Distinguishing between loans and equity investments: Substance over form

Journal of Accounting Education, Vol. 14, No. 4, pp. 551-578, 1996

Copyright © 1996 ElsevierScienceLtd Printed in Great Britain.All rights reserved 0748-5751/96 $15.00 + 0.00

Pergamon

S0748-5751(96)00029-2

Case

DISTINGUISHING BETWEEN LOANS AND EQUITY INVESTMENTS: SUBSTANCE OVER FORM Tad Miller CAL POLY--SAN LUIS OBISPO Abstract: The distinction between debt and equity is critical in determining both the issuer's

and investor's incomes. In the past, financial institutions frequently accelerated income by reporting interest income on financing arrangements even when the financial institution retained substantially all of the risks of ownership. Regardless of the terminology used in the financing agreement, current accounting standards do not permit accrual of interest on such transactions. Financial institutions are required to report such arrangements as equity investments unless the risks and rewards of ownership are transferred to the developer. This case uses an acquisition, development, and construction arrangement between a developer and savings and loan to allow students to evaluate the following issues: (1) the timing of income from lending activities contrasted with the timing of income from equity investments; (2) the party to which the risks and rewards of ownership accrue; and (3) accounting pronouncements as responses to previous reporting practices that failed to portray accurately underlying economic events. Copyright © 1996 Elsevier Science Ltd

1. P A R T O N E I n J a n u a r y o f 1981, Stanbell C o n s t r u c t i o n identified a tract of land suitable for b u i l d i n g 100 houses. The p r o p e r t y was already z o n e d for residential d e v e l o p m e n t , m a k i n g it easier to o b t a i n the necessary permits. E x h i b i t 1 shows Stanbell C o n s t r u c t i o n ' s estimate of the costs to develop the area a n d the p o t e n t i a l revenues the project could generate. Because the p r o p e r t y was adjacent to a lake, Stanbell C o n s t r u c t i o n referred to the project as " L a g u n a Shores". T o o b t a i n financing for the project, Stanbell C o n s t r u c t i o n p r e p a r e d the projections i n Exhibit 2 from the preceding cost a n d revenue estimates. T h e projections a s s u m e d that US$1,250 in miscellaneous fees w o u l d be p a i d w h e n each house was sold a n d that a real-estate b r o k e r w o u l d receive a 3% sales c o m m i s s i o n . Stanbell C o n s t r u c t i o n was indifferent to the type of f i n a n c i n g arrangem e n t as long as it could r e a s o n a b l y expect to receive US$975,000 w i t h o u t i n c u r r i n g a n y liability. O n e way to raise m o n e y w o u l d be to i n c o r p o r a t e L a g u n a Shores. T o receive the desired a m o u n t of the profit, Stanbell C o n s t r u c t i o n w o u l d retain 26% of the stock a n d sell the r e m a i n i n g stock 551

Estimated profit

US$100,000 selling price

Total costs

Land Engineering & architecture Engineering & architecture Infrastructure Supervision & overhead Construction of houses Marketing (~ 3% of sales Miscellaneous fees

Description of costs and revenues

31-72

1 2 13-18 17-24 22-71 22-71 31-72 31-72

Months in which acUvitles occur

100,000

1,250

100 units(~

100 units@

16,000 160,000 6,500 72,000 3,000

US$ per unit or per month

6 months(~ 8 months(~ 50 months(~ 50 months(~ 100 units(~

No. of active months or No. of units

Exhibit 1. Schedule of estimated costs and revenues

3,764,000

10,000,000

6,236,000

125,000

500,000 10,000 96,000 1,280,000 325,000 3,600,000 300,000

Total costs and revenues

.,-.

Net investment Note payable Retained earnings

Cash Accumulated construction costs Accumulated cost of houses sold

Unit sales Sales Cost of houses sold Real-estate commission Miscellaneous fees Income 0 0 0 0 0 0 2,121,500 0 2,121,500 2,121,500 0

0 0 0

0

510,000

0

510,000 510,000 0

1982

0 0

1981

2,366,180 1,914,500 451,680

<697,320>

3,063,500

0

1,913,540 558,500 1,355,040

<2,091,960>

4,005,500

0

72,000 30,000 903,360

24 2,400,000 1,394,640

12 1,200,000 697,320 36,000 15,000 451,680

1984

1983

Exhibit 2. Laguna Shores income projections

937,910 0 2,597,160

<4,009,590>

4,947,500

1,659,250

99,000 41,250 1,242,120

33 3,300,000 1,917,630

1985

0 0 3,764,000

<5,811,000>

5,811,000

3,764,000

93,000 38,750 1,166,840

31 3,100,000 1,801,410

1986

E.

0

[.-

554

T. Miller

to the bank. Stanbell Construction liked the limited liability provided by a corporation. Another possibility was for Stanbell Construction and the bank to organize Laguna Shores as a partnership which would then borrow money from the bank. If this were the case, Stanbell Construction would insist that the bank be the general partner and Stanbell Construction be a limited partner so that Stanbell Construction could not be held liable for Laguna Shore's loan. 1.1. SLO Town S&L

SLO Town S&L was a large savings and loan association serving a rapidly growing metropolitan area. During the late 1970s, the spread between its lending rate and cost of funds averaged 1.75%, which permitted a reasonable profit. During this period, home prices in the area skyrocketed. While the high levels of lending activity were beneficial to SLO Town S&L, it did not get rich. On the other hand, some of those who borrowed money from SLO Town did get rich from rising real-estate prices. Homeowners who made small down payments and obtained fixed rate mortgages often realized tremendous appreciation on relatively small investments. Home builders who obtained loans to build houses often made small fortunes as real-estate appreciated. In the late 1970s and early 1980s rising interest rates created problems for the entire S&L industry. At the time, Regulation Q permitted S&Ls to pay a maximum of 5.5% interest on deposits insured by the Federal Savings and Loan Insurance Corp. (FSLIC). SLO Town encountered problems as depositors withdrew money for alternative investments which paid higher rates. To fund these withdrawals, SLO Town sold some mortgage receivables. However, the market price of fixed-rate mortgages was declining as interest rates rose, so SLO Town had to report a loss when it sold older lower-rate mortgages. In 1980, federal regulators relaxed constraints on interest rates and FSLIC began insuring certificates of deposits (CDs). This enabled SLO Town to offer insured CDs paying competitive rates. Although insured CDs helped raise money, they created other problems. High-rate CDs not only attracted new depositors, but many existing depositors exchanged their 5.5% savings accounts for CDs. As CDs became a greater portion of SLO Town's deposit base, interest expense increased rapidly. SLO Town's interest income, on the other hand, did not increase as rapidly. While depositors easily converted savings accounts to high-rate CDs, the majority of SLO Town's income was interest from fixed-rate mortgages that earned low rates and would not mature for many years. During this period, short-term interest rates exceeded long-term lending rates (see Exhibit 3). This created serious problems for S&Ls, which borrowed money short-term from depositors and invested in long-term

Distinguishing between Loans and Equity Investments

555

Exhibit 3. E c o n o m i c i n d i c a t o r s

December 1980 January 1981 February 1981 March 1981

Prime rate (%)

Rales on 30-year mortgages (%)

19.625 21.500 20.000 19.000

13.28 13.26 13.54 14.02

US Council of Economic Advisors Y 4.EC7 EC7/981-986.

