Real Estate

Introduction & Basics of Internal Audit

November 30, 2012 CMII, ICAI

Introduction

Real estate is an imperishable asset, ever increasing in value. It is the most solid security that human ingenuity has devised. It is the basis of all security and about the only indestructible security. - Russell Sage

Real Estate sector is a large, huge diversified sector, with many verticals such as land, design/construction, development, investment, lending etc.

India, emerging as one of the most important business locations in the world with its favourable demographics and strong economic growth, makes it an attractive place for property investors as the demand for property is determined mainly by business development and demographic trends.

Of late, the nature of demand is also changing, with heightened consumer expectations that are influenced by higher disposable incomes, increased globalization and the introduction of innovative real-estate products and services.

Advantage India
Growing Demand

Investment

Policies

Attractive Opportunities

Demand for residential property has gone up due to increased urbanisation

FDI of more than USD9 billion in real estate in the last decade

Allocation of USD625 million for rural housing

Growing requirements of space from sectors such as education and healthcare

Growing economy driving demand for commercial and retail space

Real estate also emerged as the popular sector for private equity (PE) funds, which witnessed investments worth US$ 1,700 million in the sector during 2011.

FDI up to 100 per cent allowed with government permission for developing townships and settlements

Growth in tourism providing opportunities in the hospitality sector

Real Estate Being Driven by Policies and growing economy

Urbanization

Growth in Tourism

Growing Economy

Growth Drivers
Epidemiological Changes Policy Support

Easier Financing

Professional Opportunities In Real Estate

Advisory
Risk Based Advisory

Taxation
Management of Indirect Tax Provisions

Statutory
Accounting

Other services
Valuation

Cost Consultancy

Management of Direct Tax provisions

Statutory Audit

Drafting documents

Process Improvement

Return filling

IFRS Accounting

Registration & Stamp duty

Feasibility study

Registration with taxation authorities

Investment Funding

Basics Risks for Real Estate Companies

Business process framework for real estate developer

Stakeholder Management Vendors/ Contractors

Strategy

Shareholders

Government

Lenders

Lessees/ Customers

Employees

Product Conceptualization & Business Development Capital Mobilization & Financing Strategic Alliances

Operations

Land Acquisition

Design & Architecture

Projects

Purchase

Sales & Marketing Residential

Contract management

Revenue Billing and collection

Inventory management

Support

HR Taxation

Secretarial Legal

IT Finance

Departments/functions addressing the risk Core functions Support Functions

Risk Category

Business Developme nt

Architec ture

Sales & Marketi ng

Finan ce

IT

HR

Lega l

Ad min

Cust omer Care

Risk definition

Land acquisition
Title of the site being acquired/already acquired is not clear/is defective This may occur on account of reasons such as insufficient diligence at the time of acquisition or ATS being entered into with multiple parties by the seller or not safeguarding ownership records post the acquisition of land..

Title and ownership of land is not clear/secured

Land Acquisition

Commercial & technical feasibility of site

The cost of acquisition of the site and construction is not commensurate to the potential realisation from the developable area on the site. This may be due to acquisition of land where construction is not permissible/feasible on account of factors such as environment, site, archaeological, FSI restrictions etc. or paying a premium for the site that is not justifiable by the market conditions. Also, where the acquisition of land is by way of shares of a land holding company, hidden liabilities and encumberances may be acquired by the Company

Delays in closure of proposal for site acquisition

Potential loss in time for development/loss of opportunity to acquire a site on account of delays in closure of the purchase transaction The risk manifests itself in 3 forms: a. inability to enforce the Agreement to Sell/ jointly develop the land; b. the terms of the contract are prejudicial to the interests of the Company; and c. non-performance of the contractual obligations

Risk of contracting and contract commitments relating to land acquisition

Risks associated with creating, managing and acquiring Special Purpose Entities for acquiring land

Compliance, taxation and diligence risks associated with creating, merging and maintaining land acquisition companies

Risk to be primarily managed by this function These functions also play an active role in supporting risk management

Departments/functions addressing the risk Core functions Support Functions

Risk Category

Business Developme nt

Sales & Architect Marketin ure g

Finan ce

IT

HR

Lega l

Ad min

Cust omer Care

Risk definition

Architecture

Product failure

The product being sold does not address the need of the market resulting in unsold inventory/ lower realisation from the developed area

Delays/changes in finalising design

Delays in finalising the design/ frequent changes to design post finalisation. This may occur as the customer needs have either changed or were not appropriately understood etc.
High cost of construction/ownership on account of over-design of HVAC, structural engineering etc.

Architecture

High cost of construction/ownership

Security and safety risk of the building structure

Due consideration has not been paid to safety and security of the building in the design

Outsourcing risk

Design and architecture is outsourced to 3rd parties. While outsourcing, the design team needs to manage several risks such as quality of design, timely delivery of intial design & GFC drawiings, contracting at the right price, meeting contract commitments, adherence of the design to regulatory requirements, avoiding single source dependence etc.

