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28 34 • REAL ESTATE AND CONSTRUCTION 2. Gross Cash Flow Analysis. An entity that detects one or more of the indicators discussed above should evaluate whether the sum of the expected future net cash flows (undiscounted and without interest charges) associated with an asset to be held and used is at least equal to the asset’s carrying amount. The FASB imposed a high threshold for triggering the impairment analysis. The selection of a cash flow test based on undiscounted amounts will trigger the recognition of an impairment loss less frequently than would a test based on fair value. 3. Measurement. For assets to be held and used, the Statement requires an impairment loss to be measured as the amount by which the carrying amount of the impaired asset exceeds its fair value. The distinction between the recognition process, which uses undiscounted cash flows, and the measurement process, which uses fair value or discounted cash flows, is significant. As a result of a relatively minor change in undiscounted cash flows, the impairment measurement process might kick in, thus causing the balance sheet amount to drop off suddenly in any period in which undiscounted cash flows fall below a long-lived asset’s carrying amount. Once assets to be held and used are written down, the Statement does not permit them to be written back up. Thus, a new depreciable cost basis is established after a writedown, and subsequent increases in the value or recoverable cost of the asset may not be recognized until its sale or disposal. In addition, an asset that is assessed for impairment should be evaluated to determine whether a change to the useful life or salvage value estimate is warranted under APB Opinion No. 20, “Accounting Changes.” SFAS No. 144 thus forces entities to immediately record a loss on an impaired asset instead of shortening the depreciable life or decreasing the salvage value of the asset. (b) ASSETS TO BE DISPOSED OF. SFAS No. 144 requires long-lived assets held for sale to be reported at the lower of carrying amount or fair value less cost to sell regardless of whether the assets previously were held for use or recently acquired with the intent to sell. The cost to sell generally includes the incremental direct costs to transact the sale, such as broker commissions, legal and title transfer fees, and closing costs. Costs generally excluded from cost to sell include insurance, security services, utility expenses, and other costs of protecting or maintaining the asset. Subsequent upward adjustments to the carrying amount of an asset to be disposed of may not exceed the carrying amount of the asset before an adjustment was made to reflect the decision to dispose of it. A long-lived asset that is classified as held for sale is not depreciated during the holding period. While SFAS No. 121 required an entity’s management to be committed to a disposal plan before it could classify that asset as held for sale, it did not specify other factors that an entity should consider before reclassifying the asset. SFAS No. 144 lists six criteria that must be met in order to classify an asset as held for sale: 1. Management with the authority to do so commits to a plan to sell the asset (disposal group). 2. The asset (disposal group) is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets (disposal groups). This criterion does not preclude an entity from using an asset while it is classified as held for sale nor does it require a binding agreement for future sale as a condition of reporting an asset as held for sale. 3. The entity initiates an active program to locate a buyer and other actions that are required to complete the plan to sell the asset (disposal group). 4. The entity believes that the sale of the asset (disposal group) is probable (i.e., likely to occur), and, in general, it expects to record the transfer of the asset (disposal group) as a completed sale within one year. 5. The entity actively is marketing the asset (disposal group) for sale at a price that is reasonable in relation to its current fair value. 6. Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn. 28.6 CONSTRUCTION CONTRACTS 28 35 • SFAS No. 144 requires an asset or group that will be disposed of other than by sale to continue to be classified as held for use until the disposal transaction occurs. As a result, the asset continues to be depreciated until the date of disposal. Dispositions other than by sale include abandonment or a transaction that will be accounted for at the asset’s carrying amount, such as an exchange for a similar productive long-lived asset or a distribution to owners in a spinoff. (c) REAL ESTATE DEVELOPMENT. For homebuilders and other real estate developers, SFAS No. 144 classifies land to be developed and projects under development as assets to be held and used until the six criteria for reclassification as held for sale are met (see previous subsection). As a result, unlike assets to be disposed of, such assets are analyzed in light of the impairment indicator list and gross cash flows generated before any consideration is given to measuring an impairment loss. In the absence of such a provision, nearly all long-term projects, regardless of their overall profitability, would be subject to