mortgages. During the first quarter of 1981, SLO Town paid 16% interest on CDs (even higher on US$100,000 jumbo CDs), while interest on new 30-year mortgages was only 14.0%. Even though mortgage rates were lower than SLO Town's marginal cost of funds, they were too high for many potential homebuyers. High mortgage rates increased house payments and reduced demand for new mortgages. Increasing rates from 9.5% (as recently as 1979) to 14% increased monthly payments from 841 to US$1,185 on a US$100,000 mortgage. Such high payments took many potential homebuyers out of the market and virtually eliminated the demand to refinance existing mortgages. For the above reasons, SLO Town's interest income did not increase as rapidly as its interest expense. As shown in Exhibit 4, interest expense increased from 85.3% of interest income in the first quarter of 1980 to 94.3% in the first quarter of 1981. Members of the Federal Home Loan Bank Board (FHLBB) directed the operation of the FSLIC insurance fund and also regulated federally chartered S&Ls. The FHLBB had authority to place S&Ls into receivership if they failed to comply with regulatory requirements. One such regulation required an S&L's net worth to exceed 5% of its liabilities. The term net worth is used instead of shareholders' equity because mutual associations, such as SLO Town S&L, do not have stockholders; mutual associations are owned by their depositors, and their net worth equals retained earnings. If the FHLBB had not lowered the net worth requirement from 5 to 4% in November of 1980, SLO Town S&L would have failed to meet the requirement. Because SLO Town's net worth was low, management was concerned that future losses could leave SLO Town S&L unable to satisfy the net worth requirement, and force the FHLBB to place SLO Town in receivership. SLO Town needed investments with returns in excess of its marginal cost of funds. Prior to 1980, the FHLBB had required S&Ls to invest virtually all of their funds in residential mortgages. However, mortgages were unprofitable now that short-term interest rates exceeded long-term lending rates. Federal regulations were changed in 1980 so thrifts could diversify their investments. The new regulations permitted direct invest-

556

T. MiUer

Exhibit 4. SLO Town S&L Income statement (×US$1,000): quarters ending March 31,1981 and 1980; year ending December 31,1980 First quarter 1981 1980

Year 1980

Revenues

39,339 2,606 1,007 42,952

29,469 2,392 1,015 32,876

131,743 9,883 4,047 145,673

Interest expense General and administrative expense Expenses

37,087 6,635 43,722

25,141 5,091 30,232

116,926 22,554 139,480

Interest i n c o m e Loan fees and s e r v i c e c h a r g e s M i s c e l l a n e o u s o p e r a t i n g income

Income < loss > before income tax

< 770 >

2,644

6,193

P r o v i s i o n < c r e d i t > f o r i n c o m e tax

< 254 >

978

2,293

Net Income < loss >

< 516 >

1,666

3,900

ments in real-estate. Having observed the appreciation of real-estate, in the late 1970s, SLO Town believed future appreciation would ensure a return on real-estate in excess of its marginal cost of funds. It was under these conditions that Stanbell Construction approached SLO Town S&L to obtain financing. As discussed, Stanbell Construction had two preconditions: it expected to receive at least US$975,000 and it would not be liable for Laguna Shore's debts. Otherwise Stanbell Construction was indifferent about the nature of the financing arrangement. 1.2. Reporting the Transaction as an Equity Investment

SLO Town S&L did not see any need to incorporate Laguna Shores. SLO Town S&L could purchase the land and provide the money to develop the property and construct the houses. After all houses were sold, SLO Town S&L would distribute 26% of the profit to Stanbell Construction. If the project went as planned, this would provide Stanbell Construction with US$978,640. Such an arrangement would provide SLO Town the majority of the profits if the property appreciated. However, Exhibit 5 (derived from Appendix A) shows that SLO Town would not book any profits until the third year, and SLO Town was under pressure from regulators to increase its net worth. 1.3. Reporting the Transaction as a Loan Receivable

If SLO Town and Stanbell Construction created a partnership, then SLO Town could lend Laguna Shores the money to buy and develop the

0 0 0 0 0 0

Equity investment

Net distribution received

Cash advances Equity in earnings cash received less Stanbell's 26%

2,121,500

0 0

0 0

510,000

2,121,500

0 0 0 0 0 0

1982

510,000

SLO Town's equity Investment in Laguna Shores

SLO Town's share(~74%

Lagune Shore's Income

Sales Cost of houses Real-estate commission Miscellaneous fees

1981

2,386,180

< 1,031,563 >

3,063,500 334,243 < 1,149,000 > 117,437

1,200,000 697,320 36,000 15,000 461,680 334,243

1983

1,913,540

< 3,094,689 >

4,005,500 1,002,729 < 3,447,000 > 352,311

2,400,000 1,394,640 72,000 30,000 903,360 668,486

1984

937,910

< 5,931,488

4,947,500 1,921,898 < 6,606,750 675,262

3,300,000 1,917,630 99,000 41,250 1,242,120 919,169

1985

0

< 8,596,360 >

5,811,000 2,785,360 < 9,575,000 > 978,640

863,462

1,166,840

3,100,000 1,801,410 93,000 38,750

1986

Exhibit 5. Contributions to SLO Town S&L's income with Laguna Shores reported as an investment in real-estate

J: E

0 I=

==

OQ

oo

558

T. MiUer

Exhibit 6. Contribution to SLO Town S&L's I n c o m e with a d v a n c e s to L a g u n a S h o r e s r e p o r t e d as an A D C loan 1981 Origination fees Interest income 50% of profit Total contribution to SLOTown's income

1982

1983

1984

1985

1986

15,773 115,144

49,840 268,584

14,567 606,139

0 498,520

0 235,298

0 0 980,067

130,917

318,424

620,706

498,520

235,298

980,067

property. To satisfy Stanbell's preconditions, SLO Town would agree that Stanbell Construction would not be liable if there was insufficient cash to pay off the loan. Only the assets of the Laguna Shores development would be collateral for the note. SLO Town would charge 3% origination fees on the loan and accrue interest at prime+ 1%. Interest would be posted monthly and proceeds from sales would pay down the loan. Such an arrangement is often referred to as an ADC loan with an equity kicker (ADC stands for acquisition, development, and construction). Under this proposal, SLO Town and Stanbell Construction would divide the accumulated profits equally. Using 20% interest (prime was 19.625% in December of 1980), SLO Town estimated origination fees and interest costs would total US$1,803,865 (see Appendix A) over the life of the development. While the cash flows were nearly identical under the two proposals, Exhibit 6 shows that SLO Town would report greater income in each of the first 3 years if Laguna Shores were structured as a loan. The partnership would capitalize origination fees and interest costs until houses were sold, at which time these costs would be amortized against income (see Exhibit 7). For example, if 12 houses were sold in 1983, Stanbell Construction would amortize 12 one-hundredths of the total projected origination fees and interest costs.

1.4. Assignments for Part One

1. Would you recommend that SLO Town S&L purchase the land and provide the money to develop the property or that it form a partnership with Stanbell Construction and lend the money to the Laguna Shores partnership? Explain why you prefer the option you recommended. Explain why Stanbell Construction will insist on a higher percentage of the profits if SLO Town structures the transaction as a loan to Laguna Shores rather than an investment. . Review the project's total cash flows in Exhibit 1 and compare this to Laguna Shore's total income over the 6-year period in Exhibit 5.

640,917 0

Note payable Retained earnings

2,570,841 0

2,121,500 449,341 2,984,548 235,216

2,366,180 853,584

235,216

< 216,464 >

1,200,000 697,320 36,000 15,000 451,680

1983

2,127,068 705,648

1,913,540 919,176

470,432

<432,928

2,400,000 1,394,640 72,000 30,000 903,360

1984

0 1 960,134

607,642

646,844

144,616 1 352,492

<559,198>

<595,276>

0 0

3,100,000 1,801,410 93,000 38,750 1,166,840

3,300,000 1,917,630 99,000 41,250 1,242,120

937,910 559,198

1986

1985

a Capitalized interest represents the accumulation of origination fees and interest reported by SLO Town S&L in Exhibit 6 less the capitalized interest that has been amortized against Laguna Shore's income. For example, in 1983 capitalized interest equals US$130,917+318,424+620,706-216,464.

510,000 130,917

0

Net Income

Balance sheet Land and houses Capitalized interest a

0

0

0

0 0 0 0 0

0 0 0 0 0

1982

Sales Cost of houses Real-estate commission Miscellaneous fees Income before interest Amortization of capitalized interest cost

1981

Exhibit 7. L a g u n a S h o r e ' s b o o k s

<

~.

O

= o-

~.

