When evaluating a real estate sale transaction, two separate issues arise: (1). Is it appropriate to record the transaction as a sale? And; (2). If a sale can be recorded, what method should be used to recognize profit on the sale? This post is going to emphasize these issues. It is going to be the longest post I ever made. So read it only if you really need a complete and comprehensive guidelines about Accounting method for sales and profit of a real estate company. If you really want to follow this post, you would definitely need at least a cup of drink 🙂
Premature profit recognition on real estate sales transactions had been an issue for many years. In subsequent years, real estate transactions became increasingly innovative and complex. Their legal form frequently did not reflect the substance of the transaction. These developments prompted the American Institute of Certified Public Accountants (AICPA) to establish the Committee on Accounting for Real Estate Transactions in 1971.
Financial Accounting Standards Board (FASB) Statement No. 66, Accounting for Sales of Real Estate, extracts the principles from that Accounting Guide and from the guidance in the two Statements of Position (SOP) No. 75 – 6, “Questions Concerning Profit Recognition on Sales of Real Estate“, and SOP No. 78 – 4, “Application of the Deposit, Installment, and Cost Recovery Methods in Accounting for Sales of Real Estate“.
Applicability Of FASB Statement No. 66
FASB Statement No. 66 provides guidance for the recognition of profit on all real estate transactions without regard to the nature of the seller’s business. While Statement 66 specifically mentions the sale of hotels, motels, marinas, and mobile home parks as being within its scope, it does not explicitly define the term “real estate” or the transactions that are within its scope.
FASB Interpretation No.(we, accountants say it as “FIN”) 43, Real Estate Sales , provides clarification of the scope of Statement 66 follows:
Statement 66 applies to all sales of real estate, including real estate with property improvements or integral equipment. The terms property improvements and integral equipment as they are used in this Interpretation refer to any physical structure or equipment attached to the real estate that cannot be removed and used separately without incurring significant cost. Examples include an office building, a manufacturing facility, a power plant, and a refinery.
Equipment is considered integral when the cost of removing the equipment and the resulting decrease in value, which includes the cost of shipping and reinstalling the equipment at a new site, exceeds 10 % of the fair value of the equipment. Whether something is determined to be a business or not is not a factor in determining whether its sale is subject to the provisions of Statement 66. The attributes of the combined assets being sold (i.e.; the manufacturing facility, the power plant, or the hotel plus the land, receivables, payables, etc.) need to be considered when determining whether the nature of the assets being sold is in substance the sale of real estate. The sale of timberlands or farms (that is, land with trees or crops attached to it) is viewed as being similar to the sale of land with property improvements or integral equipment and thus also subject to the guidance relating to the sale of real estate.
However, natural assets that have been extracted from the land (such as oil, gas, coal, and gold) are not subject to the provisions governing the sale of real estate. Similarly, the sale of timber or harvested crop (i.e.; anything that will have been detached from the land by the time it reaches the buyer) is not subject to the provisions relating to the sale of real estate.
The provisions of FASB Statement No. 66 do not apply to transactions that involve the following:
- The sale of only property improvements or integral equipment without a concurrent (or contemplated) sale of the underlying land, unless the underlying land is leased to the buyer; such lease may be explicit or implicit. An example of a sale of property improvements not subject to the provisions of Statement 66 would be the sale of storage tanks attached to real estate that are not used on the property and are removed subsequent to the sale.
- The sale of the stock or net assets of a subsidiary or a segment of a business containing real estate, unless the transaction is, in substance, the sale of real estate.
- The sale of securities that are accounted for in accordance with FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.
Application Of Accounting Methods For Sales and Profit Of Real Estate
The following matrix shows—in simplified form—the accounting methods applicable to real estate sales transactions for easier navigation to the next discussion.
And here are accounting methods we are going to discuss in detail: Deposit Method, Installment Method, Cost Recovery Method, Reduced Profit Method, Percentage-of-Completion Method, Financing Method, Leasing Method, Profit-Sharing Method, Performance-of-Services Method.
