Centre Main

1 June 2003

 

Mr. Marc Simon
Technical Manager
Accounting Standards
AICPA
1211 Avenue of the Americas
New York, NY 10036-8775

 

File Ref: 4210.TS: Exposure Draft, Proposed Statement of Position: Accounting for Real Estate Time-Sharing Transactions

 

Dear Mr. Simon:

 

The Financial Accounting Policy Committee (FAPC) of the Association for Investment Management and Research (AIMR)1 is pleased to comment on the Financial Accounting Standards Board's (FASB) Proposal, Principles-Based Approach to U.S. Standard Setting. The FAPC is a standing committee of AIMR charged both with maintaining liaison with standard setters who develop financial accounting standards and regulate financial statement disclosures and with responding to new regulatory initiatives. The FAPC also maintains contact with professional, academic, and other organizations interested in financial reporting.

 

General Comments

 

We believe that transparent, relevant, and reliable financial information is the absolute bedrock supporting financial markets' ability (1) to allocate capital efficiently and effectively, and (2) to ensure the trust and confidence of investors and other participants. Both are critical to any market system. Consequently, the FAPC commends the Accounting Standards Executive Committee (AcSEC), and the FASB, for undertaking the consideration of one of the most important and challenging areas of financial reporting standard-setting at the present time, revenue recognition.

 

We agree that many of the most difficult problems facing standard-setters in the general area of revenue recognition are involved in the financial reporting of revenues for real estate time-sharing transactions ("TSTs"). These problems include difficulties with application of the most fundamental current GAAP recognition criteria.

 

TSTs are characterized in many if not most cases by exceedingly high defaults and very limited contract enforceability or redress in the case of default, short of repossession of the time-share unit. In this industry, a significant number of units that are first recognized as "sold" can be expected to be "resold," perhaps multiple times, following default and repossession. Indeed, these would seem to us to be defining characteristics of the real estate time-sharing business model. However, these attributes are not restricted to this industry alone but are pervasive in others as well, including those that use "rent-to-own" or "time-sale-of-membership" practices.

 

Perhaps the most telling characteristic of TSTs is that third-party financing by financial institutions, the traditional source of funding for most commercial and consumer real estate mortgages and other contractual real estate transfers, is generally not available for these transactions except in rare instances, as the SOP makes clear. Consequently, financing is generally available only from the seller of the time-sharing units. The absence of third-party financing must immediately raise serious concerns about the underlying economic nature of the transactions, including the quality of the assets generated from the sales, that is, the long-term receivables, the ability to estimate future losses, and the enforceability of the contract other than by repossession, as we observe above.

 

These deficiencies would generally argue for considerable caution and conservatism in revenue recognition. However, such caution would seem to have been problematic in these transactions. Indeed, acceleration and premature recognition of revenue has been altogether too common for TSTs, particularly given the high risk nature of the transactions.

 

Also, we are not convinced that the "non-reversionary transfer of title," used to support the presumption that a "sale" has occurred, and that a substantial portion of the revenue should be recognized, is of material economic substance in TSTs. We would agree that such transfer in the presence of unrelated third-party financing is usually compelling. However, again, this financing is generally unavailable for TSTs. The fact that in a sizable number of such "sales" the purchaser will default, resulting in repossession by the seller, who will then "resell" the same unit, accompanied by "transfer of title" to a new purchaser, and that this process can repeat a number of times for a single unit, argues that the transfer of title is more form than substance.

 

As the SOP states, the FASB has a major project on its agenda whose objective is "to issue a comprehensive Statement on revenue recognition, and to amend the related guidance on revenue and liabilities in certain of the FASB Concepts Statements." The stated goals of this project are to:

 

(1) eliminate inconsistencies in the existing authoritative literature and accepted practices;
(2) fill voids that have emerged in revenue recognition guidance in recent years; and
(3) provide guidance for addressing issues in the future. [p. 3]

 

The FAPC has strongly supported this project, arguing on a number of occasions that this effort should receive the highest priority. Although revenue recognition has been a problem for a very long time, we observe that dubious revenue recognition practices have been identified by regulators as a major factor in the over-valuation of most of the large companies that have suffered sudden collapse in recent years. Moreover, they have resulted in the delayed recognition of the problems inherent in the companies' business models, compounding the losses of investors. The time is ripe for a major reconsideration of the broad principles underlying all revenue recognition, and for significant reforms.

