Madayag Development Corporation (MDC) is a real estate development company that is 60% owned by Thomas Madayag. Seaton’s Inc., a privately owned Canadian department store chain, owns 30%, and 10% is owned by a Canadian bank. MDC engages in two types of development: residential land sites, and commercial retail space.

Mr. Madayag has been considering issuing a new class of MDC non-voting common shares to a small group of private investors. The purpose would be to provide a larger equity base so that MDC could be more aggressive in its commercial division. Like all real estate development companies, MDC is very highly leveraged; about 90% of the assets are financed by debt, most of which is provided by or through the shareholder bank. The issue price of the new share would be determined on the basis of the net market value equity of the company’s properties (that is, the total appraised values minus the company’s outstanding debt).

Since the company will continue to be private, a shareholders’ agreement will govern the company’s buy-back of the new shares should any investor decide in the future to sell his or her shares. The buy-back price of the non-voting shares is to be determined as the original issue price of the shares plus a proportionate share in the increase in the net book value of the common share equity from the date of issue to the date of repurchase, based on the most recent audited financial statements.

The shareholders’ agreement places no restrictions on the potential resale price of the voting shares held by Mr. Madayag, Seaton’s Inc., and the bank; should any of these shares be sold, they would be sold at their fair market value (which, for real estate developments, is normally based on the present value of future cash flows).

Mr. Madayag is interested in the implications of the proposed non-voting share issue for financial reporting. Therefore he has engaged an accounting advisor to offer advice on the most desirable accounting policies. A description of the business of the company follows.

Residential development In the residential division, MDC buys large tracts of land near major Canadian cities and holds the land for a few years until the growth of the city makes the land attractive for residential development. The purchase of the land is financed at least 90% by bank loans, and the loans provide for a line of credit to enable the company to borrow from the bank to pay the interest on the loans for up to five years after the land purchase; this holding period is considered by the bank to be the development period. When the time seems right (but usually within five years), MDC develops the land by providing services (e.g., sewer, water, electrical, and telephone mains and connections), laying out roads, and subdividing the land into home sites. The development process takes less than a year.

The sites are then advertised and sold to customers; about 25% of the sales are for cash, but most often they are for a 10-20% down payment with MDC accepting a mortgage for the remainder. The mortgages are usually for a five-year term and a 20-year amortization and bear interest at a fixed rate that is one or two percentage points below the market rate of mortgage interest (but above the cost of MDC’s borrowing). The prices charged to customers for the land vary within an individual tract. Some locations are considered more desirable than others and may therefore carry a price that is as much as double that of the less desirable locations within the same development. MDC does no residential building; the company only sells the sites.

Purchasers must arrange for construction of the houses themselves. Usually, however, MDC enters into an exclusive contract with one (or sometimes two) house builder(s) to perform the construction on the sites. The builders erect model homes on the front sites (i.e., on the major access road), and then negotiate individually with the customers for construction of their homes. MDC charges the builders rent for the properties occupied by the model homes. When sales of the sites are complete, MDC sells the property under the model homes to the purchasers of the model homes or to the builder.
MDC has been quite successful in its residential land development business.
However, there is one land tract outside of Calgary that it has been unable to sell as quickly as desired. Purchased eight years ago and developed three years ago, only about 30% of the tract has been sold. Defaults by purchasers have been high, and the proceeds from the land sales have not been sufficient to pay the interest on the bank loan; the company has had to use cash from other developments to service the loan.

Commercial development The commercial division builds and leases retail developments in urban and suburban locations. Sometimes the shopping centres are built on a part of the residential development areas described above, but usually the sites are completely independent of the residential division. There is littie lag between acquisition and development of a retail site, although the project can take up to six years from land assembly to final grand opening. The acquisition and development costs are financed by the bank, although in very large developments the bank will syndicate its participation (that is, bring in other banks to share the cost and the risk). Syndicate members demand audited financial statements from MDC.

MDC’s general policy is to hold and operate the properties, although the company will sell if the price is right. Each property usually has a Seaton’s store as an “anchor” store (a major retailer that occupies a large space and provides much of the attractiveness of the development to shoppers and thereby to smaller retail lessees). There is a long-term lease agreement between the Seaton’s store and MDC that locks the store into the development for at least 30 years. Similar leases bind other major anchor stores, but smaller retailers usually sign five-year leases that are cancellable by either party at the end of the lease term.

The long-term leases are for fixed lease payments, with provision for increases due to inflation and due to increases in operating costs. Shorter-term (e.g., five year) leases are for a minimum monthly amount plus a percentage of the gross sales of the store. Smaller lessees also pay a large amount, equivalent to 50% of one years minimum lease payments, at the inception of the lease; this payment is not repeated for lease renewals. MDC’s cash flow from the lease payments is used to operate the developments and to service the bank debt that financed them.

MDC has not had to pay any income taxes in the commercial division because capital cost allowance on the properties is more than enough to offset lease income. Excess CCA from the commercial division cannot be used to offset profits in the residential division, however, for income tax purposes.

Most of the retail developments have been very successful; the insurable value of the properties is, in aggregate, four times the depreciated historical cost of the properties. There are three recently built shopping centres that have not yet reached their full potential but are expected to do so within the next two years.

Four other developments were built in the early 2000s in parts of the country that were hit hard by the economic recession in those years and they have never fully recovered; these properties are unable to recover their full operating and carrying costs.

Required:
Outline the accounting policies that would seem to best serve the reporting objectives of MDC, assuming that the new share issue is to occur. Your recommendations should include (but not be limited to) recognition of the revenues for each division, treatment of costs (including development costs and interest), and valuation of properties under development and after development.