write-downs in their early stages of development, only to be reversed later in the life of the project. Upon completion of development, the project is reclassified as an asset to be disposed of. 28.6 CONSTRUCTION CONTRACTS Although most real estate developers acquire land in order to develop and construct improvements for their own use or for sale to others, some develop and construct improvements solely for others. There are also many general contractors whose principal business is developing and constructing improvements for others and rarely, if ever, do they own the land. This section covers guidelines for accounting for development and construction contracts where the contractor does not own the land but is providing such services for others. The principal issue in accounting for construction contracts is when to record income. Construction contracts are generally of two types: fixed price and cost-plus. Under fixed price contracts, a contractor agrees to perform services for a fixed amount. Although the contract price is fixed, it may frequently be revised as a result of change orders as construction proceeds. If the contract is longer than a few months, the contractor usually receives advances from the customer as construction progresses. Cost-plus contracts are employed in a variety of forms, such as cost plus a percentage of cost or cost plus a fixed fee. Sometimes defined costs may be limited and penalties provided in situations where stated maximum costs are exceeded. Under cost-plus agreements, the contractor is usually reimbursed for its costs as costs are incurred and, in addition, is paid a specified fee. In most cases, a portion of the fee is retained until the construction is completed and accepted. The method of recording income under cost-plus contracts generally is the same as for fixed price contracts and is described below. (a) AUTHORITATIVE LITERATURE. In 1955, the AICPA Committee on Accounting Procedures issued ARB No. 45 “Long-Term Construction-Type Contracts.” This document described the generally accepted methods of accounting for long-term construction-type contracts for financial reporting purposes and described the circumstances in which each method is preferable. In 1981, the AICPA issued SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” This Statement culminated extensive reconsideration by the AICPA of construction-type contracts. The recommendations set forth therein provide guidance on the application of ARB No. 45 but do not amend that Bulletin. In 1982, the FASB issued SFAS No. 56, “Contractor Accounting” which states that the specialized accounting and reporting principles and practices contained in SOP 81-1 are preferable accounting principles for purposes of justifying a change in accounting principles. 28 36 • REAL ESTATE AND CONSTRUCTION Prior to the issuance of SOP 81-1, authoritative accounting literature used the terms “long term” and “short term” in identifying types of contracts. SOP 81-1 chose not to use those terms as identifying characteristics because other characteristics were considered more relevant for identifying the types of contracts covered. The guidelines set forth below are based largely on SOP 81-1. (b) METHODS OF ACCOUNTING. The determination of the point or points at which revenue should be recognized as earned and costs should be recognized as expenses is a major accounting issue common to all business enterprises engaged in the performance of construction contracting. Accounting for such contracts is essentially a process of measuring the results of relatively long-term events and allocating those results to relatively short-term accounting periods. This involves considerable use of estimates in determining revenues, costs, and profits and in assigning the amounts to accounting periods. The process is complicated by the need to continually evaluate the uncertainties that are inherent in the performance of contracts and by the need to rely on estimates of revenues, costs, and the extent of progress toward completion. There are two generally accepted methods of accounting for construction contracts: the percentage of completion method and the completed contract method. The determination of the preferable method should be based on an evaluation of the particular circumstances, as the two methods are not acceptable alternatives for the same set of circumstances. The method used and circumstances describing when it is used should be disclosed in the accounting policy footnote to the financial statements. (i) Percentage of Completion Method. The use of this approach depends on the ability of the contractor to make reasonably dependable estimates. The percentage of completion method should be used in circumstances in which reasonably dependable estimates can be made and in which all the following conditions exist: • • • The contract is clear about goods or services to be provided, the consideration to be exchanged, and the manner and terms of settlement. The buyer can be expected to pay for the services performed. The contractor can be expected to be able to perform his contractual obligations. The percentage of completion method presents the economic substance of activity more clearly and in a more timely manner than does the completed contract method. It should be noted