Mind the GAAP
What advantages does the income-tax basis accounting method offer?
GAAP is widely used. It is required for public companies such as publicly traded real estate investment trusts, and often it is demanded of private real estate companies by institutional investor partners. But GAAP is not the only choice for real estate companies that issue financial statements. Income tax-basis reporting should be considered when the entity’s choice of accounting method is not mandated by governing bodies.
The income tax basis for financial reporting has much to offer. It often produces financial reporting results that match cash flows and are more closely aligned with a business’s day-to-day realities. As a management tool, income tax-basis financials might be more useful, providing a better window into business performance. In addition, income tax-basis reporting can be easier, less time-consuming, and less expensive to apply.
For example, suppose a tenant has a two-month rent holiday at the beginning of its lease term on January 1 and pays $25,000 per month in base rent for the remainder of its 10-year lease. Under GAAP, base rent is straight-lined over the life of the lease and the same amount of rent is recognized each month, regardless of the amount a tenant is billed. Applying GAAP, $295,000 in rent income would be recognized in the financials in year one of the lease.
Using income tax-basis accounting, reported rent income would be $250,000, reflecting the two-month rent concession. Since the landlord actually billed and received $250,000, the income reported is in sync with the cash flow received from the tenant and the amount of income the company will report on its income tax returns.
The accounting method adopted also has a significant impact on the balance sheet. Using GAAP instead of income tax-basis accounting affects loan covenants such as debt service coverage; debt-to-equity ratios; and earnings before interest, taxes, depreciation, and amortization, also known as EBITDA.
Owners who are refinancing will have to consider this. For those who bought properties during the height of the market, values likely have declined. GAAP requires owners to determine whether there has been impairment of their real estate, and if so, record an impairment charge in earnings. These write-downs result in a reduction in the basis of assets carried on the balance sheet.
Under income tax-basis accounting, real estate generally is carried at historical cost, less accumulated depreciation. No write-downs for impairment are necessary or allowed.
The bottom-line impact of impairment can be quite significant on a GAAP financial statement. Impairment charges are presented in the income statement as an ordinary expense, along with other operating expenses of the business. While a financial analyst calculating EBITDA likely would add back impairment charges, it is not depreciation or amortization; therefore, when calculating certain financial covenants, including EBITDA, impairment likely will be included, barring a special carve-out in the loan documents.
Models used to test for impairment require a significant amount of development and fine-tuning. Often, independent appraisals are needed to satisfy third parties. This is only one example of the cost and complexity that can be associated with GAAP reporting.
Making a Choice
Given the added expense and time, why would anyone stay with GAAP reporting? GAAP accurately reports impairment and an owner might want a property to be carried at its lower value. If the purchase price was $100 million and the property is now carried on the books at $70 million, the lower figure might be a better reflection of reality.
Prior to adopting a method of accounting, owners should project income and expenses as well as a balance sheet to assess the impact of the two financial reporting methods. They also should prepare projections of financial covenants to ensure that they can meet all of them given their choice of financial reporting.
Which accounting method best serves the interests of real estate companies? The choice depends on each owner’s business situation. But given the ease of application and the close alignment to day-to-day cash flows, income tax-basis accounting is something that every real estate entity should consider if the choice is available.