<br><h3> Chapter One </h3> <b>Acquisition, Development, and Construction of Real Estate <p> <p> 1.1 OVERVIEW</b> <p> Investments in real estate projects require significant amounts of capital. For real estate properties that are developed and constructed, rather than purchased, project costs include the costs of tangible assets, such as land and other hard costs (sometimes referred to as "bricks and mortar"); intangible assets and other soft costs, such as architectural planning and design; and interest and taxes. Costs are often incurred before the actual acquisition of the project, which raises certain questions—for example, from what point in time should costs be capitalized? What types of costs are capitalizable? <p> Determining what types of costs to capitalize in the preacquisition, acquisition, development, and construction stages of a real estate project has been an issue for many years. Several decades ago, in reaction to significant diversity in practice, the American Institute of Certified Public Accountants (AICPA) issued this accounting guidance related to cost capitalization: <p> * Industry Accounting Guide, <i>Accounting for Retail Land Sales</i>, issued in 1973 <p> * Statement of Position (SOP) No. 78-3, <i>Accounting for Costs to Sell and Rent, and Initial Rental Operations of, Real Estate Projects</i>, issued in 1978 <p> * SOP 80-3, <i>Accounting for Real Estate Acquisition, Development, and Construction Costs</i>, issued in 1980 <p> <p> In 1982, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 67, <i>Accounting for Costs and Initial Operations of Real Estate Projects</i>, codified in Topic 970, <i>Real Estate—General</i>, extracting the accounting principles provided by these AICPA pronouncements. Nevertheless, diversity in practice has continued to exist in some areas, including the capitalization of indirect costs during the development and construction period and the treatment of repair and major maintenance costs incurred subsequent to the completion of real estate projects. <p> The AICPA undertook another project to develop a comprehensive framework for cost capitalization and, in 2003, issued for public comment the proposed SOP, <i>Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment</i>. That proposed SOP was approved by the AICPA Accounting Standards Executive Committee (AcSEC) in September 2003; however, a final SOP was never issued. In April 2004, the FASB decided not to clear that proposed SOP, mainly for these stated reasons: <p> * Lack of convergence with International Accounting Standards <p> * The concept of componentization, particularly the amount of judgment allowed, which could potentially result in lack of comparability <p> * Implications for the capitalization of major overhaul expenses <p> <p> <b>1.2 ACQUISITION, DEVELOPMENT, AND CONSTRUCTION COSTS</b> <p> The Real Estate Project Costs guidance of Topic 970 (FASB Statement No. 67) provides the primary authoritative guidance for the cost capitalization of real estate project costs. That Statement divides the costs incurred to acquire, develop, and construct a real estate project into preacquisition and project costs. Preacquisition costs encompass costs incurred in connection with, but prior to the acquisition of, real estate. Project costs include costs incurred at the time of the real estate acquisition as well as costs incurred during the subsequent development and construction phase (see Exhibit 1.1). <p> Real estate developed by a company for use in its own operations other than for sale or rental is not within the scope of the Real Estate Project Costs Subsections of Topic 970 (Statement No. 67). Because—aside from the proposed SOP, <i>Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment</i>—there is no authoritative literature related to the capitalization of costs for properties used by an enterprise in its own operations, the guidelines in the Real Estate Project Costs Subsections of Topic 970 (Statement No. 67) are generally also applied to properties used by an entity in its own operations. <p> <p> <b>1.2.1 Preacquisition Costs</b> <p> Preacquisition costs are costs related to a real estate property that are incurred for the express purpose of, but prior to, obtaining that property. They may include a variety of costs, such as: <p> * Payments to obtain an option <p> * Legal fees <p> * Architectural fees <p> * Other professional fees <p> * Costs of environmental studies <p> * Costs of feasibility studies <p> * Costs of appraisals <p> * Costs of surveys <p> * Planning and design costs <p> * Costs for zoning and traffic studies <p> <p> <i>1.2.1.1 Principles for the Capitalization of Preacquisition Costs <p> Options to Acquire Real Property.</i> Payments for options to acquire real property are capitalized. <p> <i>Preacquisition Costs Other than Options to Acquire Real Property.</i> Preacquisition costs other than the cost of options can only be capitalized if the acquisition of the property (or an option to acquire the property) is probable, and if the costs meet these two criteria: <p> <i>1.</i> The costs must be directly identifiable with the property. <p> <i>2.