To Capitalize or Not to Capitalize?

by David Taube and George Yungmann

That is the question.

The American Institute of Certified Public Accountants (AICPA) has formed a task force to develop an accounting standard (Statement of Position or SOP) that would define which costs associated with real estate assets should be capitalized as improvements or expensed as repairs and maintenance. Based on accounting pronouncements recently issued, this SOP may require companies to expense more capital maintenance costs, resulting in lower earnings for all companies that undertake subsequent improvements, or repairs and maintenance, on real estate assets already owned. Since repairs and maintenance would be expensed rather than capitalized and depreciated, they reduce Funds From Operations.

The Securities and Exchange Commission (SEC) has identified diversity in practice regarding capitalization of costs as one of the most prevalent accounting problems in the real estate industry. The proposed SOP, titled Capitalization of Costs in Real Estate Assets Not Within the Scope of FASB Statement No. 67 (FASB 67 covers costs of developing and renting real estate projects), will attempt to enhance consistency by providing accounting and related disclosure guidance that would establish uniform criteria for expenditures eligible for capitalization and those that must be charged to periodic earnings.

Specific items on which the AICPA task force would provide guidance include:

• Ordinary repairs and maintenance
• Extraordinary repairs and maintenance-(e.g., major overhauls, major electrical system improvements, leading to an increase in either use value or service life)
• Replacements-(i.e., the removal of a major component of real estate, replacing it with a new component of essentially the same type and capability)
• Betterments-(i.e., the removal of a major component of real estate and substituting it with a new component having significantly improved and superior capabilities)
• Additions-comprising extensions, enlargements or expansions.

The task force also will consider requiring the separation of components of the asset with significantly different useful lives. Currently, companies may use composites or weighted-average useful lives to measure the depreciation expense for real estate assets. Guidance also may be provided with respect to whether certain indirect costs or overhead costs may be allocated to subsequent capitalizable improvements on owned real estate.

The significance of this issue on real estate companies led NAREIT to form a Cost Capitalization Task Force in August 1999. The NAREIT task force will make recommendations to the AICPA task force as it develops its proposal and ultimately will respond to the SOP exposure draft. The AICPA task force's projected timetable provides for an exposure draft in the third quarter of 2000, with issuance of a final SOP in the first quarter of 2001.

George L. Yungmann is senior advisor, financial standards, and David M. Taube is financial standards analyst for NAREIT.

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