Real Estate Development Accounting Challenges

By CA. Ramakrishna Prabhu

Agenda
Understanding the industry What is real estate development? Property development cycle Development versus construction Development business risks Accounting considerations Auditing a real estate developer

What do we mean by real estate development?

Activity that is intended to create or add value to a real estate asset A developer owns the asset during construction, sets the design, provides development finance and arranges for the building works They may manage the project themselves and provide labour and materials on site. However, many developers subcontract all or part of the construction work. Developers range from high volume house builders to large single project joint ventures Real estate developers may have land banks of undeveloped land, held for strategic purposes to facilitate future developments This module considers development for sale (held as inventory) and development to be held for long term capital appreciation or rental income (held as investment property)

What do we mean by real estate development? Accounting definitions

In accounting terms real estate development can include a number of alternatives The accounting approach depends on intentions for use of the asset under development: Assets under development to be held by the developer for longterm rental income and/or capital appreciation = Investment property, accounted for under AS 13 (IndAS 40) Investment properties Assets under development for sale = Inventory (AS2)(IndAS2) Assets under development for use by the developer (owneroccupied property) are accounted for under AS 10 (IAS 16 Property, Plant & Equipment). This is out of scope of this module. The above applies to new build (development of bare land) and to redevelopments of existing buildings

Property development critical success factors

Effective cost control Understanding government policies and their implications Production of goods currently favoured by the market Pre-development leases or sales

Difference between development and construction

Developer exposed to both revenue and cost risk Construction is a service. Development is the sale of a good Constructor usually has no equity (i.e. ownership interest) in a project Developer usually has equity interest in project (i.e. own money at risk) Developer engages constructor Constructor is engaged to build a specific asset and their involvement in a project is completed once the asset is completed and handed over to their client Developer devises a strategy for the asset, commissions the development works and markets the asset for sale and/ or lease to tenants. Different risk profiles

Property development cycle

Plan: Identify property asset for development Develop concept Initial project feasibility

Execute: Appoint architects, project managers, other consultants and constructor Finalise: Secure approvals, i.e. local council and internal Acquire property Obtaining funding

Market for sale/ lease (pre-sale targets for residential)

Construction

Finalise sale

Parties to a development
Local council Loan agreement Joint venture agreement Financing Mezzanine First mortgage debt Equity JV parties Development and construction approval (DA & BA)

Landowner Development agreement Own land (land purchase contract)

Developer

Sales/ leasing agreements

Purchaser Corporates End Users Investors/on-sellers

Construction contract

Construction company
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Development business risk often speculative in nature

What are the two main categories of risks?
Revenue Realisation of value
Market risk Settlement risk

Cost Risk of cost blowout Funding risk Approval risk Completion risk

Development business risk risk of cost blow out

Key risks Construction risk Design risk Schedule risk Finance and holding costs Developers risk management Committing costs early Use of fixed price/lump sum contracts Updating and reviewing forecast costs and progress against project feasibilities regularly Adequate project contingencies
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Development business risk market risk

Most fundamental risk matching timing and nature of developments with market demand Fluctuations in property cycles Commercial Retail Industrial Residential Factors impacting property cycle Market sentiment Interest rates Competing supply (other developers) Legislation, e.g. Incentive under tax law Demographics Economics Developers risk management:
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Development lead time, i.e. Hold short/[med] term Pre-commitments, i.e. sales, leasing

 Risk of not being able to fund the development or fund at a commercially viable rate

Development business risk funding risk

Increase in risk

Increase in interest rate

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Development business risk funding risk (cont.)

Lender requirements for debt
Project viability (robust feasibility) Minimum level of developer equity Security Pre-commitments Interest rate Advances and covenants

Developers risk management

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Pre-sale commitments Project feasibilities

Development business risk Approval risk

Risk that approvals to commence the development or a stage within the development are not received
Development approval (DA)
Building design Property zoning Environment clearance

Construction approval (CA)

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Development business risk completion risk

Risk that development not ready for intended use by forecast completion date Implications Potential fall over of pre-commitments Sunset dates in sales contracts Lease agreements, e.g. rental guarantees Blow out of holding and financing costs Developers risk management Pass on to builder Early completion incentive Liquidated damages Program float (buffer between contracted completion and sunset dates)
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Development business risk settlement risk The risk that sales

(exchanges) will not complete (i.e. not settled in cash) Developers risk management
Exit strategy Enforceable sales contracts Assessment of credit risk Deposits (e.g. 10% cash or deposits bonds)

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Accounting challenges
Which accounting standard valuation? Cost accumulation and allocation Borrowing costs Which accounting standard - revenue? Revenue recognition

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Accounting considerations Which accounting standard valuation?

Valuation AS 2 Inventories development for sale Inventory measured at lower of cost and NRV AS 13(IAS40) Investment Property development to hold for long term capital appreciation or rental income Asset measured at fair value OR depreciated historic cost Revision to IAS 40 eliminated potential different treatment between new development and redevelopment of existing investment property AS 10/IAS 16 Property, Plant and Equipment development by owner occupiers Asset measured at fair value OR depreciated historic cost

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Accounting considerations
Key questions
1.

Accounting impact/considerations

What is the nature of the entitys investment in the development?

Asset Subsidiary Joint venture Joint agreement How is the project funded? How does the developer acquire the land?

Inventory Consolidation Equity accounting/proportionate consolidation Proportional consolidation Debt (on or off balance sheet) Equity Upfront Instalments Land release/ related sale of lot/ property

2.