560

T. Miller Describe the relationship between Laguna Shores' total cash flows over the 6-year period and total income over the 6-year period. Explain why accrual financial statements might be more useful to investors than cash-based financial statements. . Describe the differences between the timing of income from investments and from loans. It may be helpful to consider the relationship between the investee's earnings and the recognition of income under the equity method. It may also be helpful to think about how investor's report dividends paid from retained earnings and how they report dividends that represent a return of capital. . Describe the characteristics of an equity investment (ownership position) in a company and the characteristics of a loan to a company. . At question is whether SLO Town invested in real-estate or lent money to Laguna Shores. If real-estate does not appreciate as expected, and the houses sell for US$80,000, this will illustrate the risks to which the parties are exposed. Total profit would be US$1,940,000 less than projected (100 houses times a US$20,000 reduction in price less the 3% marketing fee). If SLO Town reports Laguna Shores as an investment, then the distribution of accumulated profits to SLO Town S&L and to Stanbell Construction will be reduced proportionately. However, if SLO Town reports Laguna Shores as a loan, the lower selling price will not generate sufficient cash flows to pay off the note. Appendix B indicates that the note will have an unpaid balance of US$567,150 (US$557,852+9,298) after all of the houses are sold. The agreement does not require Stanbell Construction to participate in losses. Should SLO Town report interest income for 1981-1985 if there is a reasonable possibility that the proceeds would not be sufficient to pay off the loan?

1.5. Readings to Precede Part Two

1. Read "ADC Arrangements", Appendix I of Practice Bulletin 1, AICPA Technical Practice Aids as of June 1, 1992, or Appendix A of the AICPA Audit and Accounting Guide--Audits of Savings Institutions as of August 31, 1991. 2. Read the Exposure Draft of the Proposed Statement of Position (SOP) "Identifying and Accounting for Real-estate Loans that Quality as Real-estate Investments" which is dated October 28, 1993, and which was prepared by Accounting Standards Executive Committee of the AICPA.

Distinguishing between Loans and Equity Investments

561

PART TWO Had " ADC Arrangements" been issued, SLO Town S&L would have been unable to report Laguna Shores as a loan. Both "ADC Arrangements" and the proposed SoP "Identifying and Accounting for Real-estate Loans that Quality as Real-estate Investments" require S&Ls to report such transactions as investments in real-estate. If adopted, the proposed SoP will supersede "ADC Arrangements". For most transactions, "ADC Arrangements" or the proposed SoP would result in the same classification as loan or investment. However, the proposed SoP takes a different conceptual approach. Whereas, "ADC Arrangements" focused on the proportion of the residual profit the lender expected to earn, the proposed SoP focuses on the risks and rewards of ownership. If SLO Town S&L assumes the risks normally associated with ownership and if it will receive most of the benefits of ownership, then Laguna Shores should be classified as an investment. On the other hand, if Stanbell Construction assumes the risks and rewards of ownership then the project should be classified as a loan.

2.1. Capitalization of Interest SFAS Statement No. 34 "Capitalization of Interest Costs" does permit capitalization of interest on real-estate developments. SLO Town could achieve cash distributions similar to a loan to Laguna Shores by structuring the transaction as an investment in real-estate, capitalizing interest, and distributing 38% of the profits to Stanbell Construction. Exhibit 8 (derived from Appendix B) shows the projections for such an arrangement with interest capitalized at 16%, the rate SLO Town was paying for CDs.

2.2 Assignments for Part Two 1. The proposed SoP would require SLO Town to classify this transaction as if it were an investment in Laguna Shore in the form of cumulative preferred stock. As such, payments described as interest expense in the ADC arrangement would be treated as if they were preferred stock dividends. Explain how dividends in arrears are similar to interest in establishing SLO Town's preference over Stanbell Construction? 2. Assume that SLO Town accounted for this transaction as if it were an investment in preferred stock. When is the earliest SLO Town could recognize income from Laguna Shore?

Equity investment

Net distribution received

SLO Town's equity Investment In Laguna Shores Cash advances Capitalized interest Equity in earnings cash received less Stanbell's 38%

Total income effect

SLO Town's share of net income@62% Reduced interest expense

Net income

Sales Cost of houses Real-estate commission Miscellaneous fees Income before interest Amortization of capitalized interest costs

597,704

510,000 87,704 0 0 0

87,704

0 87,704

0

0 0 0 0 0 0

1981

638,720

192,496 446,224

310,477

1,200,000 697,320 36,000 15,000 451,680 < 141,203>

1983

718,024

384,991 333,033

620,954

2,400,000 1,394,640 72,000 30,000 903,360 < 282,406 >

1984

637,652

529,363 108,289

853,812

3,300,000 1,917,630 99,000 41,250 1,242,120 < 388,308 >

1985

497,281

497,281 0

802,066

3,100,000 1,801,410 93,000 38,750 1,166,840 < 364,774 >

1986

2,410,646

2,960,346

<1,031,019>

2,558,333

<3,093,056>

1,302,684

<5,928,357>

0

<8,591,822>

2,121,500 3,063,500 4,005,500 4,947,500 5,811,000 289,145 735,369 1,068,402 1,176,691 1,176,691 0 192,496 577,487 1,106,850 1,604,131 0 <1,149,000> <3,447,000> <6,606,750> <9,575,000> 0 117,981 353,944 678,393 983,178

201,441

0 201,441

0

0 0 0 0 0 0

1982

Exhibit 8. Contributions to SLO Town S&L's income. Investment in real-estate with capitalization of interest

hJ

Distinguishing between Loans and Equity Investments

563

3. How would Laguna Shore's total cost be affected if it accounted for the money advanced from SLO Town S&L as preferred stock instead of a loan? 4. When SLO Town S&L accrues interest on a loan it increases both the carrying value o f the loan and net income. Capitalizing interest also increases the carrying value of the investment and reduces interest expense which increases net income. Contrast reporting Laguna Shores as an A D C loan with reporting the transaction as an investment with interest capitalized.

APPENDIX A

Real-estate Loan when Houses Sell for US$100,000 (20% interest rate with 3% origination fees) Sales [less 3%, less US$1,250]

Costs Month/ year

Land off-sites

1/81 2/81 3/81 4/81 5/81 6/81 7181 8/81 9/81 10181 11/81 12/81 Subtotal

500,000 10,000

Units

US$

Cash flows

Advances Odglnellon Loan [payments] fees balance

78,500 78,500 78,500 235,000 78,500 78,500 78,500 78,500

Interest @20%

(500,000) 500,000 (10,000) 10,000 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

15,464 309 0 0 0 0 0 0 0 0 0 0 15,773

06,000) (16,000) (16,000) (16,000) (176,000) (176,000) (160,000) (160,000) (160,000) (238,500) (238,500) (238,500)

16,000 16,000 16,000 16,000 176,000 176,000 160,000 160,000 160,000 238,500 238,500 238,500

495 495 495 495 5,443 5,443 4,948 4,948 4,948 7,376 7,376 7,376 49840

657,412 684,864 712,773 741,147 934,943 1,131,969 1,315,783 1,502,661 1,692,654 1,966,741 2,245,397 2,528,696

10,957 11,414 11,880 12,352 15,582 18,866 21,930 25,044 28,211 32,779 37,423 42,145 268,584

(78,500) (78,500) (78,500) (78,500)

78,500 78,500 78,500 78,500

2,428 2,428 2,428 2,428

2,651,769 2,776,893 2,904,102 3,033,432 Conflnued

44,196 46,282 48,402 50,557 overleaf

510,000

1/82 16,000 2•82 16,000 3•82 160,00 4•82 16,000 5182 176,000 6•82 176,000 7/82 160,000 8•82 160,000 9•82 160,000 10/82 160,000 11/82 160,000 12/82 160,000 Subtotal 1,378,000 1183 2•83 3•83 4/83

House

515,464 8,591 5 3 4 , 3 6 4 8,906 5 4 3 , 2 7 0 9,055 5 5 2 , 3 2 5 9,205 5 6 1 , 5 3 0 9,359 5 7 0 , 8 8 9 9,515 5 8 0 , 4 0 4 9,673 5 9 0 , 0 7 7 9,835 5 9 9 , 9 1 2 9,999 6 0 9 , 9 1 0 10,165 6 2 0 , 0 7 6 10,335 6 3 0 , 4 1 0 10,507 115,144

564

T. Miller

Appendix A. Continued Sales [less 3%, less US$1,250]