 

The Board expects to issue an exposure draft of a Statement on revenue recognition in 2004. Consequently, given the broad conceptual nature of the project, and the likelihood that the resulting Standard will have far-reaching consequences for any limited-scope statements, we strongly recommend that this SOP not be adopted at this time. The provisions and conclusions reached in the Proposal may appropriately be reconsidered once the FASB's project has been completed and the implications of the project for transaction-specific reporting, such as real estate time-share transactions, are more fully understood. In fact, we believe that careful consideration of the financial reporting problems discussed in this SOP could prove useful in examining revenue recognition in general and framing a robust, broadly-applicable standard.

 

If the FASB believes that the problems with recognition and reporting of revenue for real estate time-sharing transactions is of such urgency that steps must be taken immediately, prior to the finalization of a general revenue recognition standard, then the FAPC would propose the following interim solution. We believe that the hurdle rate for "demonstrating collectibility," based on collection by the seller of cumulative payments exclusive of interest and fees, should be raised to 25%, as proposed in the SOP, paragraph 25(b). This step may curb some of the more egregious revenue recognition practices in the near-term while not requiring the dislocations attendant to what could be a very short-term adoption of an entirely new standard.

 

As we have stated, the business model for real estate time-sharing arrangements is predicated on an assumption that a sizable number of contracts will default with little enforceability of the contract other than repossession of the time-sharing unit. Indeed the contracts appear not to enforce collectibility, but rather, to enforce foreclosure. We believe that under such conditions and assumptions, a presumption that a "sale" has been completed and, therefore, that the revenue should be recognized when only 10% of the revenue has been "collected," frequently achieved by the purchaser's charging of the "down payment" to a credit card, may be unwarranted in most, if not all cases.

 

We have several other general comments:

 

  • This SOP is an industry-focused standard, as compared to a transactions-focused proposal. At a time when global financial reporting standard-setting is moving toward adoption of a single standard for reporting of similar transactions, regardless of the industry, we question whether this approach is appropriate. For example, we would prefer to see a single standard for the reporting of all revenue transactions involving financing arrangements associated with high levels of default resulting in repossession.
  • Similar to the above, we observe that the SOP proposes five different methods of reporting real estate time-share revenues for essentially the same transaction.
    In our comment letter to the FASB in response to the Proposal, Principles-Based Approach to U.S. Standard Setting, the FAPC observed:
    Accounting standards should permit only a single method of accounting for similar transactions, with no exceptions allowed.
    This position is consistent with those put forward in the Principles-Based Approach Proposal. We believe that in the setting of financial reporting standards, the needs of investors for relevant, reliable, complete, and transparent information should supersede all other considerations. Financial information that allows preparers a menu of choices for reporting of similar transactions obscures the information critical to informed investment decision-making, rendering it useless.

    To overcome this deficiency, vast amounts of explanatory material must be provided in the notes to achieve the necessary transparency. However, we believe strongly that investors should not have to search in the notes for relevant and important disclosure, in this case or any other. Such information should be provided in the primary financial statements, using a single method for similar transactions.

    It is entirely possible that a single hybrid method of revenue recognition for these transactions, derived from one or more of the five methods proposed, would be suitable for reporting for TSTs. For example, such a method might combine a conservative cash-based or "deposit" method, for early-stage recognition, with an accrual method, applied once the probability of default can be demonstrated to have diminished to reasonable levels. This single method should then be applied to all TSTs, with appropriate disclosure in the notes. However, we believe it is premature to consider such a step at this stage.
  • Related to this concern is that the SOP does not provide a new set of fundamental principles to guide the accounting and reporting for real estate time-sharing transactions. Instead, the proposal appears to us to be, at least to some extent, an accommodation to current practices, a codification of the existing welter of different approaches to an admittedly difficult problem. We recognize fully that the conclusions reached in this project were, of necessity, informed and constrained by the existing authoritative literature, primarily Statement No. 66.
     
