Accounting for common interest realty associations.by Temple, Raymond M.
Certain industries require a greater understanding of the operating characteristics on which its accounting and reporting standards are based. Oil and gas producing activities, long-term construction contracts, and mortgage banking activities are examples. However, it is unusual when an area that appears to have reasonably simple operating characteristics such as Common Interest Realty Associations (CIRAs), results in a complex accounting model. This article reviews the proposed Accounting and Audit Guide for CIRAs prepared by the Task Force of the Accounting Standards Executive Committee of the AICPA.
Real Estate ownership has taken on many new forms over the years. These include cooperatives, condominiums, planned units developments, and homeowners associations. It is estimated that one out of eight households in the U.S. are part of CIRAs. They play an important part in providing housing and affect thousands of people that live in them, work for them and provide goods and services to them. The main characteristics of ownership are:
. Individual ownership of lots,
defined interior spaces, or shares of
. Ownership of undivided interests
in the common property with all
owners bound by covenant, restriction,
or contract through an association
. Automatic membership in a CIRA
that has been established under
state laws and performs maintenance
and other service activities
for the owners.
. Funding of the CIRA's activities by
periodic assessments of all owners.
The major accounting issues stem from the form of ownership, not the operations of a CIRA. They are capitalization of common properties and accounting and disclosure for major repairs and replacements.
Common Property and Facilities
Originally the proposed guide required assets transferred by a developer to be capitalized when the CIRA had the right to sell the transferred assets and had unrestricted use of the proceeds from such sales. The guide also required capitalizing fixed assets purchased if the CIRA had the ability to control use or access and use benefit or service potential.
The AICPA Task Force based its conclusions on the fact that CIRAs cannot use the common property other than to maintain it and provide services in connection with it. Additionally, a CIRA cannot prevent members from using common property regardless of whether it has title or not. Furthermore, the Task Force indicated that common areas do not meet the definition of an asset as presented in Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements." That Statement defines assets as probable future economic benefits obtained or controlled by a particular entity. Since common property does not provide future benefit or service potential to the CIRA, this property would not meet the definition of an asset. It cannot be exchanged by the CIRA for cash goods or service, settlement of liabilities, or to increase the value of CIRA assets. The Task Force was unable to see how inclusion of any common property on a CIRA's balance sheet might benefit financial statement users.
The FASB rejected the notion that CIRAs should not recognize common property as assets. Board members had significant concerns about apparent inconsistencies between the proposed guide and the Board's conceptual framework and other professional standards. They believe that CIRAs should recognize assets in their financial statements on the same basis as other reporting entities (i.e., transfer of title, etc). As a result, the proposed Accounting and Audit Guide was changed to comply with the Board's reasoning.
Major Repairs and Replacement
A CIRA is expected to maintain and replace common property. Some state statutes require a CIRA to accumulate funds for future major repairs and replacements. If provision for replacement of the CIRA's assets is not made through other means, it is generally desirable to set aside funds periodically to provide for replacement. What is the appropriate accounting for these funds?
Some accountants and industry associations believe that periodic accounting should charge the appropriate expense account (Repair and Replacement Reserve) and credit an appropriate balance sheet account (also Repair and Replacement Reserve--part of the Members' Equity). However, the Task Force stated that a CIRA should not recognize liabilities related to future maintenance of an entity's assets, regardless of its duties to maintain such property. The members recommended the use of fund accounting as the most informative method of presenting a CIRA's normal operations and long-term major repair and replacement requirements. It was reasoned that the net assets included in such a presentation would inform users of the amount of resources accumulated for future major repairs and replacements.
As noted, a major function of a CIRA is to maintain and preserve the common property, and to decide on a method for funding the cost of future major repairs and replacements. Since that funding usually is accomplished by assessing owners, the Task Force recommended extensive disclosure of those funding policies. In addition to disclosures required by GAAP for other entities, one of the unique disclosures for CIRAs proposed in the guide included the following funding policy information:
. Requirements in statutes or association
documents, if any, to accumulate
funds for future major
repairs and replacements and the
CIRA's compliance or lack of
compliance with them.
. Estimates of current or future costs
of major repairs and replacements
that will be required, such as a roof
replacement, including estimated
amounts required, methods used to
determine the cost of future major
repairs and replacements, the basis
for calculations, including assumptions,
if any, about interest and
inflation rates, sources used, and the
date of a study, if any.
. Description of the CIRA's funding
policy, if any, and compliance with
. Presentation showing components
to be repaired and replaced,
estimates of the remaining useful lives
of the assets in each category,
estimates of current or future replacement
costs, and amounts of funds
accumulated for each category to
the extent designated by the Board.
. Statement that funds, if any, are
being accumulated based on
estimated future (or current) costs and
that actual expenditures may vary
from estimates and that such
variations may be material.