Costa Month/ year

Land off-sites

House

Units

US$

5•83 6•83 7•83 8•83 9•83 10/83 11/83 12/83 Subtotal

78,500 78,500 78,500 78,500 78,500 78,500 785,00 78,500 942,000

2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 12 1,149,000

1/84 2•84 3•84 4•84 5•84 6•84 7•84 8•84 9•84 10/84 11/84 12184 Subtotal

78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 942,000

1/85 2•85 3•85 4•85 5•85 6•85 7•85 8•85 9•85 10/85 11/85 12/85 Subtotal 1/86 2•86 3•86 4•86 5•86 6•86 7•86 8•86 9/86 10/86 11/86 12/86 Subtotal Total

Advances Origination Loan [payments] fees balance

Interest @20%

(78,500) (78,500) 113,000 113,000 113,000 113,000 113,000 113,000

78,500 78,500 (113,000) (113,000) (113,000) (113,000) (113,000) (113,000)

2,428 2,428 0 0 0 0 0 0 14,567

3,164,917 3,298,594 3,240,570 3,181,580 3,121,606 3,060,633 2,998,643 2,935,621

52,749 54,977 54,010 53,026 52,027 51,011 49,977 48,927 606,139

2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 24 2,298,000

113,000 113,000 113,000 113,000 113,000 113,000 113,000 113,000 113,000 113,000 113,000 113,000

(113,000) (113,000) (113,000) (113,000) (113,000) (113,000) (113,000) (113,000) (113,000) (113,000) (113,000) (113,000)

0 0 0 0 0 0 0 0 0 0 0 0 0

2,871,548 2,806,407 2,740,180 2,672,850 2,604,397 2,534,804 2,464,051 2,392,116 2,318,987 2,244,637 2,169,047 2,092,198

47,859 46,773 45,670 44,547 43,407 42,247 41,068 39,869 38,650 37,411 36,151 34,870 498,520

78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 942,000

2 191,500 2 191,500 2 191,500 3 287,250 3 287,250 3 287,250 3 287,250 3 287,250 3 287,250 3 287,250 3 287,250 3 287,250 33 3,159,750

113,000 113,000 113,000 208,750 208,750 208,750 208,750 208,750 208,750 208,750 208,750 208,750

(113,000) (113,000) (113,000) (208,750) (208,750) (208,750) (208,750) (208,750) (208,750) (208,750) (208,750) (208,750)

0 0 0 0 0 0 0 0 0 0 0 0 0

2,014,068 1,934,636 1,853,880 1,676,028 1,495,212 1,311,382 1,124,488 934,480 741,304 544,909 345,241 142,245

33,568 32,244 30,898 27,934 24,920 21,856 18,741 15,575 12,355 9,082 5,754 2,371 236,298

78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 76,500

3 287,250 3 287,250 3 287,250 3 287,250 3 287,250 3 287,250 3 287,250 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 31 2,968,250

208,750 208,750 208,750 208,750 206,750 208,750 208,750 113,000 113,000 113,000 113,000 191,500

(208,750) (208,750) (208,750) (208,750) (208,750) (206,750) (208,750) (113,000) (113,000) (113,000) (113,000) (191,500)

0 0 0 0 0 0 0 0 0 0 0 0 0

(64,134) (272,884) (481,634) (690,384) (899,134) (1,107,884) (1,316,634) (1,429,634) (1,542,634) (1,655,634) (1,768,634) (1,960,134)

0 0 0 0 0 0 0 0 0 0 0 0 0

863,800 1,888,000

Cash flows

3,925,000

100 9,575,000

80,180

1,723,686

Distinguishing between Loans and Equity Investments

565

APPENDIX B Real-estate Loan when Houses Sell for US$80,000 (20% interest rate with 3% origination fees) Sales [less 3%, less US$1,250]

Costs Month/ year

Land off-sites

1/81 2/81 3/81 4/81 5/81 6/81 7/81 8/81 9/81 10181 11181 12/81 Subtotal

500,000 10.000

House

Units

US$

1183 2•83 3•83 4•83 5•83 6•83 7/83 8•83 9•83 10/83 11/83 12/83 Subtotal

78,500 78,500 78,500 78,500 78,500 78,500 76,500 78,500 78,500 78,500 78,500 78,500 942,000

2 2 2 2 2 2 12

152,700 152,700 152,700 152,700 152.700 152,700 916,200

1184

78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78.500 78,500

2 2 2 2 2 2 2 2 2 2

152,700 152,700 152,700 152.700 152,700 152,700 152,700 152,700 152,700 152,700

3•84 4•84 5•84 6•84 7•84 8•84 9•84 10•84

Advances Origination Loan [payments] fees balance

Interest @20%

(500,0001 (10,000

500,000 10,000 0 0 0 0 0 0 0 0 0 0

15,464 309 0 0 0 0 0 0 0 0 0 0 16,773

(16,000) (16,000) (16,000) (16,000) (176,000) (176,000) (160,000) (160,000) (160,000) (238,500) (238,500) (238,500)

16,000 16,000 16.000 16,000 176,000 176,000 160,000 160,000 160,000 238,500 238,500 238,500

495 495 495 495 5,443 5,443 4,948 4,948 4,948 7,376 7.376 7.376 49,840

657,412 684.864 712.773 741,147 934,943 1,131,969 1,315,783 1,502,661 1,692,654 1,966,741 2,245,397 2,528,696

10,957 11,414 11,880 12,352 15,582 18,866 21,930 25,044 28,211 32,779 37,423 42,145 268,584

(78,500) (78,500) (78,500) (78,500) (78,500) (78,500) 74,200 74,200 74,200 74,200 74,200 74,200

78,500 78,500 78,500 78,500 78,500 78,500 (74,200) (74,200) (74,200) (74,200) (74,200) (74,200)

2,428 2,428 2,428 2,428 2,428 2,428 0 0 0 0 0 0 14.567

2,651,769 2,776,893 2,904,102 3,033,432 3,164,917 3,298,594 3,279.370 3,259.826 3,239,957 3.219,756 3,199,219 3,178,339

44,196 46,282 48,402 50,557 52.749 54,977 54,656 54,330 53,999 53,663 53,320 52,972 620,193

74,200 74,200 74,200 74,200 74,200 74,200 74,200 74,200 74,200 74,200

(74,200) (74,200) (74,200) (74.200) (74,200) (74,200) (74,200) (74,200) (74.200) (74,200)

0 0 0 0 0 0 0 0 0 0

3,157,111 3,135,530 3,113,589 3,091,282 3,068,603 3,045,546 3.022,106 2,998,274 2.974.045 2.949,413 Continued

52,619 52,259 51,893 51,521 51,143 50,759 50,368 49,971 49,567 49,157 overleaf

510,000

1182 16,000 2•82 16,000 3•82 16.000 4•82 16,000 5•82 176,000 6/82 176,000 7/82 160,000 8182 160,000 9•82 160,000 10/82 1 6 0 , 0 0 0 78,500 11/82 1 6 0 , 0 0 0 78,500 12/82 1 6 0 , 0 0 0 78,500 Subtotal 1,376,000 235,500

2/84

Cash flows

5 1 5 . 4 6 4 8,591 5 3 , 4 3 6 4 8,906 5 4 3 , 2 7 0 9,055 5 5 2 . 3 2 5 9,205 5 6 1 , 5 3 0 9,359 5 7 0 , 8 8 9 9,515 5 8 0 , 4 0 4 9,673 5 9 0 , 0 7 7 9,835 5 9 9 , 9 1 2 9,999 6 0 9 , 9 1 0 10,165 6 2 0 , 0 7 6 10,335 6 3 0 , 4 1 0 10,507 115,144

566

T. Miller

APPENDIX B. Continued Sales [less 3%, less US$1,250]

Costs Month/ year

Land off-sites

House

Units

US$

Cash flows

Advances Orlglnaflon Loan [payments] fees balance

Interest @20%

11/84 12/84 Subtotal

78,500 78,500 942,000

2 152,700 2 152,700 24 1,832,400

74,200 74,200

(74,200) (74,200)