    We believe that this argues strongly for a delay in the adoption of the SOP until the FASB has completed the revenue recognition project. When this has been accomplished, it will be possible to review the alternatives in light of the broad general principles developed in the Standard.

    The Proposal, Principles-Based Approach to U.S. Standard Setting, stated:
    The main differences between accounting standards developed under a principles-based approach and existing accounting standards are (1) the principles would apply more broadly than under existing standards, thereby providing few, if any, exceptions to the principles and (2) there would be less interpretive and implementation guidance…for applying the standards.
    The FAPC strongly endorsed this approach as outlined in the Proposal in the belief that it may well lead to higher quality standards, and more relevant and transparent financial reporting under those standards.
  • The Proposal states:
    Subsequent to the issuance of Statement 66 [Accounting for Sales of Real Estate, issued in 1982] extensive changes in the methods used by the time-sharing industry to offer its products resulted in divergent accounting practices. [p.1]
    We commend the AcSEC for undertaking the study of financial reporting practices in the time-sharing industry. We recognize that this Proposal has been designed to address not only the plethora of accounting practices, but serious abuses of financial reporting under SFAS No. 66 as well. Nonetheless, although we are aware that the project has been underway for a number of years, we do not find compelling argument that time is of the essence in this case and that further delay of a year or two until the FASB has completed its project on revenue recognition is not tolerable.

    However, if it should be felt that steps must be taken in the interim, then we would propose, as stated earlier, the following interim solution. We believe that the hurdle rate for "demonstrating collectibility," based on collection by the seller of cumulative payments, should be raised to 25%, as proposed in the SOP, paragraph 25(b). This step may curb some of the more egregious revenue recognition practices while not requiring the dislocations attendant to what could be a very short-term adoption of an entirely new standard.
  • We are cognizant of the fact that new standards are not required to conform to the current Conceptual Framework and related theory, including such forward-looking proposals as the "Principles-Based Approach" document, in either their formulation or requirements. However, we believe that best practice would argue for either conformity or some argument or explanation of why those principles do not or should not apply in a particular case.

    It does not appear to us that some of the basic principles in Statement of Concepts No. 5, "Recognition and Measurement in Financial Statement of Business Enterprises," and Statement of Concepts No. 7, "Using Cash Flow Information and Present Value in Accounting Measurement," have informed the development of this Proposal. For example, although the valuation of the future streams of expected future cash flows would seem to lie at the heart of measurement of both the financing receivables and revenue recognition, the Statement No. 7 requirements do not appear in this Proposal. If it was felt that such principles could not be applied in this case, it would have been helpful for us to understand what conditions made them either irrelevant or inapplicable.

    Put slightly differently, we believe that in these transactions, as in all others, the most useful information to investors and other users of the statements, would be the fair values of the expected future cash flows, and the changes in those cash flows. If such values are not obtainable directly from market prices, or indirectly from market prices for similar assets, then Statement No. 7 should apply, barring compelling argument to the contrary.

 

The attached appendix responds to the SOP's enumerated questions.

 

Concluding Remarks

 

The Financial Accounting Policy Committee appreciates the opportunity to express its views on the AICPA's Proposed Statement of Position: Accounting for Real Estate Time-Sharing Transactions. If the Board or staff have questions or seek amplification of our views, please contact Rebecca McEnally at 1-434-951-5319 or at rebecca.mcenally@cfainstitute.org. We would be pleased to answer any questions or provide additional information you might request.

Respectfully yours,

 

Jane Adams
Chair, Financial Accounting Policy Committee 		Rebecca McEnally, Ph.D., CFA
Vice-President, Advocacy, AIMR

 

Specific Comments

 

1 With headquarters in Charlottesville, VA, and regional offices in Hong Kong and London, the Association for Investment Management and Research is a non-profit professional organization of 64,000 financial analysts, portfolio managers, and other investment professionals in 115 countries of which 55,800 are holders of the Chartered Financial Analyst (CFA ) designation. AIMR's membership also includes 125 affiliated societies and chapters in 44 countries. AIMR is internationally renowned for its rigorous CFA curriculum and examination program. More than 102,000 candidates are enrolled for the June 2003 exam.