</i> The costs would be capitalized if the property were already acquired. <p> <p> The guidance in Accounting Standards Codification (ASC) 970-340-25-1 through 25-3 (FASB Statement No. 67) has established a high threshold for the capitalization of preacquisition costs with the requirement that the acquisition of real property be <i>probable</i>. If the purchaser is not actively seeking to acquire the real estate property or does not have the ability to finance or obtain financing for the property, or if there is an indication that the real estate property the purchaser seeks to acquire will not be available for sale, the project is not considered probable. Any costs (other than costs related to an option to acquire real estate) incurred before a project is considered probable have to be expensed as incurred. If the project becomes probable at a later point in time, costs incurred prior to the project becoming probable cannot subsequently be capitalized. <p> Preacquisition costs that meet the requirements for capitalization outlined above are capitalized. Once the real estate property is acquired, any capitalized preacquisition costs are included in project costs. If, however, a company determines that the acquisition of the property is no longer probable, capitalized preacquisition costs are charged to expense to the extent they are not recoverable through the sale of plans, options, and the like. <p> The proposed SOP, <i>Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment</i>, states with respect to the accounting for preacquisition costs when it is no longer probable that the property will be acquired: <p> If it becomes no longer probable that specific PP&E [property, plant, and equipment] will be acquired or constructed, previously capitalized preacquisition stage costs related to the specific PP&E should be reduced to the lower of cost or fair value. A rebuttable presumption exists that the fair value of the asset consisting of those preacquisition stage costs (excluding option costs) is zero (that is, the costs of the asset would be charged to expense), unless management, having the authority to approve the action, has committed to a plan to either (a) sell the asset and the proceeds can be reasonably estimated or (b) redeploy the asset in other specific PP&E of the entity and the redeployed asset meets the criteria for capitalization under the project stage framework in this SOP. If an entity subsequently acquires or constructs PP&E previously considered no longer probable to acquire or construct, preacquisition stage costs charged to expense under this paragraph should not be reversed. <p> <p> AcSEC establishes a rebuttable presumption that the fair value of any capitalized preacquisition costs is zero once a project is abandoned, because the majority of the costs incurred in this stage are "soft" costs that generate only limited value for other projects. <p> <p> <i>1.2.1.2 Capitalization of Internal Preacquisition Costs</i> <p> Activities in the preacquisition stage may be carried out by a company's in-house departments, which raises the question of (1) whether and (2) to what extent such internal preacquisition costs should be capitalized. <p> The Other Assets and Deferred Costs Subsection of Topic 970 (Emerging Issues Task Force (EITF) Issue No. 97-11, <i>Accounting for Costs Relating to Real Estate Property Acquisitions)</i> provides that internal preacquisition costs are only capitalizable if the property is expected to be nonoperating at the date of acquisition. They are not capitalizable if the property is expected to be operating at the date of acquisition, such as internal preacquisition costs related to the purchase of an existing shopping mall. <p> A prerequisite for the capitalization of internal preacquisition costs is that they be directly identifiable with the specific property. While "directly identifiable" is not further defined in Topic 970 (Statement No. 67), the term has been interpreted narrowly in practice. <p> One may look to the proposed SOP, <i>Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment</i>, for implementation guidance: <p> ... [d]irectly identifiable costs include only: <p> a. Incremental direct costs of PP&E preacquisition activities incurred for the specific PP&E. <p> b. Certain costs directly related to preacquisition activities performed by the entity (or by parties not independent of the entity) for the specific PP&E. Those costs include only payroll and payroll benefit-related costs (for example, costs of health insurance) of employees who devote time to a PP&E preacquisition stage activity, to the extent of time the employees spent directly on that activity and in proportion to the total hours employed. <p> c. Payments to obtain an option ... to acquire PP&E. <p> <p> Notwithstanding the foregoing, an option to acquire property, plant, and equipment that meets the definition of a derivative instrument within the scope of Topic 815, <i>Derivatives and Hedging</i> (FASB Statement No. 133, <i>Accounting for Derivative Instruments and Hedging Activities)</i>, is accounted for following the guidance in that topic (Statement No. 133). <p> Further, the proposed SOP, <i>Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment</i>, states that costs of facilities, such as rent and depreciation, as well as general and administrative costs, should be expensed as incurred, as should all costs of executive management, corporate accounting, acquisitions, office management and administration, marketing, human resources, and similar costs or functions. <p> While that proposed SOP has never been issued in final form, the guidance it provides nevertheless proves helpful when interpreting the provisions in the Real Estate Project Cost Subsections of Topic 970 (Statement No. 67). <p> <p> <b>1.2.2 Project Costs</b> <p> Project costs are defined as "[c]osts clearly associated with the acquisition, development, and construction of a real estate project." In certain real estate projects, land is developed and structures are being built or refurbished. In addition to the costs of acquiring land, development and construction costs are incurred to complete the project. Other real estate projects involve property acquisition only, such as the acquisition