What’s the Best Basis of Accounting for Your Real Estate Company?
September 18, 2019
By Donna Fleres
Real estate companies need to understand the differences in accounting principles generally accepted in the U.S. (“GAAP”) and the income tax basis of accounting. Both are common methods of accounting for real estate entities, but owners should understand the options and choose which is best for their companies.
Public companies, such as a publicly traded or public non-traded real estate investment trust (“REIT”), are required to use GAAP reporting. Privately held companies may be required by their financial institutions to use GAAP reporting. When an entity’s accounting method is not dictated by a governing body, the entity should consider which basis is a better financial management tool and what the impact of the basis on the company’s financial results and presentation will be. The main differences between GAAP compared to the income tax basis of accounting are highlighted below.
The income tax basis differs from GAAP primarily because GAAP requires that buildings and improvements be depreciated over their estimated useful lives. Under the income tax basis, the recording of depreciation is done over the lives prescribed by the Internal Revenue Code ("IRC"). The IRC may provide accelerated depreciation deductions for certain assets that do not exist for GAAP.
In accordance with the IRC and income tax basis financial statements, revenue is recorded at the earlier of when received or earned; whereas under GAAP, revenue is recorded only when earned. Under GAAP, rental revenue is recognized on a straight line basis over the life of the lease, which results in the same amount of rent being recognized each month of the lease agreement, regardless of the amount the tenant is actually billed. Rent holidays, abatement periods, and escalations are all generally considered in the straight line calculation. Under the income tax basis, revenue primarily represents the cash received.
Under GAAP, if the previously mentioned revenue was received in advance of its due date, a company would record deferred revenue on its balance sheet (a liability account) until earned under the terms of the lease agreement. If reporting under the income tax basis, the rent is recorded as revenue in the period it is received.
A company utilizes the direct write-off method to account for bad debts for income tax purposes. Under GAAP, the company would provide for an allowance for doubtful accounts.
Under the income tax basis, property and equipment is recorded at historical cost. However, under GAAP, these assets would have been recorded at fair value and subject to impairment testing. GAAP requires companies to evaluate whether there has been a triggering event that would result in impairment of their real estate. If a triggering event is indicated, the company would then need to determine the fair value of the property and may incur impairment charges to adjust the carrying amount to estimated fair value. A company would need to estimate future cash flows using assumptions regarding factors such as market rents, economic conditions and occupancy rates. Company management may utilize appraisals of property in addition to making these estimates and assumptions.
Variable Interest Entities (VIEs)
Under GAAP, an entity must evaluate each commonly controlled entity and determine whether it is a VIE and then consider whether it is required to be consolidated with the reporting entity. The income tax basis does not require evaluation or consolidation of variable interest entities.
Reporting under the GAAP basis or income tax basis of accounting each has its pros and cons, which will vary by entity. The bottom line is real estate companies should always consider consulting with their accountants and business advisors to better navigate the benefits, complexities and nuances of both U.S. GAAP and the income tax basis of accounting to select the most appropriate basis of accounting to meet their needs.