that estimates of revenues, costs, and percentage of completion are the primary criteria for income recognition. Billings may have no real relationship to performance and generally are not a suitable basis for income recognition. (ii) Completed Contract Method. This method may be used in circumstances in which an entity’s financial position and results of operations would not vary materially from those resulting from the percentage of completion method. The completed contract method should be used when reasonably dependable estimates cannot be made or when there are inherent hazards that cause forecasts to be doubtful. (iii) Consistency of Application. It is possible that a contractor may use one method for some contracts and the other for additional contracts. There is no inconsistency, since consistency in application lies in using the same accounting treatment for the same set of conditions from one account- 28.6 CONSTRUCTION CONTRACTS 28 37 • ing period to another. The method used, and circumstances when it is used, should be disclosed in the accounting policy footnote to the financial statements. (c) PERCENTAGE OF COMPLETION METHOD. The percentage of completion method recognizes the legal and economic results of contract performance on a timely basis. Financial statements based on the percentage of completion method present the economic substance of a company’s transactions and events more clearly and more timely than financial statements based on the completed contract method, and they present more accurately the relationships between gross profit from contracts and related period costs. The percentage of completion method informs the users of the general purpose financial statements concerning the volume of a company’s economic activity. In practice, several methods are used to measure the extent of progress toward completion. These methods include the cost-to-cost method, the efforts-expended method, the units-of-delivery method and the units-of-work-performed method. These methods are intended to conform to the recommendations of ARB 45 (par. 4), which states: . . . that the recognized income be that percentage of estimated total income, either: a. that incurred costs to date bear to estimated total costs after giving effect to estimates of costs to complete based upon most recent information, or b. that may be indicated by such other measure of progress toward completion as may be appropriate having due regard to work performed. One generally accepted method of measuring such progress is the stage of construction, as determined through engineering or architectural studies. When using the “cost incurred” approach, there may be certain costs that should be excluded from the calculation. For example, substantial quantities of standard materials not unique to the project may have been delivered to the job site but not yet utilized. Or engineering and architectural fees incurred may represent 20% of total estimated costs whereas only 10% of the construction has been performed. The principal disadvantage of the percentage of completion method is that it is necessarily dependent on estimates of ultimate costs that are subject to the uncertainties frequently inherent in long-term contracts. The estimation of total revenues and costs is necessary to determine estimated total income. Frequently a contractor can estimate total contract revenue and total contract cost in single amounts. However, on some contracts a contractor may be able to estimate only total contract revenue and total contract cost in ranges of amounts. In such situations, the most likely amounts within the range should be used, if determinable. If not, the least favorable amounts should be used until the results can be estimated more precisely. (i) Revenue Determination. Estimating revenue on a contract is an involved process. The major factors that must be considered in determining total estimated revenue include the basic contract price, contract options, change orders, claims, and contract provisions for incentive payments and penalties. All these factors and other special contract provisions must be evaluated throughout the life of a contract in estimating total contract revenue. (ii) Cost Determination. At any time during the life of a contract, total estimated contract cost consists of two components: costs incurred to date and estimated cost to complete the contract. A company should be able to determine costs incurred on a contract with a relatively high degree of precision. The other component, estimated cost to complete, is a significant variable in the process of determining income earned and is thus a significant factor in accounting for 28 38 • REAL ESTATE AND CONSTRUCTION contracts. SOP 81-1 states that the following five practices should be followed in estimating costs to complete: 1. Systematic and consistent procedures that are correlated with the cost accounting system should be used to provide a basis for periodically comparing actual and estimated costs. 2. In estimating total contract costs the quantities and prices of all significant elements of cost should be identified. 3. The estimating procedures should provide that estimated cost to complete includes the same elements of cost that are included in actual accumulated costs; also, those elements should reflect expected price increases. 