. Amounts assessed and collected
that have been used in current and
cumulative operations, if any. In addition, CIRAs that have decided to fund future major repairs and replacements by special assessments or borrowing as needs occur should disclose that information.
It is interesting to note that the FASB, often criticized for failure to consider the smaller business in its standard setting process, had some concern about the effort that would be required by some very small organizations to provide these extensive disclosures. However, the Committee was able to persuade the FASB to include them in the proposed guide.
Practitioners servicing CIRA clients should consider seriously the proposed accounting and disclosure requirements. It seems to this author that the proposed guide has all the ingredients of standards overload.
Materiality Guidelines for Interest Capitalization
The FASB has concluded that general standards of materiality are not feasible. This opinion is expressed in the FASB's Statement of Financial Accounting Concepts No. 2 where the Board states that its "present position is that no general standards of materiality could be formulated to take into account all the considerations that enter into experienced human judgment." It deems an item to be material if the correction or inclusion of the item in the financial statements would have a probable impact on a user's judgment.
Even though the FASB does not provide general materiality guidelines, it does utilize them for specific items in some of its pronouncements. When not otherwise provided, accountants must rely on their own rules of thumb concerning materiality. Depending on many factors (including the nature of the item and size of the entity), criteria such as the following are used:
. 10-15% of average net income
after taxes for the three to five most
. 5-10% of the current year's income
from continuing operations before
. .5-2% of total revenue or total assets.
. 1-2% of stockholders' equity.
Capitalization of Interest Cost
The concept of materiality has direct application to capitalization of interest cost required by SFAS 34. However, the FASB provides no specific guidelines. The purpose of this article is to help fill this void.
If an extended period of time is required to construct or acquire a plant asset, SFAS 34 requires that interest cost incurred as a result of expenditures on the asset be capitalized as part of the cost of the asset. The purposes of capitalizing interest are a) to provide a better measure of the asset's acquisition cost, and b) to obtain a better matching of future revenues and expenses. The Board stated, however, that interest cost does not have to be capitalized when its effects are not material.
If an accountant determines that his firm's capitalizable interest cost is material, the cost should be recorded as part of the cost of the asset. For any period in which a portion of the interest cost is deemed material and therefore capitalized, both the total interest cost incurred and the amount capitalized must be disclosed.
Materiality Guidelines Developed
To determine the materiality levels currently being used for interest capitalization, the financial statements of approximately 350 firms were examined. The firms were randomly selected from the listing of firms in Moody's Industrial Index. For each firm, the financial statements and footnotes for the two most recent years (in general, 1986 and 1987) were examined.
To evaluate the materiality levels used by those firms in the sample that capitalized interest, various materiality measures were examined. For each of the observations, the amount of interest capitalized was computed as a percentage of the following bases:
1. Current year's income from
continuing operations before taxes.
2. Average net income for the three
most recent years.
3. Total assets.
4. Stockholders' equity.
5. Net sales.
6. Property, plant, and equipment
7. Property, plant, and equipment
8. Total interest cost incurred
(including the amount of interest
The first five measures are commonly-used measures of materiality while the last three relate more specifically to interest capitalization.
The interest capitalized as a percentage of each of the above eight bases was computed for each firm in the sample. For each percentage, a mean was calculated for the entire group. These means provide surrogates for the materiality thresholds used by the group as a whole. The mean percentages provide an indication of the materiality levels of interest cost being capitalized by the profession as a whole. As such, they can be used as general guidelines for evaluating the materiality of capitalizable interest.
Let us assume an accountant has computed a firm's capitalizable interest cost to be 7% of income from continuing operations before taxes. He feels that this amount is not material, yet there is some doubt. The information shows that the average amount of interest capitalized as a percentage of income from continuing operations before taxes is over 10%. Knowing this, the accountant could confirm that the firm's capitalizable interest is not material and should be expensed in the current period. He also might wish to apply several of the other materiality tests before making his final decision. In this case, the information provided the accountant with additional input for and comfort in the decision reached.
The risks or consequences of omitting a material item increase as the size of the firm increases. This is because more users rely on the financial statements of a larger firm than on the financial statements of a smaller firm. Thus, materiality levels for larger firms are often set at lower percentages than they are for smaller firms.
Sales for the companies included in the sample ranged from a low of $17 million to a high of almost $13 billion. To make the information on materiality levels more useful, the sample was divided into two subsamples with an equal number of observations in each group. A company's sales were used as the measure of its size. Firms with sales of less than or equal to $3 billion were placed in one group, while firms with sales exceeding $3 billion were placed in the other group. This particular cutoff point was chosen because it represented the median point for the entire group and resulted in 158 observations in each subsample. The mean materiality thresholds for the two subsamples.
Materiality thresholds do indeed decrease as the size of the firm increases.
This article provides rule of thumb materiality guidelines for capitalizing interest bases on current practice. The guidelines are, of course, not intended to replace an accountant's judgment, but rather to provide comfort and/or support for the particular decision reached.
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