0 0 0

2,924,369 45,739 2,898,009 48,315 606,313

1/85 2•85 3•85 4•85 5•85 6•85 7•85 8•85 9•85 10/85 11/85 12/85 Subtotal

78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 942,000

2 152,700 2 152,700 2 152,700 3 229,050 3 229,050 3 229,050 3 229,050 3 229,050 3 229,050 3 229,050 3 229,050 3 229,050 33 2,519,550

74,200 74,200 74,200 150,550 150,550 150,550 150,550 150,550 150,550 150,550 150,550 150,550

(74,200) (74,200) (74,200) (150,550) (150,550) (150,550) (150,550) (150,550) (150,550) (150,550) (150,550) (150,550)

0 0 0 0 0 0 0 0 0 0 0 0 0

2,873,024 2,846,708 2,819,953 2,716,402 2,611,126 2,504,094 2,395,279 2,284,651 2,172,178 2,057,831 1,941,578 1,823,388

47,884 47,445 46,999 45,273 43,519 41,735 39,921 38,078 36,203 34297 32,360 30,390 484,104

1/86 2•86 3•86 4•86 5•86 6•86 7•86 8•86 9•86 10/86 11/86 12/86 Subtotal

78,500 78,500 78,500 70,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500

3 229,050 3 229,050 3 220,050 3 220,050 3 220,050 3 229,050 3 229,050 2 152,700 2 152,700 2 152,700 2 152,700 2 152,700 31 2,366,850

150,550 150,550 150,550 150,550 150,550 150,550 150,550 74,200 74,200 74,200 74,200 152,700

(150,550) (150,550) (150,550) (150,550) (150,550) (150,550) (150,550) (74,200) (74,200) (74,200) (74,200) (152,700)

0 0 0 0 0 0 0 0 0 0 0 0 0

1,703,228 1,581,065 1,456,866 1,330,597 1,202,224 1,071,711 939,022 880,473 820,947 760,430 698,904 557,852

28,387 26,351 24,281 22177 20,037 17,862 15,650 14,675 13,682 12,674 11,648 9,298 215,722

Total

863,500 1,886,000

3,925,000

100 7,635,000

80,180

2,310,969

APPENDIX C Real-estate Loan when Houses Sell for

US$100,000 (16% interest rate with

0% origination fees) Sales [lass 3%, less US$1,2SO]

Costs Month/ year

Land off-sites

1181 2181 3181 4/81 5/81 6181 7/81

500,000 10,000

House

Unite

US$

Cash flows

Advances Origination Loan [payments] fees balance

(500,000) 500,000 (10,000) 10,000 0 0 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0

Interest @16%

500,000 0,067 5 1 6 , 6 6 7 6,889 523,556 6,981 5 3 0 , 5 3 6 7,074 5 3 7 , 6 1 0 7,168 544,778 7,264 5 5 2 , 0 4 2 7,361 Continued opposite

Distinguishing between Loans and Equity Investments

567

Appendix C. Continued Sales [less 3%, less US$1,250]

Costs Month/ year 8/81 9/81 10/81 11/81 12181 Subtotal

Land off-sites

House

Units

US$

Advances Origination Loan [payments] fees balance 0 0 0 0 0

1/83 2•83 3•83 4•83 5•83 6•83 7•83 8/83 9•83 10183 11/83 12/83 Subtotal

78,500 78,500 78,500 78,500 78,500 78,500 78.500 78,500 78,500 78,500 78,500 78,500 942,000

2 191,500 2 191,500 2 191,500 2 191.500 2 191,500 2 191,500 12 1,149,000

1/84 2/84 3•84 4/84 5•84 6184 7•84 8•84 9•84 10•84 11/84 12•84 Subtotal

78,500 78,500 78,500 78,500 78,500 78.500 78,500 78,500 78,500 78,500 78,500 78,500 942,000

2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 2 191.500 2 191,500 2 191.500 2 191,500 2 191,500 2 191,500 2 191,500 24 2,298,000

78,500 78,500 78,500 78,500 78,500 78,500 78,500

2 2 2 3 3 3 3

191,500 191,500 191,500 287,250 287,250 287,250 287,250

Interest @16%

0 0 0 0 0

0 0 0 0 0 0

559,403 566,861 574,419 582.078 589.839

7,459 7,558 7,659 7,761 7,865 87.704

(16,000) (16,000) (16,000) (16,000) (176,000) (176,000) (160,000) (160,000) (160,000) (238,500) (238,500) (238,500)

16,000 16,000 16,000 16.000 176,000 176,000 160.000 160,000 160,000 238,500 238,500 238,500

0 0 0 0 0 0 0 0 0 0 0 0 0

613,704 637,887 662,392 687,224 872,387 1,060,018 1,234.152 1,410,607 1,589,416 1,849,108 2,112.262 2,378,926

8,183 8,505 8.832 9,163 11,632 14,134 16,455 18.808 21,192 24,655 28,163 31,719 201,441

(78,500) (78,500) (78,500) (78,500) (78,500) (78.500) 113,000 113,000 113,000 113,000 113,000 113,000

78,500 78,500 78,500 78,500 78,500 78,500 (113,000) (113,000) (113,000) (113,000) (113,000) (113,000)

0 0 0 0 0 0 0 0 0 0 0 0 0

2,489,145 2,600,834 2,714,011 2,828,698 2,944,914 3,062,680 2,990,515 2,917,389 2,843,287 2,768,198 2,692.107 2.615.002

33,189 34,678 36,187 37.716 39,266 40,836 39,874 38,899 37,910 36.909 35,895 34,867 446,224

113.000 113,000 113,000 113,000 113,000 113,000 113,000 113,000 113,000 113,000 113,000 113,000

(113,000) (113,000) (113,000) (113,000) (113,000) (113,900) (113,000) (113,000) (113,000) (113.000) (113,000) (113,000)

0 0 0 0 0 0 0 0 0 0 0 0 0

2,536.869 2,457,694 2,377,463 2,296,162 2,213,778 2,130,295 2,045.699 1,959,975 1,873,108 1,785,083 1,695,884 1,605,495

33,825 32,769 31,700 30,615 29,517 28,404 27.276 26,133 24,975 23,801 22.612 21,407 333,033

113,000 113,000 113,000 208,750 208,750 208,750 208,750

(113,000) (113,000) (113,000) (208,750) (208,750) (208,750) (208,750)

0 0 0 0 0 0 0

1,513,902 1,421,087 1,327,035 1.135,979 942,375 746,190 547,390 Continued

20.185 18,948 17,694 15,146 12,565 9,949 7,299 overleaf

510,000

1/82 16,000 2182 16,000 3•82 16,000 4/82 16,000 5•82 176,000 6•82 176,000 7•82 160,000 8•82 160,000 9•82 160,000 10/82 1 6 0 , 0 0 0 78,500 11/82 1 6 0 , 0 0 0 78,500 12/82 1 6 0 , 0 0 0 78,500 Subtotal 1,378,000 235,500

1185 2•85 3•85 4•85 5•85 6•85 7•85

Cash flows

568

T. Miller

Appendix Sales [ i o n 3%, less US$1,250]

Costs Month/ year

Land off-sltas

C. Continued

H o u s e Units US$

Cash flows

AdvancesOrigination L o a n [payments] fees balance

Interest @15%

8•85 9•85 10/85 11/85 12/85 Subtotal

78,500 78,500 78,500 78,500 78,500 942,000

3 287,250 3 287,250 3 287,250 3 287,250 3 287,250 33 3,159,750

208,750 208,750 208,750 208,750 208,750

(208,750) (208,750) (208,750) (208,750) (208,750)

0 0 0 0 0 O

345,938 141,801 (65,059) (273,809) (482,559)

4,613 1,891 0 0 0 108,289

1/86 2•86 3•86 4•86 5•86 6•86 7•86 8•86 9•86 10/86 11186 12/86 Subtotal

78,500 78,500 78500 78,500 78,500 78,500 78,500 78,500 78,500 78,500 78,500

3 287,250 3 287,250 3 287250 3 287,250 3 287,250 3 287,250 3 287,250 2 191,500 2 191,500 2 191,500 2 191,500 2 191,500 31 2,968,250

