7.3 Participating Mortgages
7.3.1 Background
ASC 470-30 addresses a debtor’s accounting for a participating mortgage, which is
a mortgage loan that entitles the investor to share in either (or both) an
increase in the market value of, or the income from, a mortgaged real estate
project. Under ASC 470-30, the accounting depends on whether the participation
involves market value appreciation (see Section 7.3.3) or
the project’s results of operations (see Section
7.3.4).
7.3.2 Scope
ASC 470-30
05-1 This
Subtopic establishes the borrower’s accounting for a
participating mortgage loan if the lender is entitled to
participate in any of the following:
-
Appreciation in the fair value of the mortgaged real estate project
-
The results of operations of the mortgaged real estate project.
05-2 The
desire for instruments in which the return to the
lenders was tied more closely to the performance of the
property led to the introduction of participating
mortgage loans.
05-3
Participating mortgage loans and nonparticipating
mortgage loans share all of the following
characteristics:
-
Debtor-creditor relationships between those who provide initial cash outlays and hold the mortgages, and those who are obligated to make subsequent payments to the mortgage holders
-
Real estate collateral
-
Periodic fixed-rate or floating-rate interest payments
-
Fixed maturity dates for stated principal amounts.
05-4 However,
unlike a nonparticipating mortgage loan arrangement, in
a participating mortgage loan, the lender participates
in appreciation in the fair value of the mortgaged real
estate project or the results of operations of the
mortgaged real estate project, or in both.
05-5 The
terms and economics of participating mortgage loan
agreements vary by agreement. The terms and economics of
one agreement may create a circumstance in which any
participation payment is remote. In another agreement,
the terms and economics may transfer many of the risks
and rewards of property ownership.
05-8 The
participation terms of a participating mortgage loan
agreement usually are negotiated concurrently with the
other terms of the underlying mortgage loan. A borrower
agrees to participation rights generally because of
market conditions, or in exchange for concessions
granted by the lender on some other term(s) of the loan,
such as a lower interest rate or a higher loan-to-value
ratio.
05-9 The
lender’s participation reduces the borrower’s potential
realization of operating results or gain on the sale of
the real estate. However, the participation also may
reduce any of the following:
-
The contract interest the borrower is required to pay
-
The risk that the borrower will be unable to pay interest at the stated or floating rate in the loan agreement and, consequently, the risk that the borrower will default on the loan and need to sell the property
-
The amount of capital the borrower has at risk, because the loan-to-value ratio normally is higher.
Further, the obligation to pay the lender a share of the
property appreciation does not increase the current
exposure of the borrower to loss in its investment,
because the participation payments are made only if the
fair value of the property appreciates.
15-1 The
guidance in this Subtopic applies to the following
entities:
- All borrowers in participating mortgage loan arrangements.
15-2 The
guidance in this Subtopic does not apply to the
following entities:
- Creditors in participating mortgage loan arrangements.
15-3 The
guidance in this Subtopic does not apply to the
following transactions and activities:
-
Participating leases
-
Debt convertible at the option of the lender into equity ownership of the property
-
Participating loans resulting from troubled debt restructurings.
In exchange for allowing the creditor to participate in the real
estate project that is financed by a loan, the debtor might receive a reduced
interest rate, more favorable debt covenants, higher loan-to-value ratios, or
other benefits. That is, the lender generally grants certain concessions to the
borrower in return for the right to participate in the appreciation in the fair
value of the mortgaged real estate project, the operations of the project, or
both. The borrower has received something of value (e.g., a lower interest rate)
in exchange for the participation feature and must therefore recognize the
exchange.
ASC 470-30 does not apply to (1) participating mortgages for
which the borrower has elected the fair value option in ASC 815-15 (see
Section 8.5.6)
or ASC 825-10 (see Section
4.4), (2) participating leases, (3) debt that is convertible into
an ownership interest in the mortgaged property, or (4) participating loans
resulting from TDRs under ASC 470-60 (see Chapter 11). If a participation feature in
a debt obligation is contingent on the sale of the property (e.g., a requirement
to pay 20 percent of any sales proceeds) and the borrower has no obligation to
sell the property, ASC 470-30 does not apply because the lender is not entitled
to participate unless the borrower elects to sell the property. Further, ASC
470-30 applies only to debt with a participation feature that does not represent
a separate unit of account (see Section 3.3). If the participation feature
is a separate unit of account that is not subject to other applicable GAAP
(e.g., derivative accounting), the issuer should consider the indexed-debt
guidance that applies to separable contingent payments (see Section 7.4).
