Mike:
We’d like you to double-check LHCC’s accounting treatment of the contingent funds which might be received from Aqua Virginia relating to the sale of the Utility. Your name came up in LHCC Treasurer John Martel’s explanation to the board of directors regarding certain accounting entries. He explained that an accountant required that these contingent monies be discounted to reflect their value in today’s dollars, or their present value. In simple terms, he said the discount was required because an accountant “cannot let that ride.”
We’ve included a video of John Martel’s explanation to make sure we’re on the same page:
According to John Martel, the discount you calculated, as reflected in G/L account # 1502, was $345,786.50. The original amount recorded in G/L account # 1501 is $1,140,000. That’s a big discount. In simple terms, this discount means these funds are worth over $345,000 – or about 30% – less than the amount that some LHCC directors present to members. These amounts are taken directly from LHCC’s 2/28/07 Balance Sheet.
But is that accounting treatment correct? We think that the contingent Aqua Virginia funds, in accounting terms as of today, are worth $0. We believe the correct treatment is the conservative one: to make appropriate entries on a year-by-year basis only after the contingency has been satisfied. This eliminates putting optimistic projections on the books, and it eliminates the need to discount the funds to present value.
The contingent Aqua Virginia funds involve a pretty big uncertainty. To earn the $76,000 in 2007, Aqua Virginia must receive 70 new tap fees. Common sense says that tap fees will track new home sales over time. In 2005, there were approximately 45 new homes sold at Lake Holiday, and 49 were sold in 2006. By most accounts, 2005 was a very strong year for new home sales. There are plenty of reports in the media that new home sales are slowing in 2007. First quarter results are already known, and new home sales at Lake Holiday were flat at 14 units compared to 2006. Most of these 1Q 2007 sales represented tap fees paid in prior years. How likely is it that new home sales will jump by 60% for the remainder of this year to create the tap fee demand required to earn the contingent payment?
It seems to us that if you include the full amount of the contingent funds in LHCC’s accounts, you think collecting them is the equivalent of a “slam dunk.” Or did John Martel neglect to explain just how tough it will be to satisfy the contingency? We ask that question because we’ve yet to read anything written by an LHCC director that explains that satisfying the contingency, particularly in the early years, will be a real challenge. Although John Martel mentions the contingency in LHCC’s April 2007 newsletter, he doesn’t provide any historical data on home sales to enable a reader to assess the likelihood of collecting this money.
Under the provisions of the two Aqua Virginia contracts (there’s the water system contract and the wastewater system contract), if those tap fees are not received in 2007, the payment for 2007 is gone for good. If Aqua Virginia gets more than 70 tap fees in a year in the future, that surplus can be applied to possible short-falls in future years. But the Chris Allison-negotiated contract doesn’t contain a look-back provision. Members can moan about just how bad the Chris Allison-negotiated deal is now, but it’s up to the accountants to report it accurately. If Aqua Virginia doesn’t get those tap fees in 2007, the $76,000 for 2007 will not be received. These near-term dollars are discounted less than dollars which might be received 15 years from now, so not receiving them will have a greater impact on the present value of the contingent funds compared to receipts in later years. Any effort to calculate a present value may be wildly off the mark if the contingency is not met in the early years.
More importantly, we wonder how recording any value for these contingent funds squares with FAS No. 5.
That statement has been the guiding light on accounting for gain contingencies for more than 30 years, and we’re not aware of any changes in this area. Paragraph 17 states:
a. Contingencies that might result in gains usually are not reflected in the accounts since to do so might be to recognize revenue prior to its realization.
b. Adequate disclosure shall be made of contingencies that might result in gains, but care shall be exercised to avoid misleading implications as to the likelihood of realization.
Consider these comments by Craig Olinger, the Deputy Chief Accountant of the SEC, at a speech in 1998:
The staff believes that the circumstances where recognition of a contingent gain could be justified under US GAAP prior to realization of cash are extremely rare.
Mr. Olinger refers back to that same basic authority, Paragraph 17 of FAS No. 5.
Do you really think it is a good idea to record a contingent gain in the books and records of LHCC, particularly when the probability of receiving a material portion of the funds is so low? Doesn’t this fly in the face of adhering to the principle of conservatism?
This is clearly a material issue. This single contingent gain represents approximately 25% of LHCC’s total assets and approximately 29% of its equity after the discount you calculated. The undiscounted value of the gain is an even higher proportion of assets and equity. Given the materiality of this gain, we believe recording it, even on interim statements, is simply not appropriate. Since the Aqua Virginia contracts were executed in October of 2005, there has been ample time for LHCC to determine the correct accounting treatment for these contingent funds.
We also think it is misleading to refer to the terms of the Aqua Virginia contracts as a “note receivable.” A note in this context commonly refers to something that is owed. But if the specified levels of tap fees are not reached, nothing is owed. What’s the point of entering a $0 value note?
Being able to review books and records properly prepared in accordance with GAAP is a good way for members to understand our Association’s finances. That’s why we’d like you to take a close look at this issue to insure that the books conform to GAAP.
Can you let us and the other members of LHCC know about this as soon as possible?
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