208,750 208,750 208750 208,750 208,750 208,750 208,750 113,000 113,000 113,000 113,000 191,500

(208,750) (208,750) (208750) (208,750) (208,750) (208,750) (208,750) (113,000) (113,000) (113,000) (113,000) (191,500)

0 0 0 0 0 0 0 0 0 0 0 0 O

(691,309) (900,059) (1,108,809) (1,317,559) (1,526,309) (1,735,059) (1,943,809) (2,056,809) (2,169,809) (2,282,809) (2,395,809) (2,587,309)

0 0 0 0 0 0 0 0 0 0 0 0 0

Total

863,500

1,886,000 3,925,000 100 9,575,000

APPENDIX

0

1,176,691

D

Teaching Note I use this case in a Senior Project workshop/seminar for accounting majors who are currently taking or have completed Advanced Accounting. Students find the case relevant because the savings and loan crisis has received broad coverage from the news media. They find the case realistic because the costs came from an actual ADC project which took place at the approximate time period represented in the case. While distributing the case, at the end of one class period, I discuss the economic environment in which SLO Town S&L found itself. This background material is included in Part One Section 1 under the subsection heading SLO Town S&L Section 1.1. Three or four students are assigned to work on each team and they are instructed to read and do the Assignments for Part One Section 1.4. This material familiarizes students with the reporting of ADC arrangements prior to recent accounting standards. Students see that reporting ADC arrangements as loans did not reflect the underlying economic events, and this helps them identify the issues. I do not discuss accounting standards at this time. At the end of the next class, after discussing Part One, students are assigned the Readings to precede Part Two Section 1.5, Part Two, and the Assignments for Part Two Section 2.2. It is not necessary for all students to read both readings. You might have each team read one or the other of the readings. In Part One, students see that reporting A D C arrangements as loans did not reflect the underlying economic events. In Part Two, students see that accounting standards attempt to make financial reporting more accurately reflect the underlying economic events.

Distinguishing between Loans and Equity Investments

569

My objectives for the course were to: 1. Introduce students to various pronouncements available for guidance on accounting issues. 2. Demonstrate how accounting choices can affect the timing of income. 3. Distinguish between loans and equity investments. 4. Demonstrate how the substance of a transaction may differ from its reported form. 5. Demonstrate the need for financial accounting standards. To achieve these objectives with undergraduate students, I took an active role directing the class. With different objectives or with graduate students, I would probably give the class less direction. The case discusses an S&L's participation in an ADC arrangement and demonstrates that the choice of accounting methods affects reported income even though cash flows are virtually identical under the different accounting treatments. Students can see that more income is allocated to earlier accounting periods when the transaction is reported as a loan than when it is reported as an investment. The case provides a structured environment to research accounting issues and introduce students to accounting pronouncements. The primary issue is whether the Laguna Shores transaction is a loan or an equity investment. The distinction between loans and equity investments was addressed by the Accounting Standards Executive Committee (AcSEC) of the AICPA in February 1986 in "ADC Arrangements" which can be found in Practice Bulletin 1 of the AICPA Technical Practice Aids, or in the AICPA audit and accounting guide "Audits of Savings Institutions". The distinction between loans and equity investments is currently being revisited in a proposed SoP, "Identifying and Accounting for Real-estate Loans that Qualify as Real-estate Investments" which focuses on the risks and rewards of ownership.

Part One I try to make sure the discussion for Part One covers the lbllowing issues: the effect accounting choices can have on the timing of income, the residual nature of investment income, the risk SLO Town S&L is accepting, and the substance of the Laguna Shores transaction.

Timing of income. When houses sell for US$100,000, cash inflows exceed costs by US$3,764,000, which will also be the combined profit SLO Town S&L and Stanbell Construction realize over the life of the project. This is an important concept that few students understand. Profit over the life of a project equals net cash flows. SLO Town's total income from this transaction will equal the amount by which the cash it receives exceeds the cash it advances to Laguna Shores. If reported as a loan (investment) the transaction will contribute US$2,783,933 (US$2,785,360) to SLO Town's income. With the exception of the $1,427 difference in the distribution of profit to Stanbell Construction at the end of the 72nd month, the cash flows are identical (see Exhibit D1). In spite of this, the timing of the income varies significantly. If SLO Town reports the transaction as a loan, it will recognize US$1,070,047 income in the first 3 years compared to US$334,243 if it is reported as an investment. This is an opportunity to discuss the appropriate use of present value techniques with students who want to calculate the present value of the income streams. They must learn that present value applies to cash flows. Present value techniques can only be applied to accounting income when it is a surrogate for cash flows. In this case, except for the distribution to Stanbell Construction at the end of the 72nd month, all cash flows are identical under the various accounting treatments.

T. Miller

570

Exhibit D1. Cash distributions under different accounting t r e a t m e n t s AccounUng treatment

Division of profits

Cash distributions to: SLO Town Stanbell

Investment ADC loan

74%•26% 50%•50%

2,785,360 2,783,933

978,640 980,067

1,427

- 1,427

Difference

Total 3,764,000 3,764,000

Residual interest. The Financial Accounting Standards Board (FASB) has a discussion memorandum, "Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both" which addresses these same issues from the standpoint of the issuing entity. The difference between an equity investment and a loan has to do with the certainty of the cash flows and the preference with which cash flows are allocated between parties. Statement of Financial Accounting Concepts No. 6 "Elements of Financial Statements" defines equity and liabilities:

49. Equity or net assets is the residual interest in the assets of an entity that remains after deducting its liabilities. 35. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. When the transaction is recorded as an investment, SLO Town's residual position is obvious. If Laguna Shores generates sul~cient revenue to create profits, then SLO Town will recover its investment and participate in the distribution of profits. If Laguna Shores does not generate sufficient revenues, there will not be any profits and SLO Town will not recover its investment. Structuring the transaction as a loan does not increase the certainty of the cash flows because the sale of houses remains the sole source of cash. However, SLO Town does receive preference in the distribution of certain cash flows. In the case of an investment, SLO Town would recover the money advanced to Laguna Shores before allocating the residual with Stanbell Construction. In the case of a loan, SLO Town would recover the money advanced and also interest on those advances before allocating the residual with Stanbell Construction. However, the sale of houses remains the sole source of cash flows, and SLO Town will not recover its loan unless Laguna Shores generates sufficient revenues. Risk. Exhibit D2 (derived from Appendix B) shows what happens if houses sell for US$80,000, instead of US$100,000. This will not create a reporting problem if Laguna Shores is reported as an investment because SLO Town will not recognize income until houses are sold to third-parties, and the income will be calculated from the selling price. However, if SLO Town reports the transaction as a loan and the houses sell for US$80,000, then a timing problem will arise. Cash flows will not be sufficient to pay the principal and interest. Exhibit D3 shows that SLO Town reports origination fees and interest income in excess of the cash flows created by the project. At some point, SLO Town will need to book a loss. In Exhibit 11, SLO Town does not book the loss until all of the houses are sold. This example illustrates the residual nature of SLO Town's interest in Laguna Shores. SLO Town S&L structured the transaction as a loan in order to report interest income during the early years of the development. However, the future cash flows were uncertain because repayment of the loan depended entirely on the sale of houses to third-parties. Although an US$80,000 selling price generates sufficient cash flow to pay back SLO Town's

Equity investment

Net distributions received

510,000

0

2,121,500

2,386,180

< 859,291 >

960,000 697,320 28,800 15,000 218,880 161,971

0

0 0 0 0 0 0

1983

3,063,500 161,971 < 916,200> 56,909

0 0 0 0 0 0

1982

SLO Town's equity investment In Laguna Shores Cash advances 510,000 2,121,500 Equity in earnings cash received 0 0 less Stanbell's 26% 0 0

Sales Cost of houses Real-estate commission Miscellaneous fees Laguna Shore's Income SLO Town's share(~74%

