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Participating mortgage loans: a historical cost paradox.

During the 1980s, when rising interest rates made otherwise promising real estate projects uneconomical, a financing device known as a participating mortgage loan was born. With this type of loan, lenders were given the opportunity to participate in a project's potential appreciation or operating profits in exchange for a reduction in the loan's interest rate or an increase in the loan-to-value ratio. Because of participating mortgages' lower fixed-financing costs and initial investment requirements, developers were able to undertake real estate projects that otherwise might have been rejected as too risky.

Today, many participating mortgages remain outstanding and, in spite of the soft real estate market, many lenders are eligible to receive a share of property appreciation. Nevertheless, the accounting rules for participating mortgages remain unclear and have grown controversial. In fact, Securities and Exchange Commission Chief Accountant Walter P. Schuetze recently announced in a public meeting that increasing an asset account to offset the payment for a participation in appreciation would be unacceptable in filings with the SEC.

That announcement bodes ominously for borrowers, many of whom expected to amortize the participation payment over an extended time period rather than taking an immediate charge to the income statement. This article reviews the basics of participating mortgages and outlines a paradox that the accounting treatment of these loans creates.


A participating mortgage includes a claim against the borrower that is contingent on the mortgaged property's performance. The ultimate effect of that contingent claim may vary based on the negotiated terms of the loan and the property's performance. For example, participation on a property located in an economically depressed area may become effective only if the property's value doubles, making it unlikely the borrower will have to pay anything for the participation feature. Or the terms may be structured so the borrower retains so few of the risks and rewards of property ownership that it essentially operates as a compensated property manager on behalf of the lender.

When a borrower and a lender enter into a participating mortgage, they negotiate the participation features along with other mortgage terms. A borrower may grant participation rights to a lender either because market conditions preclude the borrower from obtaining financing without granting such rights or because the lender grants compensating concessions on other loan terms. For example, lender participation may affect the interest rate, cash payments during the first years, the loan-to-value ratio, the project-funding level and the lender's recourse (if any) to the borrower's other assets.

Borrowers' accounting for participating mortgages may not seem complicated at first. The more the issue is considered, however, the more complex it becomes. The claim created by a participating mortgage against an asset and the operating results of that asset has characteristics of both debt and equity. It is like debt because minimum fixed payments must be made to the lender at periodic intervals and at maturity; on the other hand, it is like equity because property appreciation and operating results are shared. Unfortunately, there is no convenient place on either the borrower's balance sheet or income statement for such a complex claim to be recorded.


The American Institute of CPAs real estate committee has been looking for a solution to the participating mortgage problem within a historical cost framework. Ideally, that solution would reflect the transaction's underlying economics by acknowledging the borrower is better off as a result of the property's appreciation, even though some of the appreciation may have to be shared with the lender.

Sharing of results. Because accounting income is determined for each period, the borrower's accounting for a lender's share of the property's income is relatively straightforward. The lender's participation in operations generally is charged by the borrower as an expense of its corresponding operating period, and each period is accounted for separately. The lender's share generally is paid by the borrower from the period's cash proceeds and is payable only to the extent the property yields positive operating results. Both the participation payment and the index on which it is based--current operating income--are reported in current dollars.

Sharing of appreciation. In contrast, the borrower's accounting for the lender's share of appreciation can cause financial reporting headaches. The paradox is that, although the historical cost model readily permits write-ups for increases in participation liabilities before any payments are made, it does not provide an obvious means of reporting increases in corresponding asset values before they are realized. The financial statements of a borrower choosing to report the lender's participation in appreciation before the property is sold will look worse as the property appreciates.

Any liability reported by the borrower for the lender's share of appreciation must be offset by reporting either an increase in assets or a charge to income or equity. If the mortgaged property's increase in market value was reported, the asset value increase would more than offset the appreciation-sharing obligation. However, paragraph 67a of Financial Accounting Standards Board Concepts Statement no. 5, Recognition and Measurement in Financial Statements of Business Enterprises, makes it clear generally accepted accounting principles prohibit current recognition of increases in a property's value.

The FASB emerging issues task force (EITF) considered participating mortgage obligations as a part of Issue no. 86-28, Accounting Implications of Indexed Debt Instruments. The EITF consensus specifically mentions participating mortgages as examples of indexed debt instruments and suggests the borrower's obligation under a participating mortgage to pay the lender a share of unrealized property appreciation should be recognized as a liability immediately when the property appreciates. Nevertheless, because Issue no. 86-28 did not cover the essential point of how to offset the liability, most participating mortgage loan borrowers have, rightly or wrongly, ignored the consensus.

The amount ultimately paid to the lender is determined by changes in the property's value over the mortgage term, and payments generally are not made until the end of that time. The property's value may change every reporting period, but the lender's share of appreciation is uncertain until the payment is actually due. Current property value, the index on which the lender's participation payment is based, is different from the historical amount at which the property is reported.

The conceptual issues are further complicated by practical matters such as the fact a borrower may have no choice about reporting a participation payment before the property value is realized. For example, the borrower may have to pay the lender its share of appreciation on a specified date regardless of whether the borrower intends to sell the property. To obtain enough cash to pay the lender, the borrower may be forced to refinance or sell the property when it may not wish to.


Periodic financial reporting araises the question of whether the borrower should allocate the income statement effect of the shared appreciation over the 1oan's reporting periods and, if so, how. Some of the possible solutions being considered are discussed below.

Reporting a liability for additional interest. This approach's proponents believe the participation represents an additional liability of the borrower to the lender. They would charge interest on the loan using the estimated market rate for a comparable nonparticipating loan and accrue an additional liability for the difference between interest expense and interest paid. The borrower's balance sheet at the 1oan's maturity would show a liability for the recorded, but unpaid, interest and the 1oan's remaining principal balance.