Typically, participation features in participating mortgage loans are not
bifurcated as derivative instruments under ASC 815-15. There are scope
exceptions in ASC 815-10-15-59 to the derivative accounting requirements for
non-exchange-traded contracts whose underlying on which the settlement is based
is either (1) the price or value of a nonfinancial asset of one of the parties
of the contract provided that the asset is not readily convertible to cash (if
the nonfinancial asset is unique and the nonfinancial asset is owned by the
party that would not benefit from an increase in the fair value of the
nonfinancial asset; see Section 8.4.9.5) or (2) specified
volumes of sales or service revenues of one of the parties to the contract (see
Section 8.4.10.5). ASC 815-15-55-8 and 55-9 contain the
following illustration of a participation feature that is exempt from the scope
of ASC 815:
ASC 815-15
55-8 Under an example
participating mortgage, the investor receives a
below-market interest rate and is entitled to
participate in the appreciation in the fair value of the
project that is financed by the mortgage upon sale of
the project, at a deemed sale date, or at the maturity
or refinancing of the loan. The mortgagor must continue
to own the project over the term of the mortgage.
55-9 This instrument has a
provision that entitles the investor to participate in
the appreciation of the referenced real estate (the
project). However, a separate contract with the same
terms would be excluded by the exception in paragraph
815-10-15-59(b) because settlement is based on the value
of a nonfinancial asset of one of the parties that is
not readily convertible to cash. (This Subtopic does not
modify the guidance in Subtopic 470-30.)
It may be appropriate for an entity to apply the participating mortgage guidance
by analogy to other financial instruments that pay amounts on the basis of the
issuer’s own operations unless the feature must be bifurcated as a derivative
instrument under ASC 815-15 or other accounting requirements apply.
7.3.3 Participation in Market Value Appreciation
7.3.3.1 Background
ASC 470-30
05-6 A lender may be
entitled to participate in appreciation in the fair
value of a project at any one of the following
times:
-
Upon the sale of the project
-
At a deemed sale date
-
At the maturity or refinancing of the loan.
In exchange for more favorable debt terms, a debtor might permit the creditor
to participate in the appreciation in the value of the mortgaged property
(e.g., 25 percent of any increase in the value of the property in excess of
the initially appraised value). That participation feature might be payable
on earliest of the loan’s maturity date, the sale of the property, or the
refinancing of the loan.
7.3.3.2 Initial Accounting
ASC 470-30
25-1 If a lender is
entitled to participate in the appreciation of the
market value of a mortgaged real estate project, the
borrower shall recognize a participation liability
with a corresponding debit to a debt discount
account.
30-1 If the lender is
entitled to participate in appreciation in the fair
value of the mortgaged real estate project, the
borrower shall determine the fair value (see
Subtopic 820-10) of the participation feature at the
inception of the loan (see paragraph 470-30-25-1 for
guidance on how to recognize the participation
feature).
ASC 470-30 requires that when the lender participates in the appreciation of
the mortgaged real estate project’s market value, the debtor must recognize
a participation liability equal to the fair value of the participation
feature at the inception of the loan. The offsetting entry is recognized as
a discount on the debt, which is amortized as an adjustment to interest cost
over the life of the loan.
For example, the debtor might make the following entry on
initial recognition:
Cash (or other consideration received)
Mortgage loan discount
Mortgage loan
Participation feature (at fair value)
7.3.3.3 Subsequent Accounting
ASC 470-30
35-1 The debt discount
shall be amortized by the interest method, using the
effective interest rate.
35-2 Interest expense on
participating mortgage loans consists of the
following three components:
-
Amounts designated in the mortgage agreement as interest
-
Amounts related to the lender’s participation in results of operations
-
Amortization of debt discount related to the lender’s participation in the fair value appreciation of the mortgaged real estate project.