4. The effects of future wage and price escalations should be taken into account in cost estimates, especially when the contract performance will be carried out over a significant period of time. Escalation provisions should not be blanket overall provisions but should cover labor, materials, and indirect costs based on percentages or amounts that take into consideration experience and other pertinent data. 5. Estimates of cost to complete should be reviewed periodically and revised as appropriate to reflect new information. (iii) Revision of Estimates. Adjustments to the original estimates of the total contract revenue, cost, or extent of progress toward completion are often required as work progresses under the contract, even though the scope of the work required under the contract has not changed. Such adjustments are changes in accounting estimates as defined in APB Opinion No. 20. Under this Opinion, the cumulative catch-up method is the only acceptable method. This method requires the difference between cumulative income and income previously recorded to be recorded in the current year’s income. Exhibit 28.5 illustrates the percentage of completion method. To Date Year 1 (25% completed) Earned revenue ($9,000,000 ⫻ 0.25) Cost of earned revenue ($8,050,000 ⫻ 0.25) Gross profit Gross profit rate Year 2 (75% completed) Earned revenue ($9,100,000 ⫻ 0.75) Cost of earned revenue ($8,100,000 ⫻ 0.75) Gross profit Gross profit rate Year 3 (100% completed) Earned revenue Cost of earned revenue Gross profit Gross profit rate Exhibit 28.5 Recognized Prior Year (thousands of dollars) $2,250.0 Current Year $2,250.0 2,012.5 2,012.5 $0,237.5 $0,237.5 10.5% 10.5% $6,825.0 $2,250.0 $4,575.0 6,075.0 2,012.5 4,062.5 $0,750.0 $0,237.5 $0,512.5 11.0% 10.5% 11.2% $9,200.0 8,200.0 $6,825.0 6,075.0 $2,375.0 2,125.0 $1,000.0 $0,750.0 $0,250.0 10.9% 11.0% 10.5% Percentage of completion, three-year contract. (Source: AICPA.) 28.6 CONSTRUCTION CONTRACTS 28 39 • The amount of revenue, costs, and income recognized in the three periods would be as follows: A contracting company has a lump-sum contract for $9 million to build a bridge at a total estimated cost of $8 million. The construction period covers three years. Financial data during the construction period is as follows: (thousands of dollars) Year 1 Year 2 Year 3 Total estimated revenue $9,000 $9,100 $9,200 Cost incurred to date Estimated cost to complete $2,050 6,000 $6,100 2,000 $8,200 — Total estimated cost $8,050 $8,100 $8,200 Estimated gross profit $0,950 $1,000 $1,000 Billings to date $1,800 $5,500 $9,200 Collections to date $1,500 $5,000 $9,200 25% 75% 100% Measure of progress (d) COMPLETED CONTRACT METHOD. This method recognizes income only when a contract is completed or substantially completed, such as when the remaining costs to be incurred are not significant. Under this method, costs and billings are reflected in the balance sheet, but there are no charges or credits to the income statement. As a general rule, a contract may be regarded as substantially completed if remaining costs and potential risks are insignificant in amount. The overriding objectives are to maintain consistency in determining when contracts are substantially completed and to avoid arbitrary acceleration or deferral of income. The specific criteria used to determine when a contract is substantially completed should be followed consistently. Circumstances to be considered in determining when a project is substantially completed include acceptance by the customer, departure from the site, and compliance with performance specifications. The completed contract method may be used in circumstances in which financial position and results of operations would not vary materially from those resulting from use of the percentage of completion method (e.g., in circumstances in which an entity has primarily short-term contracts). In accounting for such contracts, income ordinarily is recognized when performance is substantially completed and accepted. For example, the completed contract method, as opposed to the percentage of completion method, would not usually produce a material difference in net income or financial position for a small contractor that primarily performs relatively short-term contracts during an accounting period. If there is a reasonable assurance that no loss will be incurred on a contract (e.g., when the scope of the contract is ill-defined but the contractor is protected by a cost-plus contract or other contractual terms), the percentage of completion method based on a zero profit margin, rather than the completed contract method, should be used until more precise estimates can be made. The significant difference between the percentage of completion method applied on the basis of a zero profit margin and the completed contract method relates to the effects on the income statement. Under the zero profit margin approach to applying the percentage of completion method, equal amounts of revenue and cost, measured on the basis of performance during the period, are presented in the income statement and no gross profit amount is presented in the income statement until the contract is completed. The zero profit margin approach to applying the percentage of completion