While proponents agree interest should be calculated using the estimated market rate for a comparable nonparticipating loan, there is no consensus on how to estimate that rate. Some would, for example, use the market rate on the maximum nonparticipating first mortgage that could be obtained on the property. Others would add a premium, because loan-to-value ratios on participating mortgages typically exceed those on nonparticipating first mortgages.

Still others would "mark-to-market" the liability based on current appraisals and offset any increase in the liability with an additional charge to interest expense. However, as noted above, net income would suffer as a result of an event benefiting the property owner--the more the property appreciates, the worse the financial statements look.

Accounting for participation as a transfer of a valuable property right. This approach's proponents believe the borrower should reduce the mortgaged property's carrying amount at the inception of the participating mortgage because the borrower transferred a valuable property right--the right to future appreciation during a specified period---to the lender. They view the borrower as caretaker of the lender's property rights with contractual and fiduciary obligations to pass along the lender's share of operating results or appreciation when specified in the contract. Proponents offer the existence of secondary markets in which lenders can assign or transfer participation rights as evidence those rights represent valuable consideration to lenders distinct from the mortgage's debt components.

The amount the borrower reports mortgaged property would be reduced by the fair value of the participation right. Because, like promises to pay interest, the property right is given as additional consideration for making the loan, the borrower would offset the reduction in the property's carrying amount by reporting the fair value of the right as a deferred financing cost the equivalent of long-term prepaid interest. Payments made for the lender's share of appreciation would be added to the property as the lender's property right expires.

Some who favor allocating the loan proceeds between debt and the participation rights object to offsetting the reduction in loan proceeds with a deferred financing cost, as proposed. They believe such an offset is inconsistent with the EITF Issue no. 86-28 consensus that the "premium or discount on the debt should be accounted for in accordance with [Accounting Principles Board] Opinion no. 21 [Interest on Receivables and Payables]." Paragraph 16 of Opinion no. 21 precludes classification of the premium or discount resulting from allocation of the proceeds of an indexed debt instrument as a deferred charge or a deferred credit.

Reporting debt with interest at the nominal rate in the loan agreement. Proponents of this treatment believe lower interest in the 1oan's early years is the consideration the lender gives the borrower in exchange for participation in property appreciation at the end of the loan term. They believe the economic substance of the transaction is ignored if the periodic interest charge is normalized to reflect participation payments at the end of the loan term.

They further believe that, as noted in the exhibit at left, the nominal rate on the loan reflects the lower default risk by the borrower during cyclical economic fluctuations. Increasing the rate used in determining periodic interest expense would thus distort the risk of default as perceived by financial statement readers.

Accounting forparticipating mortgages as hedge transactions. It has been argued that, because the borrowers' liabilities are fully hedged by property value appreciation, the transaction should be accounted for as a futures contract under FASB Statement no. 80, Accounting for Futures Contracts. The lender's share of appreciation would be shown as an increase in the liability account and as an additional element of expense (or loss). There would be a corresponding increase in an asset account and revenue (or gain) because of the direct causal relationship between the two transaction components. However, that analogy is in conflict with Concepts Statement no. 5, which, as noted above, clearly says, "Property, plant, and equipment... are reported at their historical cost."


Participating mortgages present a paradox within the context of historical cost accounting, because they do not fit comfortably on the balance sheet as asset, debt or equity. CPAs' efforts to describe participating mortgages are like the three blind men's description of an elephant. The first grabs a leg and concludes the elephant is like a tree. The second grabs the trunk and concludes it is like a snake. The third touches the side and concludes it is like a wall. All three are correct, yet none is correct. It is an elephant.

Although the AICPA real estate committee expects to submit a revised draft of the statement of position for consideration by the AICPA accounting standards executive committee (AcSEC) during 1992, the project's status currently is in flux because of difficulties AcSEC has had in reaching a consensus on the issues and because of the SEC chief accountant's position on how to account for participation payments.


* PARTICIPATING MORTGAGE loans, under which the lender participates in a real estate project's potential appreciation or operating profits in exchange for favorable loan terms, have helped to make it possible for developers to undertake marginal projects.

* THE TERMS AND CONDITIONS of the participation feature are negotiated along with other mortgage terms and may include a reduction in interest rate or in the loan-to-value ratio.

* QUESTIONS AROSE about how participating mortgages should be accounted for by borrowers. There is no convenient place on the borrower's balance sheet or income statement to reflect the lender's claim against the property.

* THE AICPA REAL ESTATE committee is trying to find a solution within a historical cost framework. Suggested approaches include reporting a liability for additional interest, accounting for participation as a transfer of a valuable property right, reporting the debt with interest at the nominal rate in the loan agreement and accounting for the mortgages as hedge transactions.

* AcSEC IS EXPECTED to consider a revised draft statement of position on the treatment of participating mortgages later this year.
 Three principal measures of capital
structure and long-term solvency
Total debt-to- Current liabilities + Long-term liabilities
total capital = ----------------------------------------
- Equity capital + Total liabilities
 Long-term liabilities
Long-term debt- = --------------------
-to-equity capital Equity capital
Times interest Income before interest and taxes
earned = ------------------------------
 Note: All three measures would look more risky as a
result of booking increased interest and increased
debt. Proponents of reporting debt with interest at the
nominal rate believe the economics of the participation
resulting the protect being less risky to the borrower
than if traditional financing had been employed.
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Article Details
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Author:Schwartz, Clifford H.
Publication:Journal of Accountancy
Date:Jul 1, 1992
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