NEW YORK, NY--(Marketwire - June 9, 2010) - Generally Accepted Accounting Principles, also known as GAAP, is a common accounting method but is not the only choice for real estate companies that issue financial statements.
Real estate owners should also consider how the use of the income tax basis for financial reporting would impact their financial results. This accounting method can produce financial results that are usually more closely aligned with the economics of the business, according to an authority on real estate accounting.
"GAAP reporting would be required if the real estate entity is a public company, such as a REIT, and would likely be required by institutional investors who are partners in a private real estate company. But when the entity's choice of accounting method is not dictated by governing bodies, business owners should be aware that income tax basis financials might be a more useful management tool and provide greater transparency and insight into how the business is performing," says Susan H. Nadler, CPA, a real estate partner at the New York accounting firm Marks Paneth & Shron.
Ms. Nadler is available for interviews and can also author a bylined article that discusses:
- Why income tax basis accounting can sometimes paint a more accurate cash flow picture than GAAP: Under GAAP, base rent is straight-lined over the life of the lease; thus, the same amount of rent is recognized each month, regardless of the amount the tenant is actually being billed and the cash flow the lease is generating. For example, if a tenant has a three-month rent holiday at the beginning of its lease term of January 1 and pays $50,000 per month in base rent for the remainder of its 10 year lease, using GAAP, $438,750 in rent income would be recognized in the financials in year 1 of the lease.
If the income tax basis of accounting was used, rent income reported on the financial statements would be $450,000. Since the landlord actually billed $450,000 and presuming that all rent was paid, the income reported is in synch with the $450,000 of cash flow received from the tenant and the amount of income the company will report on its income tax returns, Ms. Nadler says.
- Why real estate reporting entities sometimes feel compelled to use GAAP -- even when they don't have to: When negotiating financing for the first time or with a new lender, the boilerplate loan documents produced by the lender will almost always state that "the financial statements should be prepared in accordance with GAAP." But this clause is negotiable. Ms. Nadler explains. "If the debtor says that the company prefers to use the income tax basis of accounting for financial reporting purposes, 99.5 percent of the time the lender will acquiesce, without so much as a blink of the eye. A person negotiating a loan for the first time or with a new lender might not know this, and might not know that all you need to do is ask. In my experience, I have rarely encountered a situation where a lender said no to income tax basis reporting."
- Real estate owners should weigh the options. Income tax basis accounting is useful in many situations. At other times, GAAP might be the preferred route: Where there are leases with step-ups, free rent periods and/or in years where many tenants pre-pay the following January's rent, income tax basis accounting provides a clearer portrait of what the company's income tax returns will reflect, not to mention that there is a cost savings of not having to produce two sets of books and records -- one for tax and one for GAAP.
On the other hand, expenditures incurred by a real estate company that have not yet been paid to related party cash-basis service providers such as management, cleaning or leasing companies, can be deducted under GAAP but not for income tax basis reporting. Moreover, in the early years of a lease containing step-ups, GAAP can produce phantom income.
- Carefully analyze the effects on loan covenants when choosing GAAP or income tax basis reporting: Using GAAP versus income tax basis accounting could also have a material impact on loan covenants such as debt service coverage and debt to equity ratios, along with EBITDA. Your choice of accounting method can not only impact your income statement, it can also have dramatic results on the balance sheet, as well.
For instance, under GAAP, real estate must be measured periodically for impairment and in this market, write-downs are not uncommon which result in a reduction in the basis of assets carried on the balance sheet. Under income tax basis accounting, real estate is generally carried at historical cost, less accumulated depreciation and no write-downs for impairment are necessary or allowed.
The effects of your choice of accounting method should be carefully reviewed beforehand to ensure that you will be able to meet all of your financial covenants.
"There's no across-the-board answer to which accounting method might work best for a company," Ms. Nadler says. "The choice depends on each owner's business situation. But income tax-basis accounting is something that every real estate entity should consider if the choice is available."
For more information, or to schedule an interview, contact Itay Engelman of Sommerfield Communications at (212) 255-8386 or itay@sommerfield.com.
About Marks Paneth & Shron
Marks Paneth & Shron LLP is an accounting firm with nearly 475 people, of whom 64 are partners and principals. The firm provides businesses with a full range of auditing, accounting, tax, bankruptcy and restructuring services as well as litigation and corporate financial advisory services to domestic and international clients. The firm also specializes in providing tax advisory and consulting for high-net-worth individuals and their families, as well as a wide range of services for international, real estate, media, entertainment, nonprofit, professional and financial services and energy clients. Visit www.markspaneth.com for more information.
Contact Information:
For more information, contact
Itay Engelman
Sommerfield Communications
(212) 255-8386
itay@sommerfield.com