method gives the users of general purpose financial statements an indication of the volume of a company’s business and of the application of its economic resources. The principal advantage of the completed contract method is that it is based on results as finally determined, rather than on estimates for unperformed work that may involve unforeseen costs and 28 40 • REAL ESTATE AND CONSTRUCTION possible losses. The principal disadvantage is that it does not reflect current performance when the period of the contract extends into more than one accounting period. Under these circumstances, it may result in irregular recognition of income. (e) PROVISION FOR LOSSES. Under either of the methods above, provision should be made for the entire loss on the contract in the period when current estimates of total contract costs indicate a loss. The provision for loss should represent the best judgment that can be made in the circumstances. Other factors that should be considered in arriving at the projected loss on a contract include target penalties for late completion and rewards for early completion, nonreimbursable costs on costplus contracts, and the effect of change orders. When using the completed contract method and allocating general and administrative expenses to contract costs, total general and administrative expenses that are expected to be allocated to the contract are to be considered together with other estimated contract costs. (f) CONTRACT CLAIMS. Claims are amounts in excess of the agreed contract price that a contractor seeks to collect from customers or others for customer-caused delays, errors in specifications and designs, unapproved change orders, or other causes of unanticipated additional costs. Recognition of amounts of additional contract revenue relating to claims is appropriate only if it is probable that the claim will result in additional contract revenue and if the amount can be reliably estimated. These requirements are satisfied by the existence of all the following conditions: • • • • The contract or other evidence provides a legal basis for the claim. Additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in the contractor’s performance. Costs associated with the claim are identifiable and are reasonable in view of the work performed. The evidence supporting the claim is objective and verifiable. If the foregoing requirements are met, revenue from a claim should be recorded only to the extent that contract costs relating to the claim have been incurred. The amounts recorded, if material, should be disclosed in the notes to the financial statements. Change orders are modifications of an original contract that effectively change the provisions of the contract without adding new provisions. They may be initiated by either the contractor or the customer. Many change orders are unpriced; that is, the work to be performed is defined, but the adjustment to the contract price is to be negotiated later. For some change orders, both scope and price may be unapproved or in dispute. Accounting for change orders depends on the underlying circumstances, which may differ for each change order depending on the customer, the contract, and the nature of the change. Priced change orders represent an adjustment to the contract price and contract revenue, and costs should be adjusted to reflect these change orders. Accounting for unpriced change orders depends on their characteristics and the circumstances in which they occur. Under the completed contract method, costs attributable to unpriced change orders should be deferred as contract costs if it is probable that aggregate contract costs, including costs attributable to change orders, will be recovered from contract revenues. For all unpriced change orders, recovery should be deemed probable if the future event or events necessary for recovery are likely to occur. Some factors to consider in evaluating whether recovery is probable are the customer’s written approval of the scope of the change order, separate documentation for change order costs that are identifiable and reasonable, and the entity’s favorable experience in negotiating change orders (especially as it relates to the specific type of contract and change order being evaluated). The following guidelines should be used in accounting for unpriced change orders under the percentage of completion method: 28.7 OPERATIONS OF INCOME-PRODUCING PROPERTIES • • • 28 41 • Costs attributable to unpriced change orders should be treated as costs of contract performance in the period in which the costs are incurred if it is not probable that the costs will be recovered through a change in the contract price. If it is probable that the costs will be recovered through a change in the contract price, the costs should be deferred (excluded from the cost of contract performance) until the parties have agreed on the change in contract price, or, alternatively, they should be treated as costs of contract performance in the period in which they are incurred, and contract revenue should be recognized to the extent of the costs incurred. If it is probable that the contract price will be adjusted by an amount that exceeds the costs attributable to the change order and the amount of the excess can be reliably estimated, the original contract price should also be adjusted for that amount when the costs are recognized as costs of contract performance if its realization is probable. However, since the substantiation of the amount of future revenue is difficult, revenue in excess of the costs attributable to unpriced change orders should only be recorded in circumstances in which realization is assured beyond a reasonable doubt, such as circumstances in which an entity’s historical experience provides assurance or in which an entity has received a bona fide pricing offer from the customer and records only the amount of the offer as revenue. If change orders are in dispute or are unapproved in regard to both scope and price, they should be evaluated as claims. 