By John Caulfield. Home builders and their auditors are only now getting their hands around an esoteric accounting rule change aimed at curbing the off-balance-sheet abuses which recent financial scandals at Enron and other corporations have exposed.
As the next quarterly reporting cycle approaches, the implications could be significant for builders because this rule change establishes tougher guidelines defining when builders must disclose to investors certain financial details about the way they manage land assets.
Many builders claim to control huge tracts of land they don't actually own, and report the assets and related debt of those transactions only after they've purchased the land. This way, builders have been able to keep land off their books until they are ready to build on it. Plus, builders don't have to worry much about the accounting ramifications of their walking away from land deals if business conditions shift.
What's changed is subtle, but important. The accounting rule change states that the "primary beneficiary" in any business relationship -- that is, the partner that has the potential for bearing the most risk or reward from the activities of any business entity -- must "consolidate" the assets of that entity onto its books.
This rule change wasn't written specifically with home builders in mind. And the complexity of its language as a result has triggered an arduous, deal-by-deal analysis by many builders of their real estate transactions to determine which must be consolidated and which are exempt.
"More entities will fall into this definition than [builders may] think," predicted Barry Moss, a partner in Ernst & Young's real estate group. Another partner, Michael Neary, added that it was essential for builders to go through a "complex evaluation" of each land deal to ascertain who is the "primary beneficiary" of the entity's activities.
None of the builders contacted for this article thought the rule change would lead them to substantively alter how they manage land. Nor did they expect that the rule change would "materially" affect their balance sheets. But clearly, any mandate that could impel builders to disclose more liability or burps in their cash flow on their books can't be taken lightly.
"This interpretation was something of a surprise to us and our accountants, and could have a negative impact on our [financial] presentation if we are obligated to consolidate all of our options," said Sam Fuller, CFO of D.R. Horton, in Arlington, Texas, which controls 47 percent of its land assets through options.
When Investment Is Seen as a Risk
CFOs got their first glimpse of the new rule January 17. That's when the Financial Accounting Standards Board issued a 56-page document that provided new guidance to companies about off-balance-sheet transactions. In its interpretation, known as FIN 46, the FASB stated that companies now must consolidate onto their balance sheets any "Variable Interest Entities" in which the equity investment at risk isn't sufficient to permit the entity to pay for its activities without the injection of more financial support. Companies must also consolidate VIEs when they bear the greatest risk of expected losses or residual returns from an entity's activities.
VIEs created after Jan. 31 are subject immediately to FIN 46, as are companies to its disclosure requirements. VIEs created before that date are subject to FIN 46 after June 15 for public companies, and after Jan. 1, 2004, for private companies.
Before issuing its interpretation, FASB required companies to consolidate other entities onto their balance sheets only when they had a controlling financial or voting interest. Now, voting interests "are no longer the only factor," explained Ben Fried, a partner in the real estate group of Deloitte and Touche, in Los Angeles.
"What's as important is who stands to gain or lose money primarily" as a result of that entity's activities, said Fried. VIEs that, according to FIN 46, don't "effectively disperse risk" among equity investors will need to be consolidated by the company that bears the greatest risk as a result of the entity's activities, he said.
However, applying FIN 46's broad language to the home building industry has been daunting. "It's a view from the clouds," observed Leigh Austin, the president of Santa Monica, Calif.-based Saybrook Community Capital, which provides builders with land acquisition financing through structured options. Even Michael Joseph, a partner in Ernst & Young's National Professional Practices group, quipped that the scope of this interpretation is "like Jell-O" in its expansiveness.
The seminal issue that FIN 46 raises for builders appears to center around the relative risks involved in investment for the purposes of gaining access to land. Jim Pugash, CEO of Hearthstone, a San Francisco-based provider of equity for land acquisition, explained that in the past, "builders would put up 'x' amount just under the bar -- the rule of thumb was 20 percent -- to be able to keep the land controlled off their books.
"That bar between owning and optioning has moved," said Pugash, whose company has nearly $1 billion in capital commitments with builders. "How much can builders sink into a property before the accountants have to start putting that on their balance sheets?"
Will Options Still Be an Option?
Fuller, of D.R. Horton, observed that the home building industry is lined with tombstones that read "long and wrong on land." While some large builders -- such as Centex, M/I Schottenstein Homes, and Toll Brothers -- own most of the land they control, the specter of that graveyard informs the choice many builders make in using options as a less risky alternative for controlling significant chunks of real estate over extended time periods without knocking their debt-to-capital ratios out of kilter.
"Land is an increasingly important and difficult component of our business," said David Weiss, CFO of Beazer Homes USA, in Atlanta. "We need the ability to control land for two [or] three years, and if things don't go well, to be able to dispose of it" at a relatively modest cost.
Accounting for Land Deals
Auditor attempts to guide builders in dealing with new FIN 46 accounting rule.
Builders' land management strategies involve many different kinds of agreements, so their compliance with FIN 46 invariably will become "circumstance based," advised Jeff Slate, a senior manager with Ernst & Young. "Builders are going to have to devise cash-flow scenarios and probability rate them" for risk.
In March, Ernst & Young conducted an interactive webcast on the subject (archived at www.ey.com/webcast), during which three experts provided a detailed -- and at times arcane -- examination of the interpretation's key points and how they may apply to their client's business.
