena, NAREIT is actively participating in the process that will harmonize accounting standards globally,” says George Yungmann, NAREIT’s senior vice president, financial standards.

Dees Stribling is a regular contributor to Portfolio.

Editor’s Note: NAREIT is a member of a coalition of real estate organizations from around the world that has responded to a number of IASB and FASB proposals that would coverage standards. George Yungman serves on the joint FASB and IASB working group that is focused on the joint FASB/IASB leasing accounting project.