28.7 OPERATIONS OF INCOME-PRODUCING PROPERTIES (a) RENTAL OPERATIONS. Operations of income-producing properties represent a distinct segment of the real estate industry. Owners are often referred to as “real estate operators.” Incomeproducing properties include office buildings, shopping centers, apartments, industrial buildings, and similar properties rented to others. A lease agreement is entered into between the owner/operator and the tenant for periods ranging from one month to many years, depending on the type of property. Sometimes an investor will acquire an existing income-producing property or alternatively will have the builder or developer construct the property. Some developers, frequently referred to as “investment builders,” develop and construct income properties for their own use as investment properties. SFAS No. 13 is the principal source of standards of financial accounting and reporting for leases. Under SFAS No. 13, a distinction is made between a capital lease and an operating lease. The lessor is required to account for a capital lease as a sale or a financing transaction. The lessee accounts for a capital lease as a purchase. An operating lease, on the other hand, requires the lessor to reflect rent income, operating expenses, and depreciation of the property over the lease term; the lessee must record rent expense. Accounting for leases is discussed in Chapter 18 and therefore is not covered in depth here. Certain unique aspects of accounting for leases of real estate classified as operating leases, however, are covered below. (b) RENTAL INCOME. Rental income from an operating lease should usually be recorded by a lessor as it becomes receivable in accordance with the provisions of the lease agreement. FTB No. 85-3 provides that the effects of scheduled rent increases, which are included in minimum lease payments under SFAS No. 13, should be recognized by lessors and lessees on a straight-line basis over the lease term unless another systematic and rational allocation basis is more representative of the time pattern in which the leased property is physically employed. Using factors such as the time value of money, anticipated inflation, or expected future revenues to allocate scheduled rent increases is inappropriate because these factors do not relate to the time pattern of the physical usage of the leased property. However, such factors may affect the periodic 28 42 • REAL ESTATE AND CONSTRUCTION reported rental income or expense if the lease agreement involves contingent rentals, which are excluded from minimum lease payments and accounted for separately under SFAS No. 13, as amended by SFAS No. 29. A lease agreement may provide for scheduled rent increases designed to accommodate the lessee’s projected physical use of the property. In these circumstances, FTB No. 88-1 provides for the lessee and the lessor to recognize the lease payments as follows: a. If rents escalate in contemplation of the lessee’s physical use of the leased property, including equipment, but the lessee takes possession of or controls the physical use of the property at the beginning of the lease term, all rental payments including the escalated rents, should be recognized as rental expenses or rental revenue on a straight-line basis in accordance with paragraph 15 of Statement No. 13 and Technical Bulletin 85-3 starting with the beginning of the lease term. b. If rents escalate under a master lease agreement because the lessee gains access to and control over additional leased property at the time of the escalation, the escalated rents should be considered rental expense or rental revenue attributable to the leased property and recognized in proportion to the additional leased property in the years that the lessee has control over the use of the additional leased property. The amount of rental expense or rental revenue attributed to the additional leased property should be proportionate to the relative fair value of the additional property, as determined at the inception of the lease, in the applicable time periods during which the lessee controls its use. (i) Cost Escalation. Many lessors require that the lessee pay operating costs of the leased property such as utilities, real estate taxes, and common area maintenance. Some lessors require the lessee to pay for such costs when they escalate and exceed a specified rate or amount. In some cases, the lessee pays these costs directly. More commonly, however, the lessor pays the costs and is reimbursed by the lessee. In this situation, the lessor should generally