The deposit method is appropriate when, in substance, no sale has occurred. For example: the seller’s down payment is only nominal and the seller has not all conditions precedent to closing have been performed, so the sale is not considered consummated.
Under the deposit method, the seller does not recognize a sale. Instead, the seller continues to report the property and related existing debt in its financial statements—even if the debt has been assumed by the buyer — and discloses that the property and related debt are subject to a sales contract. Principal payments made by the buyer on any assumed debt are recorded as a reduction of debt and as additional deposits from the buyer.
The seller continues to record revenues and expenses relating to the property sold, as well as depreciation expense, unless the property is a long – lived asset that has been classified as held for sale. A long – lived asset that is classified as held for sale is not depreciated while it is classified as held for sale; however, interest and other expenses continue to accrue.
For better illustration, have a look at below example:
Under the installment method, the seller recognizes a sale. The real estate property sold and any debt assumed by the buyer are removed from the books. The use of the installment method is appropriate when the initial and/or continuing investment does not qualify for the use of the accrual method, and the carrying amount of the property has already been recovered or its recovery is reasonably assured if the buyer defaults. If, in a later period, the transaction meets the requirements for the accrual method of recognizing profit, the seller may change to the full accrual method. The profit not yet recognized under the installment method is recognized in income at that time.
The installment method results in deferring profits from a sale and recording these profits as cash payments are collected. Each cash receipt (and principal payment by the buyer on debt assumed) is apportioned between cost recovered and profit in the same ratio as total cost and total profit bear to sales value.
Under the installment method of accounting, interest income is recognized when received, rather than accrued into income. If the seller finances the sale with a note that carries a below – market interest rate, the seller needs to determine whether financing provided at market rates would have resulted in a loss on the sale. Any such loss should be recognized at the time of sale. Paragraph 57 of Statement 66 provides that for sales transactions that result in a profit, it is acceptable not to adjust the interest rate to reflect market rates. Since interest is recognized in full when received, whereas principal payments are allocated between cost and profit, a stated interest rate below market generally results in reduced profit recognition in earlier years.
A seller must ensure that a receivable from the sale of property less profits not recognized does not exceed what the carrying amount would have been had seller needs to monitor the amount of the receivable from the buyer and compare it to the “hypothetical” depreciated book value of the property sold to determine whether this requirement is met in periods after the sale. This provision was included in Statement 66 to prevent a seller from avoiding loss recognition in circumstances where, as a result of small down payment received, risk of ownership might not have passed to the buyer.
Cost Recovery Method
Like the installment method, the cost recovery method provides for the recording of a sale. The principal difference between the cost recovery and the installment method is that the cost recovery method does not permit the recognition of profit on sale nor the recognition of interest income until interest and principal payments made by the buyer, including payments on assumed debt, equal the carrying amount of the property sold. All payments from the buyer to the seller are credited to balance sheet accounts (principal is credited to notes receivable and interest to deferred profit) until the carrying amount of the property is recovered. Once cost is recovered, the entire amount of any subsequent payments received is credited to income. Any losses arising from the sale of real estate properties are recognized at the date of sale.
In certain situations, Statement 66 allows for the use of either the installment method or the cost recovery method. The decision whether to use the cost recovery method or the installment method is a matter of judgment: The seller has to determine whether the carrying amount of the property is recoverable in the event of buyer default. The cost recovery method is used if recovery of the cost of the property is not reasonably assured if the buyer defaults. This may occur in a transaction in which the seller does not have a lien on the property after the sale, or in which the seller has a receivable from the buyer that is subordinate to other liens on the property. Statement 66 also permits the use of the cost recovery method in lieu of the installment method.
