Real estate clients hold most of their value in a few large assets, and the accounting question on each is the same: which costs belong on the balance sheet, and is the carrying amount still recoverable. Both answers depend on management's plans for the property, which makes intent the center of the audit.
This guide covers capitalization of project costs, how sales are recorded, impairment, and the evidence to collect.
Capitalizing project costs under ASC 970
ASC 970 sets the accounting for the acquisition, development, construction, selling and rental costs of real estate projects. The principle is that costs directly associated with acquiring, developing and constructing a project are capitalized, while indirect costs that cannot be clearly attributed to the project are expensed. Direct construction costs, professional fees and permits are capitalized. Indirect costs are capitalized only when they clearly relate to the project and, for property built for sale or rental, are incremental. General and administrative overhead is presumed not to qualify. Capitalization of interest, property taxes and insurance stops when the project is substantially complete and ready for its intended use.
Three areas draw the most audit attention:
- Preacquisition costs. Costs incurred before the property is acquired, such as option fees, feasibility studies and legal work, are capitalized only when they meet the ASC 970-340 criteria, which include that the costs are directly identifiable with the property and that acquisition of the property is probable. For a property that will be operating at acquisition, these costs are expensed. Land option costs are treated separately.
- Interest and carrying costs. Interest is capitalized under ASC 835-20 during active development. Property taxes and insurance incurred while the property is being made ready for sale or rental are also capitalized. See capitalized interest.
- Cost allocation. Costs shared among phases, lots or units are allocated on a defined basis. Specific identification is used when practical. Land and common costs are generally allocated by relative fair value, construction costs by relative sales value, and area methods are a fallback when value-based methods are impracticable. Allocations are reviewed each period until the project is substantially complete and available for sale.
Auditors test the capitalization cutoff. Costs that continue after a phase is complete, or that relate to a stalled project, should no longer be capitalized.
Revenue from real estate sales
The accounting depends on whether the buyer is a customer. Sales in the ordinary course, such as homebuilders and condominium developers selling units, fall under ASC 606 and appear as revenue. Sales of property from a held portfolio to a noncustomer fall under ASC 610-20 and appear as gains or losses. Both rest on the same analysis of when control transfers.
For development, revenue is recognized over time only if one of the three criteria in ASC 606-10-25 is met. A custom building for a single buyer can qualify. Development that meets none of the criteria recognizes revenue at a point in time, when control transfers at closing. Review contracts for repurchase rights, guarantees and other terms that can mean control has not transferred. See the ASC 606 five-step model.
Impairment under ASC 360
Real estate held and used is tested for recoverability when events or changes in circumstances indicate the carrying amount might not be recoverable. Indicators include a significant drop in market price, an adverse change in how the property is used, an expectation that the property is more likely than not to be sold well before the end of its useful life, costs on a development significantly above the amount originally expected, and sustained operating losses. If undiscounted expected cash flows fall below the carrying amount, the asset is written down to fair value. Property held for sale is measured at the lower of carrying amount and fair value less cost to sell. See ASC 360 and ASC 350 impairment.
Risk areas
- Capitalization of costs that should be expensed, which inflates assets and profit
- Impairment indicators ignored or cash flow projections that are optimistic
- Related-party transactions with affiliated managers, builders and lenders
- Joint ventures and variable interest entities, where the primary beneficiary consolidates regardless of equity percentage
- Revenue timing on development and unit sales
- Debt covenants, maturities and loan-to-value tests
- Property classification between held and used, held for sale and inventory
Audit procedures
- Obtain the project cost ledger by property and phase. Reconcile it to the general ledger.
- Vouch a sample of capitalized costs to invoices, draw requests, contracts and lender inspection reports. Confirm each cost belongs to the project and falls within the capitalization period.
- Test cutoff by examining invoices around year end and unrecorded liabilities, including retainage.
- Recompute capitalized interest using the average accumulated expenditures and the applicable rate.
- Test allocations to units or phases against the policy and the sales value data.
- Read title, closing statements and contracts for each sale. Agree proceeds to bank and settlement statements.
- Review impairment analysis. Assess indicators, test the cash flow assumptions against leases, appraisals and market data, and compare prior projections with actual results.
- Evaluate related-party and joint venture arrangements and the consolidation conclusion. See related party transactions.
- Confirm loans with lenders, including balances, terms and covenant compliance.
Worked example
This example is illustrative. A developer is building a 20-unit townhome project with total capitalized costs of $6,000,000 at year end, of which $5,400,000 is attributed to units under construction. The client capitalized $90,000 of executive salaries and $45,000 of general office rent into the project.
Executive salaries and general office rent are general and administrative costs that do not clearly relate to construction, so $135,000 should have been expensed. The correction reduces the project asset to $5,865,000 and increases expense by $135,000. The auditor also reads the ledger for entries after the certificate of occupancy date. A further $60,000 of landscaping and utility costs was posted after substantial completion for 12 of the units. Those costs relate to a completed phase and need review for expensing.
The auditor then records the proposed adjustments, compares them to the clearly trivial threshold and brings the pattern to the engagement partner, since the same policy flaw repeats in later periods.
PBC items
- Project budgets, cost-to-complete reports and draw schedules
- Construction contracts, change orders and architect certificates
- Capitalized cost ledger by property and phase
- Interest capitalization workpaper and loan agreements
- Closing statements and settlement sheets for sales
- Appraisals, broker opinions and impairment analyses
- Rent rolls and lease files for income-producing property
- Operating agreements and capital account schedules
- Related-party schedules and management fee agreements
- Debt covenant compliance certificates
Red flags
- Total capitalized costs growing while construction progress is flat
- Budget overruns without a change in the forecast profit
- Soft costs capitalized for stalled or abandoned projects
- Sales recorded before closing or with side agreements
- Appraisals older than the engagement period used to support values
- Lender draw requests that do not agree to the books
- Distributions to owners while a project is under water
Sources
- JMCO, "GAAP Accounting Requirements for Real Estate Companies" (jmco.com/articles/real-estate/gaap-accounting-requirements-for-real-estate-companies)
- PwC Viewpoint, Property, plant and equipment guide, "Real estate projects for sale or rental" (viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/property_plant_equip/property_plant_equip_US/chapter_1_capitaliza_US/17-Real-estate-projects-for-sale-or-rental.html)
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