Asset impairment charges have cost the top 15 public home builders more than $16.5 billion since the beginning of 2006. Consequently, builders' net worth has eroded, throwing off financial ratios and threatening to trigger debt covenants. However, the damage from write downs may not end there. Because builders are potentially facing additional losses in 2008, the impairments have tax implications that could result in more charges to the balance sheet.
Case in point: Hovnanian Enterprises. At the close of its fourth quarter in late December, it booked a $216 million reserve against deferred tax assets. The move came at the urging of accounting firm Ernst & Young, which argued that under FAS 109 the company would be unable to recover its tax-deferred assets in the near term because its profitability over a three-year period was in question.
Less than a month later, KB Home took a $514.2 million charge to income tax expenses and a reduction of the company's deferred income tax assets.
Deferred income tax assets are effectively future tax deductions that a builder receives once management sells an asset and realizes any impairment in book value that may have been made. As a general rule of thumb, if the builder has cumulative profits over three years, it will be able to take advantage of the tax deduction. However, if the company fails to make cumulative profits, it's a different story. And now that the three-year period builders are looking at includes the potentially dreadful 2008 instead of the wildly profitable 2005, many are preparing for a higher tax rate in the form of reserve charges.
Those charges should be recouped once the company returns to profitability; but in the interim, reserve charges are pulling down builders' tangible net worth, putting many in danger of breaching covenants with their banks.
"If Ernst & Young does this to all of the builders they audit, virtually every builder is going to be in a position of violating their debt covenants," says Stephen East, managing director for Pali Capital. "They're going to have to go back to the banks and get waivers."
Hovnanian CFO Larry Sorsby says that its banks have already given the builder waivers on this issue. But whether or not a builder will record a reserve is subject to interpretation–a fact that is creating some industry unease.
"We are concerned that not all accounting firms and home building companies will interpret FAS 109 in the same way," Sorsby says. "Due to the cyclical nature of the home building industry, the fact that most home builders have only experienced one year of losses and the idea that it is probable that the home building industry will return to profitability during near-term years, it is likely that not all accounting firms will interpret FAS 109 in the same manner."
Because there is no single solution to dealing with this issue, every management team will have to wrestle with the problem to determine the right course of action for their company. "It's something that everybody is running into now," says Ed Madell, CFO of Kimball Hill Homes.