1981

4,947,500 931,334 < 5,268,150> 327,226 < 4,940,924>

937,910

< 2,577,873>

1,913,540

2,640,000 1,917,630 79,200 41,250 601,920 445,421

1985

4,005,500 485,913 < 2,748,600> 170,727

1,920,000 1,394,640 57,600 30,000 437,700 323,942

1984

0

< 7,160,760>

5,811,000 1,349,760 < 7,635,000> 474,240

2,480,000 1,801,410 74,400 38,750 668,440 418,426

1986

Exhibit D2. Contributions to SLO Town S&Us income if Laguna Shores is reported as an investment in real-estate, assuming houses sell for US$80,000 (instead of US$100,000)

$,

E,

f~

o ==

g-

0

Net loss

640,917 0

Note payable Retained earnings

2,570,841 0

2,121,500 449,341

0

0 0 0 0 0 0

606,313

0 606,313

1984

3,231,311 <68,058>

2,366,160 797,073

< 68,058>

960,000 697,320 28,800 15,000 218,880 286,938

1983

2,947,224 <204,174>

1,913,540 829,510

< 136,116>

1,920,000 1,394,640 57,600 30,000 437,760 573,876

1984

Laguna Shore's books

634,670

14,567 620,103

1983

1,853,777 <391,333>

937,910 524,534

< 187,159>

2,640,000 1,917,630 79,200 41,250 601,920 789,079

1985

484,104

0 484,104

1985

567,149 <567,149>

0 0

< 175,816>

2,480,000 1,801,410 74,400 38,750 565,440 741,256

1986

0 216,722 <567,149> <350,427>

1986

= Capitalizedinterest representsthe accumulationof origination fees and interest reported by SLO Town S&L above less the capitalized interest that has been amortized against Stanbell Construction'sincome.

510,000 130,917

Land and houses Capitalized interesta

Balance Sheet

0 0 0 0 0 0

1982

318,424

130,917

1981

49,840 268,584

1982

15,773 115,144

Sales Cost of houses Real-estate commission Miscellaneous fees Income before interest Amortization of capitalized interest costs

Net income

Originationfees Interestincome Operatingloss Totalcontributionto SLO Town'sincome

1981

Exhibit D3. Contribution to SLO Town S&L's income with Laguna Shores reported as an ADC loan, assuming houses sell for US$80,000 (instead of US$100,000)

t,J

Distinguishing between Loans and Equity Investments

573

advances to L a g u n a Shores it does not generate sufficient cash flows to pay off the interest. This illustrates the problem o f accruing income when the future cash flows are uncertain.

Substance over form. One might try to justify reporting the transaction as a loan based on L a g n n a Shores obligation to SLO Town. However, L a g n n a Shores is comprised of two parties: SLO Town Savings and Stanbell Construction. The arrangement stipulates that Stanbell is not liable if there is insufficient cash to pay off the loan. This m e a n s that, with regard to the loan, SLO Town is the only responsible party and SLO Town can only recover the m o n e y advanced to L a g n n a Shores from the sale of houses to third-parties.

Part

Two

Students are assigned to read " A D C Arrangements", and the proposed SoP "Identifying and Accounting for Real-estate Loans that Qualify as Real-estate Investments" as a m e a n s of introducing the types o f pronouncements they will use throughout their careers. I have students read both " A D C Arrangements" and the proposed SoP so that we can discuss how accounting principles evolve. Y o u can save time by assigning each group one or the other of the readings. Students do not need to read both readings to understand Part Two. Exhibit D4 illustrates the effects various accounting treatments have on the timing of SLO T o w n ' s income. Equity method investors do not recognize income until the investee earns income, which is significantly different than creditors who recognize interest income with the passage of time. If the substance of the Lagnna Shore's transaction is an investment, then the uncertain nature of the future cash flows dictates that SLO Town should not recognize revenue until arm'slength transactions are executed with third-parties. If the substance of the transaction is a loan, then SLO Town can begin accruing interest income as soon as it makes advances to L a g u n a Shores. Recording a transaction as a loan implies greater certainty about future cash flows in order to justify the accrual of interest income with the passage of time.

The risks and rewards of ownership. In most instances " A D C Arrangements" and the proposed SoP will result in the same classification, but the two pronouncements are conceptually different. " A D C Arrangements" looks at the distribution of the project's residual profit to distinguish between investments and loans. W h e n the financial institution expects to receive > 50% o f the residual profit, " A D C Arrangements" requires it to report the transaction as an investment. W h e n the financial institution expects to receive < 50% of the residual profit, then " A D C Arrangements" requires the institution to evaluate the characteristics of the arrangement to determine which party has assumed the risks and rewards of ownership. " A D C Arrangements" provides one list of characteristics which indicates the financial institution has assumed the risks and rewards of ownership and a second list of characteristics which indicate the developer has assumed the risks and rewards o f ownership. The proposed SoP does not evaluate the distribution of residual profits, but looks directly to the risks and rewards of ownership. The proposed SoP would require SLO Town to report its contributions as if it were an investment in Laguna Shore's cumulative preferred stock. L a g u n a Shores would not be allowed declare dividends until it had retained earnings, which m e a n s SLO Town could n o t record income until the third year. The cumulative feature would ensure any dividends in arrears would receive preference to c o m m o n stock dividends or liquidating dividends. This is a good example to show students how claims are prioritized when there are more than one class of owners and/or creditors. Treating SLO Town's contribution as if it were an investment in cumulative preferred stock establishes the priority o f their claim without accruing interest income. There is too m u c h uncertainty about future cash flows for SLO T o w n to accrue interest income.

Investment (Part One) ADC loan Investment with capitalization of interest

0 130,917 87,704

1981 0 318,424 201,441

1982 334,243 620,706 638,720

1983

668,486 498,520 718,024

1984

919,169 235,298 637,652

1985

Exhibit D4. Contribution to SLO Town's income under different accounting treatments

863,462 980,067 497,281

1986

Distinguishing between Loans and Equity Investments

575

Capitalization of interest. SLO Town S&L capitalized interest at a rate of 16%. SFAS No. 34 states "the amount of interest to be capitalized ... is intended to be that portion of the interest cost ... that theoretically could have been avoided ... ". SLO Town paid 16% on CDs in Part One, which is an appropriate measure of its marginal borrowing rate. Capitalizing interest expense on a real-estate investment and accruing interest on an ADC loan have similar effects on SLO Town's financial statements. Both methods increase the carrying value of an asset and increase net income. However, there are important conceptual differences. Capitalization allows SLO Town to record the cost of interest while deferring recognition of interest expense. Recognition of the expense is deferred until the houses are sold at which time the expense is matched to the related revenue. Accruing interest income on ADC loans, on the other hand, creates profit because interest income is accrued at a rate in excess of SLO Town's cost of funds.

Additional Issues Which Can be Discussed Impairment of a loan SFAS No. 114. This ease can be used to discuss SFAS No. 114 "Accounting by Creditors for Impairment of a Loan". Appendix B contains the necessary information to apply SFAS No. 114. When the first house sells for US$80,000, SLO Town should be suspect that cash flows will be iusutticient to pay off the principal and interest. Immediately prior to the first sale, the loan had a US$3,353,571 carrying value (US$3,298,594 + 54,977 cash flows are assumed to occur at the beginning of the month). SFAS No. 114 requires the creditor to discount the cash flows using the loan's effective interest rate at the time of origination. Taking the 3% origination fees into account, the effective interest rate at the date of origination would have been 21.23264°/.. At the time of the first sale, the present value of the projected cash flows generated from an US$80,000 sales price would be US$3,006,405 at this discount rate. SFAS No. 114 would require SLO Town to recognize a US$347,166 loss. The present value would be US$3,070,302 if the 20% contract rate were used as the discount rate.

SFAS No. 66 "Accounting for Sales of Real-estate". In addition to "ADC Arrangements" and the proposed SoP, you might have a third group of students read SFAS No. 66 "Accounting for Sales of Real-estate". This group could evaluate the transaction as if SLO Town S&L owned the land and sold it to Stanbell Construction to develop. SFAS No. 66 would not permit SLO Town to accrue profit on such a transaction, because Stanbell Construction did not make any investment nor did it assume the risk and rewards of ownership. Hierarchy of GAAP. This ease introduces students to diverse sources of accounting pronouncements other than SFAS, which helps them realize that the FASB is not the only source of professional guidance. Students also learn that accounting pronouncements do not have equal authority. "Accounting Principles" lET 203.03] states that SFAS, together with Accounting Research Bulletins and APB Opinions, constitute accounting principles. However, generally accepted accounting principles encompass more conventions, rules and procedures than those designated above. The Auditing Standards Division found it necessary to issue Statement on Auditing Standards No. 69 "The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles in the Independent Auditor's Report", which established the following hierarchy of accounting principles:

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Category (a). Category (b).