At the conclusion of the webcast, Ernst & Young offered some advice about the mechanics of consolidating special investment entities called VIEs, as well as five points that builders and other clients need to think about to conform their balance sheets to this interpretation:
Option purchases provide builders with the risk cushion they covet, and their importance cannot be exaggerated. For example, Beazer controls half of its land assets through options. KB Home, in Los Angeles, reported that 49,417 of the 100,200 lots it controlled in the United States in 2002 were through options. Even WCI, a regional builder based in Bonita Hills, Fla., which eschews limited partnerships and owns 90 percent of the 25,000 entitled units it controls, views certain types of options as appropriate off-balance-sheet transactions that are particularly attractive when the penalty for backing out of a deal is minimal, said Jim Dietz, WCI's CFO. Some builders feared that auditors, in their quest to regain some of their pre-Enron respectability, would give a risk-averse reading to this rule change that captures certain options and forces builders to disclose the entire purchase price of the land well in advance of their taking ownership of it; that is, if they actually buy the land at all.
One major builder was girding for that eventuality. "We would disagree with the argument that certain options won't have to be consolidated," said Larry Sorsby, CFO of Hovnanian Enterprises, based in Red Bank, N.J., which controls three-quarters of its 57,000 home sites through options that its wholly owned subsidiaries purchase from land owners. He added that Hovnanian would evaluate all deals to determine which partner bears the highest risk. Yet, like most builders, Sorsby emphasized when interviewed that it would be "premature" to speculate on the impact of FIN 46.
Some industry players contend that during the past several years home builders have been moving away from longer-term land commitments with the kind of entities that this rule change may touch upon directly.
"The vast majority of [builders'] land assets are not off balance sheet anyway," observed Carl Reinhardt, housing analyst with Bank of America Securities. Gene Rowehl, CFO of Kimball Hill Homes, in Rolling Meadow, Ill., noted that, unlike Enron, builders don't use VIEs to move losses off of their books. "They are moving land assets to reduce short-term risk. It's not like we're not reporting this."
Still, calculating "risk," as defined by FIN 46, could be a big headache for most builders because "there are very few statistical precedents," explained Toll Brothers' CFO Joel Rassman. "It's not as if a series of mortgages were rolled into a special purpose entity, and you could assess the risk based on the history of mortgage defaults. These rules were not written for real estate companies and weren't designed to capture these kinds of transactions."
Further complicating matters is the fact, which several builders pointed out, that each land deal can have unique qualities which would make compliance "almost as much art as science," said Wade Cable, CFO of William Lyon Homes, in Newport Beach, Calif. "There are always 'tweaks' in every deal when it comes to profit splits, voting power, and ownership. Every venture is a negotiation, so I can't see any absolute, black and white [application] of this rule."
That diversity could be a double-edged sword, which Dietz, of WCI, and other builders suggest could lead auditors to take FIN 46 to "inappropriate extremes" that would capture most land deals, regardless of their underlying purpose.
That wouldn't be the first time builders got snared in the web of what Barbara Allen, a housing analyst with the New York-based investment firm Natexis Bleichroeder, called "idiotic" accounting regulations. She remembered when a decade ago several large builders in California took "substantial" write-downs after FASB required that their financial subsidiaries be fully incorporated onto their balance sheets.
Rassman, of Toll Brothers, spoke of an FASB rule which governs "fair value," in which the first draft excluded builders but the final draft -- which many builders overlooked -- required builders to treat interest as an expense.
Allen observed that a prominent few builders appear to be playing "fast and loose" with their reporting of land assets at a time when investors are lukewarm on most housing stocks and builders are doing everything they can legally to keep debt off their books. "So more disclosure might actually be a good thing in those cases," she quipped.
Some builders took exception to their accounting practices being mentioned in the same breath as Enron's, even inadvertently. However, they acknowledged that they are constantly tinkering with their land management plans, regardless of changes in accounting practices. D.R. Horton, for one, now consolidates all of its joint ventures. "We don't believe in joint venture financing where we don't control the project," Fuller explained.
The way auditors regard joint ventures could be a litmus test for builders about how they must adjust their accounting and land management policies to comply with FIN 46. Fuller observed that "less-than-controlled" joint ventures seem to have been left alone by the rule change. But one Midwest builder/developer speculated that if auditors counsel builders to consolidate more joint ventures as VIEs, they may choose, instead, to take on more risk themselves to gain greater control of their land assets. "They may take a larger [investment] position in these deals, and we're assuming they won't want any partners anymore," Fuller said.
Builders also were anxious about how auditors ultimately would view their relationship with land banks, an important source of equity for some companies. Even Pugash -- who insisted that Hearthstone's capital beats most other after-tax financing available to builders -- predicted that "there will have to be some changes" to the structure of these agreements in order for companies like his to work with builders in a way that their entities don't get consolidated.
Austin, Saybrook's president, said that because FIN 46 is "principle-based," it will take some time to interpret the specific applicability of the ruling to alternative financing structures such as those provided by companies like hers. If auditors start giving Saybrook, Hearthstone, and other such entities the cold shoulder, Austin stated her concern that the unintended result of FIN 46 could be that it "stymies the flow of capital" into a market where the housing shortage is attributable not only to constraints on land use, but also to constraints on investment capital.
Learn more about markets featured in this article: Los Angeles, CA.