Risk to be primarily managed by this function These functions also play an active role in supporting risk management

Departments/functions addressing the risk Core functions Support Functions

Risk Category

Business Developme nt

Sales & Architect Marketin ure g

Finan ce

IT

HR

Lega l

Ad min

Cust omer Care

Risk definition

Sale & Sale Accounting

Inaccurate demand forecasting

Inability to accurately predict the nature/type, location and extent of demand for the product Marketing strategy refers to the risks associated with liquidating the inventory at the right price. This includes appropriate pricing the product at the time of launch, price escalation at suitable intervals, phasing of the sales (if required), effective use of sale channels, choices around issues such as whether regulatory clearances are obtained prior to launch etc Unsold inventory on account of poor sales planning or excess of supply of units in the market Inability to realise/delays in realisation of money from the customers. Alternatively, the property is handed over to the customer without clearance of dues This risk covers the risks associated with contracts ie a. enforceability of contracts with the customers is not certain (eg. contracts cannot be enforced as these are not signed) or b. the terms of the contract are not in the best interests of the Company or c. The Company has not met its contractual obligations - resulting in dis-satisfed customer. payment of penalties & charges The title to the commercial property was not transferred to the correct counter-party. This risk may occur at the time of possession or transfer of property (sale, transfer by inheritance etc.)

Ineffective market strategy (pricing, scheme formulation, price escalation etc)

Sale & Sale Accounting

Inventory (unsold units in stock)

Credit and collections risk

Risks of contracting and contract commitment

Risk associated with transfer of title and ownership (sale and transfers) to customers

Risk to be primarily managed by this function These functions also play an active role in supporting risk management

Departments/functions addressing the risk Core functions Support Functions

Risk Category

Business Developme nt

Architec ture

Sales & Marketin g

Finan ce

IT

HR

Lega l

Ad min

Cust omer Care

Risk definition

Legal & compliance Non-compliance with applicable laws and regulations. This risk manifests itself differently for different functions - for instance, architecture needs to comply with building bye-laws, where as finance with revenue laws. Risk of litigation is not effectively tackled - either through an effective strategy or its implementation. Litigation may arise in acquisition of land, suits with outsourced contractors, customers etc.

Regulatory Noncompliance

Litigation

Legal, Hazards & Information

Hazards Natural hazard and calamity Business interruption Inability to service customers on account of disruptions caused by catastrophic loss/ loss of records/ loss of information Lack of sensitivity of the top level management / affected functions to initiate a timely response to a crisis. Inadequate handling of the situation vis--vis public, government agencies, news media, shareholders, and other affected external parties in case of a crisis situation.

Risks associated with crisis management

Information Breach of information security Information availability and Infrastructure

Loss of confidential information

Non-availability of information systems to support management decisions

Risk to be primarily managed by this function These functions also play an active role in supporting risk management

Departments/functions addressing the risk

Core functions

Support Functions

Risk Category

Risk definition

Business Developme nt

Architec ture

Sales & Marketin g

Finan ce

IT

HR

Lega l

Ad min

Cust omer Care

B. Financial Liquidity risk Inability to meet cash flow obligations in a timely and cost-effective manner

Capital non-availability

Insufficient access to capital threatens the verical's capacity to grow, execute its business model and generate future financial returns.

Insurance risk

Financial

Assets of the Company are not adequately insured and/ a high premium is being paid. Also, the Company may not have taken adequate cover for different risks that it may be exposed to

Mis-statement in accounting, reporting and disclosures

Mis-statement in financial reporting and disclosures

Ineffective tax strategy and planning

The taxation strategy is not effectively articulated and executed to avail the lawful advantages provided by the fiscal regime

Tax non-compliance

Non-compliance with the revenue laws of the State

Risk to be primarily managed by this function These functions also play an active role in supporting risk management

Departments/functions addressing the risk

Core functions

Support Functions

Risk Category
Business Developme nt Architec ture Sales & Marketin g Finan ce IT HR Lega l Ad min Cust omer Care

Risk definition

D. Strategic Budgeting & Forecasting x x x Unrealistic targets are set in the business plan/ inability to meet the targets set forth for the division The Company has not exploited strategic partnerships and alliances or the alliances entered into are not in the best interests of the Company Risk of effectively tackling local and national players as the XYZ brand expands beyond the <location> area.

JVs/Alliances Partnerships and Alliance Management

Competition

Strategic

Changes in demand profile

Changes in customer demands and trends make the product offering obsolete

Socio-Political risks

Changes in the economic policies of the Government and risks arising out of political instability in the country that may affect demand Increase in interest rates may impact the borrowing capacity/ repayment capacity of customers resulting in dampening of demand or credit defaults

Interest rate risk

Over-capacity

Excess supply in commercial real estate may dampen the business potential for the division

Risk to be primarily managed by this function These functions also play an active role in supporting risk management

Internal audit objective and workflow

Internal audit objective

Processes and controls are designed to:

Address key business risks Create operational efficiencies, reduce costs and plug leakages Ensure regulatory compliance

Technology is effectively deployed to support business processes & information flows

Timely and accurate information is available for management oversight and decision making
Assurance that people follow the rules laid down for the business

Internal audit workflow

1. Audit Planning
Protocol Setting
Agree on

3. Recommendation follow up
Audit plan preparation
Identify the

Risk Assessment
Identify the

Results tracker
Log of

Recommend-ation status

protocols, execution and reporting templates

key risks to be addressed in the audit

type of audits, locations to be audited and the key focus areas

observations and recommendations across locations

Track implementation of

recommendations

2. Audit execution and reporting

Audit initiation
Initiate contact

Audit fieldwork
Identify control

Audit reporting

with auditee, validate the scope and introduce audit procedures

weaknesses, if any and recommend improvement plans

Report on

audit observations and agreed recommendations Management presentation

Questions