record these reimbursement costs as a receivable at the time the costs are accrued, even though they may not be billed until a later date. Since these costs are sometimes billed at a later date, collectibility from the lessee should, of course, be considered. (ii) Percentage Rents. Many retail leases, such as those on shopping centers, enable the lessor to collect additional rents, based on the excess of a stated percentage of the tenant’s gross sales over the specified minimum rent. While the minimum rent is usually payable in periodic level amounts, percentage rents (sometimes called “overrides”) are usually based on annual sales, often with a requirement for periodic payments toward the annual amount. SFAS No. 29 (par. 13), “Determining Contingent Rentals,” states: “Contingent rentals shall be includable in the determination of net income as accruable.” (c) RENTAL COSTS. The following considerations help determine the appropriate accounting for project rental costs. (i) Chargeable to Future Periods. Costs incurred to rent real estate should be deferred and charged to future periods when they are related to and their recovery is reasonably expected from future operations. Examples include initial direct costs such as commissions, legal fees, costs of credit investigations, costs of preparing and processing documents for new leases acquired, and that portion of compensation applicable to the time spent on consummated leases. Other examples include costs of model units and related furnishings, rental facilities, semipermanent signs, grand openings, and unused rental brochures, but not rental overhead, such as rental salaries (see “Period Costs” below). For leases accounted for as operating leases, deferred rental costs that can be directly related to revenue from a specific operating lease should be amortized over the term of the related lease in 28.7 OPERATIONS OF INCOME-PRODUCING PROPERTIES 28 43 • proportion to the recognition of rental income. Deferred rental costs that cannot be directly related to revenue from a specific operating lease should be amortized to expense over the period of expected benefit. The amortization period begins when the project is substantially completed and held available for occupancy. Estimated unrecoverable deferred rental costs associated with a lease or group of leases should be charged to expense when it becomes probable that the lease(s) will be terminated. For leases accounted for as sales-type leases, deferred rental costs must be charged against income at the time the sale is recognized. (ii) Period Costs. Costs that are incurred to rent real estate projects that do not meet the above criteria should be charged to expense as incurred. SFAS No. 67 specifically indicates that rental overhead, which is defined in its glossary to include rental salaries, is an example of such period costs. Other examples of expenditures that are period costs are initial indirect costs, such as that portion of salaries and other compensation and fees applicable to time spent in negotiating leases that are not consummated, supervisory and administrative expenses, and other indirect costs. (d) DEPRECIATION. Under GAAP, the costs of income-producing properties must be depreciated. Depreciation, as defined by GAAP, is the systematic and rational allocation of the historical cost of depreciable assets (tangible assets, other than inventory, with limited lives of more than one year) over their useful lives. In accounting for real estate operations, the most frequently used methods of depreciation are straight-line and decreasing charge methods. The most common decreasing charge methods are the declining balance and sum-of-the-years-digits methods. Increasing charge methods, such as the sinking fund method, are not generally accepted in the real estate industry in the United States. The major components of a building, such as the plumbing and heating systems, may be identified and depreciated separately over their respective lives. This method, which is frequently used for tax purposes, usually results in a more rapid write-off. (e) INITIAL RENTAL OPERATIONS. When a real estate project is substantially complete and held available for occupancy, the procedures listed here should be followed: • • • • • Rental revenue should be recorded in income as earned. Operating costs should be charged to expense currently. Amortization of deferred rental costs should begin. Full depreciation of rental property should begin. Carrying costs, such as interest and property taxes, should be charged to expense as accrued. If portions of a rental project are substantially completed and occupied by tenants or held available for occupancy and other portions have not yet reached that stage, the substantially completed portions should be accounted for as a separate project. Costs incurred should be allocated between the portions under construction and the portions substantially completed and held available for occupancy. (f) RENTAL EXPENSE. Rental expense under an operating lease normally should be charged to operations by a lessee over the lease term on a basis consistent with the lessor’s recording of income, with the exception of periodic accounting for percentage rent expense, which should be based on the estimated annual percentage rent.