Reduced Profit Method
The reduced profit method is used in transactions in which the buyer’s initial investment meets the criteria for the application of the accrual method of accounting, but the buyer ’ s continuing investment, while exceeding certain requirements, fails to meet the criteria for the application of the accrual method. Specifically, for the reduced profit method to be appropriate, paragraph 23 of Statement 66 requires that the buyer’s payment each year cover both:
- The interest and principal amortization on the maximum first mortgage loan that could be obtained on the property
- Interest, at an appropriate rate, on the excess of the aggregate actual debt on the property over such a maximum first mortgage loan.
If these requirements are not met, the seller should use the installment or cost recovery method. A “reduced profit” is calculated by substituting the receivable from the buyer with the present value of the lowest level of annual payments required by the sales contract over 20 years (for the sale of land) or the customary amortization term of a first mortgage loan by an independent established lending institution (for all other real estate); any scheduled lump sum payments are excluded from that calculation.
The present value is calculated using an appropriate interest rate, but not less than the rate stated in the sales contract. This method of profit recognition permits profit to be recognized from level payments on the buyer’s debt over 20 years (for the sale of land) or the customary amortization term of a first mortgage loan by an independent established lending institution (for all other real estate) and postpones recognition of other profits until lump sum or other payments are made.
The application of the reduced profit method is best explained in an example below:
Under the accrual, installment, cost recovery, and reduced profit methods, the entire sales price and related cost of goods sold are reflected in the income statement; depending on the profit recognition method, part or all of the profit may have to be deferred. Under the percentage-of-completion method, the application of which requires that future costs of development be reasonably estimable, costs are reported in the period they are incurred, and gross profit is reported based on the ratio of costs incurred to date as compared to total expected project costs.
The revenue to be reported in any one period is calculated as the sum of the costs incurred in that period and the related gross profit. If it is expected that a contract results in a loss, the entire loss has to be recognized in full; Statement 66 does not provide for loss deferral.
The financing method is appropriate when, in substance, the transaction is not a sale, but akin to a financing arrangement, with the loan (the proceeds from the sale) secured by the property sold. The financing method is also the appropriate method for some forms of continuing involvement, such as a guarantee provided by a seller for an extended period of time.
Under the financing method, no sale is recorded. The property and any debt assumed by the buyer remain on the seller’s books, and the seller continues to report the results of the operations of the property. If a sale transaction subsequently qualifies for sale recognition, a sale is recorded. Any results of operations of the property (other than depreciation) that do not accrue to the seller should be offset by a corresponding increase or decrease in interest expense, consistent with the accounting by a participating mortgage loan borrower. As a general rule, a real estate sale transaction that does not initially qualify for sale recognition must not result in a “scheduled loss” at the time the transaction is expected to qualify for sale recognition.
No specific guidance is provided in Statement 66 regarding the application of the financing method, and frequently questions arise with respect to:
- Recording Of The Transaction “Gross Vs. Net” – Views differ on whether a seller should record the transaction “gross” or “net”, that is, whether the seller should record the cash received and a corresponding financing obligation (“net recording”), or whether—in addition to the cash received—the seller should also record a note received from the buyer as part of the consideration (“gross recording”). The following arguments are made: In a financing transaction, the property owner receives cash from a lender, which is collateralized by real estate. Accordingly, the property owner should record a loan in the amount of cash received; any note received from the buyer does not fit into the framework of a financing transaction and should therefore not be reflected on the seller ’ s balance sheet.
- Interest Rate To Be Used – A topic of discussion is also the interest rate to be used when applying the financing method. In the case of an obligation to repurchase the property sold at a price greater than the sales value, the difference between the sales value and the repurchase price is deemed to be interest and is charged to income using the effective interest method. If continuing involvement other than an obligation or option to repurchase trigger the use of the financing method, it may be appropriate to apply the seller’s incremental borrowing rate to the amount of the financing obligation, consistent with the rationale that in a financing transaction, the seller would have to borrow funds at its incremental borrowing rate. If the application of the seller’s incremental borrowing rate leads to atypical results, however, such as a negative amortization of the financing obligation, the use of an interest rate different from the seller’s incremental borrowing rate may be more appropriate.