35-4A If a lender is
entitled to participate in the appreciation of the
market value of a mortgaged real estate project,
both of the following are required at the end of
each reporting period:
-
The balance of the participation liability shall be adjusted to equal the current fair value of the participation feature.
-
The corresponding debit or credit shall be recorded in the related debt-discount account.
35-5 The revised debt
discount shall be amortized prospectively, using the
effective interest rate.
45-1 The amortization of
the debt discount relating to the participation
liability shall be included in interest expense.
After the inception of the loan, the entity adjusts for any
changes in the fair value of the participation feature so that its
measurement equals its current fair value as of the reporting date, with a
corresponding offset to the debt discount. For example, if the fair value of
the participation feature increases, the debtor would make the following
entry:
Mortgage loan discount
Participation feature (increase in fair value)
If the fair value of the participation feature decreases,
the debtor would make the following entry:
Participation feature (decrease in fair value)
Mortgage loan discount
The adjusted debt discount is amortized prospectively to
interest expense by adjusting the debt’s effective interest rate over its
remaining life (see Section 6.2.3.3); that is, by using a prospective interest
method. This means that although changes in the fair value of a market value
participation feature in a participating mortgage are reflected immediately
on the debtor’s balance sheet, they are not recognized immediately in net
income. Instead, they are recognized over time through a prospective yield
adjustment that affects the recognition of interest expense over the debt’s
remaining life.
Generally, both increases and decreases in the fair value of
the participation feature are recognized. However, ASC 470-30-35-3 precludes
subsequent reversals of appreciation if interest amounts have been
capitalized under ASC 835-20 (see Section 14.2.4).
Periodic interest expense for mortgage loans that entitle
the lender to participate in the market value appreciation of the mortgaged
real estate project includes amounts designated in the mortgage agreement as
interest and the periodic amortization of the debt discount created by the
participation liability. These amounts should be recognized by using the
interest method (see Section 6.2). If the investor also participates in the
results of the mortgaged real estate project’s operations, such amounts are
recognized as interest expense as they become due (see Section 7.3.4.3).
7.3.3.4 Example
ASC 470-30
Example 1: Accounting by Participating Mortgage
Loan Borrower
55-1 This Example
illustrates the guidance in this Subtopic.
55-2 Assume that on
January 1, 19X1, Borrower Co. purchased a property
for $10 million. On that date, Borrower paid $1
million cash and entered into a participating
mortgage loan agreement with Lender Co. in the
amount of $9 million.
55-3 The loan agreement
has the following terms:
-
15 year term
-
Interest-only periodic payments, principal to be repaid at end of term
-
5% stated interest rate
-
20% participation in appreciation in the value of the property above $10 million, payable at maturity (or earlier if the asset is sold or the loan is refinanced).
55-4 Assumptions related
to the fair value of the participation feature are
as follows.
55-5 Based on the
preceding assumptions, Borrower Co. should make the
following journal entries for this participating
mortgage loan.
a. On January 1, 19X1, the following journal
entries should be recorded:
b. By the end of 19X1, entries to record
interest expense and amortization of discount
throughout the year would have taken the following
form:
c. At the end of 19X2, entries to record
interest expense and amortization of discount
throughout the year would have taken the following
form:
7.3.4 Participation in Results of Operations
7.3.4.1 Background
ASC 470-30
05-7 In agreements in which
lenders participate in results of operations, the
definition of the results of operations may vary
among agreements. Examples of these definitions
include, but are not limited to, the following:
-
Revenue
-
Income
-
Cash flows before or after debt service.
In exchange for more favorable debt terms, a debtor might allow a creditor to
participate in the results of operations of a real estate project. For
example, the debtor and creditor might agree to share in the revenue, net
income, or net cash flows of a mortgaged office or apartment building.
7.3.4.2 Initial Accounting
ASC 470-30 prescribes an accounting model for mortgage loans for which the
lender participates in the results of operations of the mortgaged real
estate project that is different from the accounting model for market value
participation features. Under ASC 470-30, the borrower recognizes no
liability for the fair value of the participation feature at inception.
Instead, a participation liability is recognized as amounts become
contractually due.