of shopping centers that are already in operation. <p> ASC 970-360-25-2 (paragraph 7 of Statement No. 67) states the general concept for the accounting for project costs: <p> Project costs clearly associated with the acquisition, development, and construction of a real estate project shall be capitalized as a cost of that project. <p> <p> While this concept may appear straightforward, determining which costs are clearly associated with a real estate project can require significant judgment. <p> <p> <b>1.2.2.1 Direct Costs</b> <p> Direct project costs are incremental costs that are directly related to the acquisition, development, and construction of the property. They may include the same types of costs as preacquisition costs, because certain activities can be performed before or after the acquisition. In addition to the types of costs listed in Section 1.2.1 of this chapter, project costs typically include: <p> * Purchase price <p> * Commissions due to third parties <p> * Brokerage fees due to third parties <p> * Fees for title guarantee and title searches <p> * Recording fees <p> * Property taxes incurred during construction <p> * Insurance costs incurred during construction <p> * Costs of permits <p> * Engineering costs <p> * Environmental remediation costs <p> * Demolition costs <p> * Construction costs (materials, labor) <p> * Costs of amenities <p> * Donated land <p> <p> All costs incurred need to be carefully evaluated to determine whether they qualify for capitalization. For example, the costs of real estate donated to governmental agencies that benefit a certain project are part of that project's costs. However, if donated land does not benefit (and was not made in conjunction with) a real estate project, the costs should be expensed rather than capitalized. Similarly, demolition costs incurred within a reasonable period after the acquisition of property are generally capitalized when they are incurred, if demolition is probable at the time of acquisition. Industry practice is diverse with respect to the capitalization of demolition costs that are not incurred within a reasonable period after acquisition. The proposed SOP, if it had been issued in final form as proposed, would have required that demolition costs not incurred within a reasonable period of time after acquisition be expensed. Questions also arise with respect to the capitalization of environmental remediation costs. While environmental remediation costs incurred within a reasonable period of time after the acquisition of property are generally capitalized as part of the project costs, determining whether environmental remediation costs incurred at a later point in time are capitalizable is more complex and involves significant judgment. <p> <p> <i>1.2.2.2 Indirect Costs</i> <p> Indirect project costs are capitalized to the extent that they clearly relate to the acquisition, development, or construction of a real estate project. Examples of indirect internal project costs include: <p> * Costs of planning department <p> * Costs of construction administration (e.g., the costs associated with a field office at a project site) <p> * Internal costs incurred for cost accounting or project design <p> * Depreciation of machinery and equipment used directly in construction <p> * Payroll costs and employee benefits for employees working on the project <p> <p> For internally incurred indirect costs to be capitalizable, a cost accounting system needs to be in place, and adequate documentation needs to be maintained to support cost capitalization. For example, time may be recorded by the in-house designers to determine the percentage of their salaries to be allocated to a certain project. Indirect costs for which sufficient support cannot be provided, or that do not clearly relate to a project under development or construction, including general and administrative expenses, are expensed as incurred. <p> U.S. generally accepted accounting principles (GAAP) does not provide any further guidance on how to determine what costs are clearly associated with the acquisition, development, and construction of a real estate project. As a result, considerable diversity in practice exists with respect to the types of indirect project costs that are capitalized. <p> The proposed SOP, <i>Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment</i>, limits the capitalization of indirect costs to: <p> * Costs that are directly identifiable with the specific property <p> * Costs incurred for property taxes and insurance for the portion of the property under construction <p> * Demolition costs incurred in conjunction with the acquisition of PP&E, if demolition is probable at the time of acquisition and is expected to occur within a reasonable period after acquisition <p> <p> The proposed SOP, <i>Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment</i>, provides that the capitalization of directly identifiable indirect project costs should be limited to: <p> * Incremental direct costs of acquiring, constructing, or installing the property <p> * Payroll and payroll benefit-related costs of employees who devote time to the project <p> * Depreciation of machinery and equipment used in construction or installation <p> * The cost of inventory used in construction or installation <p> <i>(Continues...)</i> <p> <p> <p> <!-- copyright notice --> <br></pre> <blockquote><hr noshade size='1'><font size='-2'> Excerpted from <b>Accounting for Real Estate Transactions</b> by <b>Maria K. Davis</b> Copyright © 2011 by John Wiley & Sons, Ltd. Excerpted by permission of John Wiley & Sons. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.<br>Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.