- Income Statement Presentation – Another frequently asked question relates to the income statement presentation when the financing method is applied. Under the financing method, the seller is deemed the accounting owner of the property: Should the seller continue to reflect rental revenue, depreciation, and operating expenses relating to the property, or should the seller reflect depreciation expense relating to the property sold, and present only the results of the operations of the property (net of depreciation) on the seller’s income statement? Some believe that the seller of the real estate property remains the accounting owner and therefore should record rental revenues, depreciation, and operating expenses like a property owner.
At the beginning of Period 1, Sarah Property (S) sells land for a cash sales price of $5 million. At the same time, S enters into an obligation to repurchase the land at the end of Period 1 for $5.5 million. The seller’s incremental borrowing rate is 10%. How should S account for the transaction? In substance, the sale is a financing transaction; $500,000, the difference between the sales price and the repurchase price, represents interest, which has to be recorded as interest expense in Period 1, using the effective interest method.
A real estate sale transaction may in substance be a lease. The leasing method is often appropriate when the seller has an obligation or option to repurchase the property at a price lower than the sales price paid by the buyer. Under the leasing method, the seller leaves the property and any related debt on its books and continues to report the property’s operating results. Any cash received from the buyer is recorded as a liability.
Under the leasing method, the difference between the repurchase price and the sales price represents, in substance, prepaid rent, which is accrued into income using the straight-line method. The liability is reduced by the amount of “lease income” recognized, so that at the time of expected repurchase, the liability account is equal to the repurchase price of the property.
At the beginning of Period 1, Strauss (S) sells a warehouse to Brave Dharma Co. (B) for $5 million, and enters into an obligation to repurchase the warehouse at the end of Period 5 for $3 million. How should S account for the transaction? In substance, the sale is a lease with $2 million prepaid rentals. The property and related debt remain on the books of S. The rental income received from B is straight-lined over the lease period. The seller records rental income of $400,000 in periods 1 through 5.
Real estate sale transactions frequently involve venture arrangements in which two or more parties undertake a real estate project or in which one party sells land to the other party and participates in future profits. These venture arrangements may or may not, involve a separate legal entity. If these transactions don’t qualify for sale accounting as a result of continuing involvement by the seller, the profit – sharing method may be the appropriate method to use.
One way the profit – sharing method is applied in practice is as follows:
The seller leaves the property and any debt assumed by the buyer on its books and records a “profit-sharing obligation” or “co-venture obligation” for any consideration received from the buyer/venture partner. The seller continues to record depreciation and the results of the property’s operations on its books. The total of the income and expense amounts attributable to the buyer/venture partner is presented in the income statement caption “profit-sharing expense/income” or “co-venture expense” or “co-venture income”.
The performance-of–services method is appropriate in situations in which the seller agrees to guarantee a return service, and contractual payments. Under the performance-of-services method, a sale is recorded; profit deferred is based on the ratio of cost incurred to date in relation to cost expected to be incurred for the project until the end of the guarantee or support period (similar to the percentage-of-completion method).
If the revenues expected from the project cannot be estimated over the support period, because no objective information is available regarding occupancy levels and rental rates for similar properties, profit recognition is not appropriate, unless the amount of the maximum support obligation can be quantified.
When the seller of income-producing property guarantees a return on investment to the buyer for a limited period of time, Statement 66 requires that certain adjustments be made when estimating the property’s rental revenues over the guarantee period to allow for unforeseen circumstances: Expected rental revenues from the property sold are to be reduced by a safety factor of one – third, but not below the amount expected to be received from signed leases. Once signed leases have been obtained, it can be assumed that the level of occupancy from signed leases is sustainable over future periods, unless there is evidence to the contrary. Actual amounts are substituted for estimated amounts once actual amounts are known, and any subsequent changes in estimates of revenues and costs are taken into consideration when determining the amount of profit to be recognized in future periods.
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