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As if declining home prices and dismal home starts weren’t enough, homebuilders now need to worry about the impact of tax treatments on their bank loans, Debtwire reports. The covenant breaches that KB Home and Hovnanian Enterprises announced in recent weeks stem from an interpretation of a federal accounting standard that governs income taxes.
Ernst & Young’s new take on the accounting rule – FAS 109 – could force additional homebuilders into amendment talks with their lenders as other auditors ponder how to apply it.
“Federal Accounting Standard Rule No. 109 is one of the reasons why all of these homebuilders are going back to their banks,” said Sue Berliner, a REIT and homebuilder analyst and senior managing director with Bear Stearns. “The other reason is due to impairment and abandonment charges.”
Other homebuilders that use Ernst and Young include Standard Pacific, Tousa, and WCI Communities.
FAS 109 contains guidance on how to treat tax assets when a company realizes a cumulative income loss for three consecutive years. During that period, an auditor will apply tests to determine whether a company is able to realize its total tax asset and to reduce income taxes when it returns to profitability. If an auditor decides that a company is unlikely to realize that full tax asset amount because it is projected to be unprofitable over the three-year period, it can force a company to reduce the size of its tax asset.
Projecting growth in 2008 will prove a tough sell for homebuilders given the steep drop-off in housing starts and home prices in recent months. Income booked in a previous year but realized in the current one is also non-applicable because most homebuilders recognize income in the same year they book it, said Kathleen McEligot, a tax partner at Deloitte & Touche.
Ernst & Young circulated its FAS 109 opinion concerning homebuilders on 7 December and informed its clients that the three-year cumulative loss period would contain a two-year look-back period, and a one-year look-forward, Hovnanian management said on a year-end conference call. The policy shifted the home builder’s cumulative loss period to 2006-2008, dropping highly profitable 2005 from the calculation.
“It is a very subjective rule,” said McEligot. “The three-year cumulative loss is not a rule, its just guidance and some industries can have a precipitous loss and get into this situation,” she added.
Meritage Homes, one of the companies Deloitte audits, did not take a FAS 109 charge in its fiscal year-end results, according to a company press release late last night. Lennar Corp and Beazer Homes also use Deloitte for audits.
“Our interpretation [of Meritage’s release] is that Deloitte must be taking a look-back period whereas Ernst & Young is using a two-year look-back and a one-year look-forward,” Berliner said.
McEligot would not comment on Deloitte’s interpretation of FAS 109, but did state that Deloitte looks at FAS 109 on a client-by-client basis.
Auditors at Ernst & Young forced both KB Home and Hovnanian Enterprises to reduce their tax assets by creating a valuation allowance. That valuation allowance became a non-cash after-tax charge to both companies’ net income, said McEligot. Shareholder equity flows from retained earnings and when retained earnings fall, so does shareholder equity, McEligot said.
Shareholder equity is the principal input for calculating tangible net worth, a key metric in homebuilders’ bank loan covenants. In 3Q07, California-based Standard Pacific had to amend its minimum tangible net worth covenant because of land impairments - never mind its tax treatment.
Some homebuilders rushed to sell assets at a deep discount in 2H07 in an effort to offset the impact of a reduction to their tax assets, said one industry analyst. The land sales – some at losses of 60% -- allow homebuilders to get a partial refund of taxes they paid in 2005, said the analyst and an investor.
“It doesn’t solve the problem, but selling land will eat into a part of [the valuation allowance],” said the analyst.
Lennar announced in late November it had completed a USD 525m land sale when it entered into a joint venture with Morgan Stanley Real Estate Partners, as previously reported. That allowed it to recoup some 2005 taxes before it began impairing its owned land, the industry analyst said. Standard Pacific sold land in San Antonio, Texas, and Tucson, Arizona, before the year end for roughly USD 100m, as previously reported.
Hovnanian’s USD 200m 6.5% senior notes due 2015 traded at 63 today, down from 65.5 on 11 January, a gap of 4 points from the previous trade of 69 on 20 December, according to MarketAxess. Lennar’s USD 499m 5.6% due 2015 are also down to 73.5 from 78 on 10 January and 80 on 11 December, MarketAxess showed.
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