If you’re like most affordable housing developers, you find accounting for developer fee income to be a troublesome part of your company’s financial reporting process.
Effective in 2018 for nonpublic companies, a new revenue recognition accounting standard (ASU 2014-09), issued by the Financial Accounting Standards Board (FASB), will remove many inconsistencies in the revenue recognition methods used by various industries. Importantly, the new standard should continue to let revenue be recognized over time when a developer enhances an asset the customer owns. This new standard will be increasingly relevant in the next three years as we approach 2018.
Two Approaches
Currently, there are two common approaches to recognizing developer fee revenue: percentage of completion and milestone.
Percentage-of-completion approach. Ideally, development service income should be recognized the same way other service providers recognize income—as the services are performed.
Because the development of an affordable housing property often lasts more than a year, milestones for releasing progress payments of the fee are established. Having seen several hundred such agreements, I can say that many variations exist in the triggering events that allow progress payments to be made.
The three-phase approach used by many developers to separate each developer fee into discrete phases—namely, predevelopment, construction, and postconstruction—allocates each fee consistently, such as 30% for predevelopment, 60% for the construction period, and 10% for postconstruction activities. Ideally, the milestones in the contract triggering release of progress payments would correspond to the discrete processes identified by the developer, but that isn’t always the case.
Using the percentage-of-completion method of accounting, the portion of the fee to be recognized during an accounting period is based on an estimate of the percentage of completion of that phase. To be conservative, most developers choose not to recognize any of the predevelopment portion until a construction lender and outside investor make written commitments to fund the project.
Estimating the percentage of completion during the construction phase is typically accomplished by examining the general contractor’s progress billing each month. Earning the final 10% postconstruction portion will generally be triggered by closing the permanent loans and, if applicable, working with the CPAs to obtain a cost certification and IRS Form 8609, which establishes the amount of tax credits available. Once these actions are completed, the amount of a limited partner’s capital contribution based on the final projections will be known and the developer fee shouldn’t be subject to further changes.
The advantage of this fee recognition method is that the fee revenue shown on a developer’s financial statements more closely matches the timing of related expenses incurred by the development department, such as salaries and office overhead costs. This method also smooths out the peaks and valleys in fee income that could occur if fees were recognized only upon suddenly meeting milestones that trigger progress payments.
Milestone approach. Concerns arise, however, when the amount of the total developer fee is in question, such as when unexpected costs might arise during the development process. In order to balance the development budget, the developer fee may need to be reduced. It is vital to update the calculations so that fee income is not recognized aggressively.
To avoid the risk of premature revenue recognition, some developers use a milestone approach that corresponds to the earnings benchmarks described in the development services agreement. Under this method, fee income is recognized as it is received under the terms of the agreement. This is, in effect, a cash-basis approach, which is not encouraged by generally accepted accounting principles unless it can be demonstrated that this approach yields a result similar to the percentage-of-completion method described above, or that the risk of not reaching a milestone is significant.
Another disadvantage to the milestone approach is that developers have some degree of control over the timing of each triggering event, potentially leading to earnings management through revenue manipulation (otherwise known as fraudulent financial reporting).
A developer’s maximum exposure to loss should also be considered if continuing involvement with a property results in a substantial risk of loss. If a developer bears such a risk, the at-risk portion of the fee should be deferred until there is no longer any substantial risk of loss.
Eliminating Developer Fees in Consolidation
For developers who consolidate their financial statements with the partnerships that incur the fees, elimination of a portion of the developer fee is necessary.
Developers who control limited partnerships through an affiliated general partner interest began to consolidate these investments in 2006 following new guidance from the FASB about a general partner’s presumptive control of limited partnerships.
By 2009, when I began work on this guidance, there was great disparity among developers’ consolidated financial statements relating to the elimination of developer fees. Accounting standards state that all intercompany balances and transactions should be eliminated so that the resulting statements are presented as a single enterprise. When assets include intercompany profits, gross profit is to be eliminated.
Once gross profit is eliminated from both the consolidated property and the revenue balances, the remaining portion of the developer fee should represent capitalizable project cost, which includes direct and indirect costs clearly related to each development. Thus, the resulting consolidated property balances reflect the same property cost that would have been capitalized had the project development and ownership been carried out by a single enterprise (see pie chart).
Although these standards have been in place since the 1950s, some developers have treated the developer fee funded by development sources differently from the portion funded by subsequent property operations and eliminated only the latter category. That approach resulted in financial statements that did not eliminate all intercompany profit.
The StrengthMatters CFO Working Group, of which I am a member, published a guidance paper on developer fee revenue recognition in 2010. I included in the paper a practical approach to estimating the profit portion of developer fee revenue based on historical relationships between development department costs and developer fees. The eliminated portion of the fee is deferred and taken into income over the same life the subsidiary partnership uses to depreciate the asset that contains the capitalized fee.
To learn more about the elimination of developer fee income in consolidation; the proper accounting method for reporting developer fees in financial statements; and other financial reporting topics, visit www.strengthmatters.net.
Strength Matters is a national initiative created by members of NeighborWorks America, the Housing Partnership Network, and Stewards of Affordable Housing for the Future. Its mission is to be a sectorwide resource for nonprofit housing enterprises to gain information about how to improve their financial strength and transparency and gain access to capital. The Strength Matters CFO Working Group includes CFOs from affordable housing developers across the country and representatives of Lindquist, von Husen & Joyce, CohnReznick, and Novogradac and Co., who work together to identify and promote financial reporting best practices for the nonprofit affordable housing industry. Products of the group include sample note disclosures, management discussion and analysis wording, and other tools, which are available on the Strength Matters website (www.strengthmatters.net).
Scott Seamands, CPA, is an audit partner at Lindquist, von Husen & Joyce in San Francisco. The firm has served affordable housing developers for more than 30 years. He is a member of the Strength Matters CFO Working Group and frequently participates in Strength Matters webinars as well as developing the tools available on Strength Matters’ website. Contact him at [email protected].