Therefore, the debtor might make the following entry on initial recognition:
Cash (or other consideration received)
Mortgage loan
7.3.4.3 Subsequent Accounting
ASC 470-30
35-2 Interest expense on
participating mortgage loans consists of the
following three components:
-
Amounts designated in the mortgage agreement as interest
-
Amounts related to the lender’s participation in results of operations
-
Amortization of debt discount related to the lender’s participation in the fair value appreciation of the mortgaged real estate project.
35-4 Amounts due to a
lender pursuant to the lender’s participation in the
real estate project’s results of operations (as
defined in the participating mortgage loan
agreement) shall be charged to interest expense in
the borrower’s corresponding financial reporting
period, with a corresponding credit to the
participation liability.
Interest expense on mortgage loans that participate in the results of
operations consist of the amounts designated in the loan agreement as
interest as well as amounts that become due to the creditor related to the
participation feature in the results of operations. The participation
feature in the results of operations is not separately recognized by the
borrower before related amounts become due. When amounts become due, the
debtor recognizes a corresponding charge to the income statement (interest
expense). For example, the debtor might make the following entry when it
becomes legally obligated to pay such amounts:
Interest expense
Mortgage loan (or accrued mortgage
participation liability)
A creditor that participates in both market value
appreciation and results of operations of the mortgaged real estate project
applies the guidance on participation features in market value appreciation
when accounting for the participation in such appreciation (see Section 7.3.3).
7.3.5 Other Considerations
7.3.5.1 Variable-Rate Participating Mortgages
ASC 470-30
35-3 Amounts designated in
the mortgage agreement as interest shall be charged
to income in the period in which the interest is
incurred. If the loan’s stated interest rate varies
based on changes in an independent factor, such as
an index or rate (for example, the prime rate, the
London Interbank Offered Rate [LIBOR], or the U.S.
Treasury bill weekly average rate), the calculation
of the interest shall be based on the factor (the
index or the rate) as it changes over the life of
the loan. Interest recognized pursuant to this
guidance is subject to the requirements of Subtopic
835-20. Once capitalized, amounts shall not be
adjusted for the effects of reversals of
appreciation.
The amount that is reported as interest expense for a
participating mortgage loan includes the stated interest rate, amounts due
to the lender for its participation in the real estate project’s results of
operations (see Section
7.3.4.3), and the amortization of any debt discount
associated with a participation liability in the real estate project’s fair
value appreciation (see Section 7.3.3). For stated interest rates that vary on the
basis of changes in a reference interest rate index (such as a prime rate or
benchmark interest rate), ASC 470-30 requires the debtor to accrue the
amounts designated as interest in accordance with the interest rate in
effect in each period as such rate changes over the debt’s life (see also
Section
6.2.5.2).
7.3.5.2 Extinguishments
ASC 470-30
40-1 If the participating
mortgage loan is extinguished before its due date,
the difference between the recorded amount of the
debt (including the unamortized debt discount and
the participation liability) and the amount
exchanged to extinguish the debt is a debt
extinguishment gain or loss.
45-2 If the participating
mortgage loan is extinguished before its due date,
the debt extinguishment gain or loss shall be
reported as required by paragraph 470-50-40-2.
The borrower should apply the general derecognition guidance
for liabilities in ASC 405-20 (see Chapter 9) and ASC 470-50 (see
Chapter
10). The calculation of the debt extinguishment gain or loss is
based on a comparison of the reacquisition price with the net carrying
amount of the debt. The net carrying amount includes any related
participation liability and any unamortized debt discount. Because ASC
470-30 requires entities to measure participation liabilities related to the
market value appreciation of the mortgaged real estate project at their fair
value on a recurring basis, the debtor should update its estimate of the
fair value of a participation liability as of the extinguishment date.
7.3.5.3 Disclosure
ASC 470-30
50-1 The borrower’s
financial statements shall disclose both of the
following:
-
The aggregate amount of participating mortgage obligations at the balance sheet date, with separate disclosure of the aggregate participation liabilities and related debt discounts
-
Terms of the participations by the lender in either the appreciation in the fair value of the mortgaged real estate project or the results of operations of the mortgaged real estate project, or both.
ASC 470-30 requires entities to provide additional disclosures beyond those
that otherwise apply to debt instruments.