The answer to each of these questions drives the accounting treatment

3.

4.

What purpose is the property being developed for?

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Outright sale (pre-commitment) Hold and lease Progressive sell down

Accounting considerations
Cost accumulation

AS2/IAS 2 Inventory
Costs must relate to that development Capitalised costs must be directly attributable (be careful with marketing costs) Inventory property held for resale
Cost of acquisition Development costs capitalised Other costs: rates, taxes and interest

Current versus non-current

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Accounting considerations
Cost allocation

1. Project level (total basis) 2. Township level (area basis) 3. Subdivision (revenue basis)
Decision based on methodology followed Consider what are the direct and allocated costs Consider retrospective catch up standard does not prescribe whether prospective or retrospective approach can be used Must be applied consistently

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Accounting considerations
Borrowing costs
AS 16 Borrowing Costs (revised) Attributable borrowing costs should be capitalised into the cost of the project Includes interest amortisation of discounts or premiums and ancillary costs finance charges exchange differences Specific borrowings versus general borrowings (allocation on a reasonable basis) Capitalisation commencement suspension Cessation

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Accounting considerations
Which accounting standard - revenue?

IFRIC 15 Agreements for Construction of Real Estate is applied to determine whether a contract is in scope of either AS 7 Construction Contracts AS 9 Revenue Recognition Guidance Note Real Estate Revenue

Accounting considerations
Revenue recognition: IAS 18 Revenue

Revenue recognition criteria sale of a good

1. Significant risks and rewards have transferred 2. Does not retain continuing managerial involvement usually associated with ownership 3. Amount of revenue can be measured reliably 4. Probable economic benefit will flow 5. Costs can be measured reliably
If the above criteria are met then revenue can be recognised
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Accounting/Audit

Key considerations revenue recognition matter of judgement

Recognise revenue Cash collected Title transferred No terms/ conditions attached to sale No continuing involvement No bonding What if Seller of land is also contracted to develop the land for the purchaser? Defer revenue recognition Cash deferred and amount is contingent Title does not transfer (is retained) Conditions attached to sale, e.g. yield guarantee Involved in assets ongoing management (continuing involvement)
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Assess who is exposed to majority of risks and benefits of ownership of asset

Accounting considerations
Revenue recognition example

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Land sale Rs. 100 Crore being fair value of land Cash received at date of completion of contract Land sale contract cannot be rescinded based on non performance of development agreement Separate development agreement fee (is fixed determined on budgeted cost plus normal commercial margin (e.g. 10%)) Seller can be terminated as developer if given 4 weeks notice, normal compensation under agreement as opposed to large penalty for termination

Accounting considerations
Practical application of revenue recognition rules

Type of product Land /plot sale

Revenue recognised when: Substantially complete (meaning sewer, water and roads are complete) Title obtained from authorities Enforceable agreement entered in to for sale and Settled (in cash by purchaser)

Built form residential, Commercial space

Sold apartments on percentage completion achieved (100% complete) Completion certificate from authorities.

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Accounting considerations
Disclosures Presentation as completed inventory or development work in progress Presentation as development property or investment property Investment property under construction accounting policy choice under AS 13/IAS 40 to hold at cost or fair value. But beware if choose cost, there is still a requirement to disclose fair value. Disclosure relating to the varying forms of joint ventures, joint arrangements and other forms of collaboration among developers. Disclosure requirements relating to financing Also: Large number of statutory financial statements common in many jurisdictions due to structure of real estate development groups, where each development project may be held in a separate statutory entity for tax, organizational or other reasons.
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Auditing a real estate developer Inventory

Recoverability of inventory is the most fundamental audit consideration
Requirements of AS 2 Measure inventory at lower of cost and NRV

Also consider cost accumulation, cost allocation, capitalization of borrowing cost How do we assess this?
Project reviews

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Specific Issues
Accounting for infrastructure cost in respect of megha township project and working out its impact on final product. Sale of land and construction under two separate agreements Perpetual ownership of infrastructure with developer having continuous revenue stream Deferred payment facilities.

Auditing a real estate developer Inventory

Total population
The extent of coverage over the total project related balances through project reviews is a key judgment

Select specific projects for testing

Apply specific item sampling to select projects for detailed assessment by project review based upon quantitative and qualitative factors: linked to inherent risk (higher risk projects) total project value greater than x forecast profit/ loss greater than x movement in forecast profit/ loss greater than x management suggestions unique or unusual arrangements complexity, specifications, regulatory environment

Audit residual population

Perform procedures to identify misstatements > performance materiality in residual population, such as: consider level of reliance that can be placed on tests of the operating effectiveness of managements key controls over the whole population, such as internal project reviews analytical procedures: compare project revenue and margin against expectation (based on prior periods) inspect internal management project reports high level discussions with management as to project status

Auditing a real estate developer

Project reviews
Understand the development and risks borne by developer through discussions with project and finance management Inspection of management reports (e.g. Project control group meeting minutes) detailed examination of all relevant contracts (including development agreement, construction contract, financing and joint venture agreements) bank covenants Detailed analysis of the project feasibility, understanding movements and obtaining corroborative evidence for: sales rates and prices escalation applied time phasing forecast construction costs being in line with contract external valuations

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Auditing a real estate developer

Revenue recognition

Inspect sale & purchase agreements

Vouch cash receipts

Inspect relevant documentation regarding presales Examine the revenue recognition principles Examine the method of valuation of inventory

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Any questions?
???

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