Category (c).

Category (d).

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Accounting principles promulgated by a body designated by the AICPA Council to establish such principles, pursuant to rule 203 [ET section 203.1] of the AICPA Code of Professional Conduct... Pronouncements of bodies, composed of expert accountants, that deliberate accounting issues In public forums for the purpose of establishing accounting principles or describing existing accounting practices that are generally accepted, provided that those pronouncements have been exposed for public comment and have been cleared by a body referred to in category (a). Pronouncements of bodies, organized by a body referred to in category (a) and composed of expert accountants, that deliberate accounting issues in public forums for the purpose of interpreting or establishing accounting principles or describing existing accounting practices that are generally accepted, or pronouncements referred to in category (b) that have been cleared by a body referred to in category (a) but have not been exposed for public Comment. Practices or pronouncements that are widely recognized as being generally accepted because they represent prevalent practice in a particular industry, or the knowledgeable application to specific circumstances of pronouncements that are generally accepted.

The categories described in SAS No. 69 are difficult for students to envision becausse they have little experience working with accounting pronouncements. Practice Bulletin 1 in the AICPA Technical and Practice Aids provides an explanation which dearly fits into the SAS No. 69 framework. Practice Bulletins and SoPs are issued by AcSEC which is an expert body; both are discussed in open meetings; and drafts of both are given to the FASB for review prior to publication. "ADC Arrangements" would be category (e) because Practice Bulletins are not exposed for public comment. The proposed SoP "Identifying and Accounting for Real-estate Loans that Qualify as Rcal-estate Investments", which is currently under exposure, introduces students to the accounting profession's exposure process. SoPs are exposed for public comment and are category (b).

Suggested Answers to Assignments

Assignments---Part One 1. Cash flows are identical for the first 71 months regardless of whether the transaction is reported as an investment or a loan. If the transaction is reported as a loan, SLO Town's share of the profit distribution will be US$1,427 less than if they reported the transaction as an investment. However, the US$1,427 is an immaterial amount and the distribution will not take place until the end of the 72nd month. Because SLO Town's net worth was low and management was concerned the FHLBB might place SLO Town in receivership, management would be expected to prefer reporting the transaction as a loan. If they report the transaction as a loan, SLO Town S&L would recognize more income in the first 3 years and its net worth would increase faster. If the transaction is reported as a loan, interest expense on the loan will reduce the profits available for distribution to the partners. Stanbcll Construction will insist on a higher percentage of the profits to offset the lower profits available for distribution. 2. Over the project's life, income equals net cash flows. This is evident in Exhibit 2 where the 12/31/86 cash balance equals retained earnings. Retained carnings as of December 31, 1986 can also be compared to the net cash flows in Exhibit 1.

Distinguishing between Loans and Equity Investments

577

Reporting negative cash flows for the first 2 years would be of limited value to investors who are interested in future cash flows. Nor would the third year's US$207,000 positive cash flow be useful in predicting future cash flows. However, the US$451,680 income reported in 1983 can be used to assess the development's future cash flows. Because Laguna Shores generated US$451,680 profit from the sale of 12 houses investors might project profit and cash flows from the sale of all 100 houses to total US$3,764,000. 3. Accounting standards recognize income from equity investments conservatively due to the residual nature of equity investments and the resulting uncertainty of these cash flows. Recipients of dividends from passive investments do not recognize income until the dividends are declared. Furthermore, the investee must have reported income before it can declare dividends. Likewise, equity method investors do not recognize income until the investee earns income. On the other hand, interest on loans is accrued as income with the passage of time, even if the investee has not earned any income. 4. An equity investment entitles the investor to a residual interest in the net assets of an entity that remain after the liabilities have been satisfied. The amount of this residual interest is unspecified and is related to the performance of the entity. Distributions to investors are discretionary and the entity has no obligation to return the investor's capital or pay a return on that capital. A loan, on the other hand, entitles the lender to receive payments on specified dates. The borrower is typically obligated to return the lender's capital and pay interest on the capital. The borrower has little or no discretion to avoid the future payments, and the satisfaction of the entity's liabilities takes precedence over distributions to its owners. Investors typically assume most of the risks and rewards of ownership. With lending activities the borrower typically assumes most of the risks and rewards of ownership. In this case, SLO Town assumes of the risks of ownership even when the transaction is structured as a loan. Exhibit D3 shows that Laguna Shores will be unable to pay off the loan if the houses sell for US$80,000. Because the agreement absolves Stanbell Construction of any liability, SLO town S&L would absorb the entire loss in year 6. It should be pointed out that, even with an US$80,000 selling price, total cash receipts will exceed total expenditures. This means that SLO Town should recognize income from the project. However, SLO Town S&L should not report the full amount of interest income in the first five years of the project if there is a reasonable possibility of a loss in year 6. As soon as Laguua Shores begins selling houses for US$80,000, SLO Town S&L should be aware that revenues will not be sufficient to cover principal and interest. At this time, SLO Town should take corrective action. SLO Town S&L might reduce the interest rate on the loan so total costs plus interest expense no longer exceed revenues.

Assignments--Part Two 1. Cumulative preferred stock dividends are similar to interest payments in that both receive precedence over dividends to common stockholders. 2. If SLO Town contributes capital to Laguua Shores, it cannot report investment income until Laguna Shores reports income. If SLO Town is a significant common stock investor, then it will not report income under the equity method until Laguna Shores reports a profit. If SLO Town holds preferred stock or a passive common stock investment, then it will not report investment income until Laguna Shores declares a dividend, which requires retained earnings. 3. Interest is a cost which Laguua Shores either expenses or capitalizes and then amortizes to cost of houses sold. Dividends, on the other hand, are distributions of

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earnings to owners. Therefore, Laguna Shore's costs would be lower if SLO Town purchases its preferred stock instead of lending it money. 4. Interest is typically accrued at a retail lending rate that exceeds the cost of funds and creates profit. The amount of interest to be capitalized, on the other hand, is the cost of interest that could have been avoided if the project had not been undertaken. Although capitalization of interest does reduce SLO Town's interest expense it does not create profit. It defers recognition of the expense until the cost can be matched to the related revenue, which in this case is from the sale of houses.

Background and Reference Materials to Which Students Must Have Access Required AICPA Proposed Statement of Position. (1993). Identifying and accounting for realestate loans that qualify as real-estate investments. New York: AICPA. AICPA Technical Practice Aids. (1992). Practice Bulletin 1: Purpose and scope of

AcSEC practice bulletins and procedures for their issuance. Exhibit I, ADC arrangements. New York: AICPA.or Audits of Savings Institutions. (1991). ADC arrangements: Appendix A. New York: AICPA.

Optional FASB Discussion Memorandum. (1990). Distinguishing between liability and equity instruments and accounting for instruments with characteristics of both. Norwalk, CT: FASB. FASB. (1992). FASB originalpronouncements, accounting standards: APB No. 18, The equity method of accountingfor investments in common stock. AINAPBIS, No. 2, The equity method of accoantingfor investments in common stock:

Accounting interpretations of APB Opinion No. 18. SFAS No. 34, Capitalization of interest costs. SFAS No. 66, Accountingfor sales of real-estate. Norwalk, CT: FASB. AICPA (1992). AICPA professional standards: Code of Professional Conduct Rule 203, Accounting principles. SAS No. 69, The meaning of present fairly in conformity with generally accepted

accounting principles in the independent auditor's report. New York: AICPA. Materials can be ordered from AICPA at (800) 8624272. Materials can be ordered from FASB: FASB, P.O. Box 5516, Norwalk, CT 06856-5116, USA.