Real Estate Development Real Estate Development – Accounting Challenges Accounting Challenges By CA. Ramakrishna Prabhu
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Real Estate Development Real Estate Development ––Accounting ChallengesAccounting ChallengesAccounting ChallengesAccounting Challenges
By CA. Ramakrishna Prabhu
Agenda– Understanding the
industry
• What is real estate
development?
• Property development
cycle
2
cycle
• Development versus
construction
• Development business
risks
– Accounting considerations
– Auditing a real estate
developer
�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
What do we mean by real estate development?
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 long-
term rental income and/or capital appreciation = Investment
property, accounted for under AS 13 (IndAS 40) 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 (owner-
occupied 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 • 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– 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 cyclePlan:
Execute:
Identify property
asset for development
Develop
concept
Initial
project
feasibility
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Finalise:
Appoint architects,
project managers, other
consultants and
constructor
Acquire
property
Obtaining
funding
Secure approvals,
i.e. local council
and internal
Market for
sale/ lease
(pre-sale
targets for
residential)
ConstructionFinalise
sale
Parties to a development
Local council
Development and construction
approval (DA & BA)
Loan agreement
Joint venture agreement
Financing
� Mezzanine
� First mortgage debt
� Equity
� JV parties
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DeveloperLandowner Purchaser
Construction company
Sales/leasing
agreements
Construction contract
� Development agreement
� Own land (land purchase contract)
� Corporates
� End Users
� Investors/on-sellers
Development business risk – often
speculative in nature
• What are the two main categories of risks?
Revenue Cost
� Realisation of value
− Market risk
� Risk of cost blow-
out
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− Market risk
− Settlement risk� 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
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– 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
Development business risk –
market risk– Most fundamental risk – matching timing and nature of developments with market
demand
– Fluctuations in property cycles
• Commercial
• Retail
• Industrial
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• 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:
• Development lead time, i.e. Hold short/[med] term
• Pre-commitments, i.e. sales, leasing
Development business risk –
funding risk• Risk of not being able to fund the development or fund at a commercially viable rate
12
Increase in risk
Increase in interest rate
Development business risk –
funding risk (cont.)
• Lender requirements for debt
– Project viability (robust feasibility)
– Minimum level of developer equity
– Security
13
– Security
– Pre-commitments
– Interest rate
– Advances and covenants
• Developers risk management
– 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)
14
– Development approval (DA)
• Building design
• Property zoning
• Environment clearance
– Construction approval (CA)
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
15
– 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)
Development business risk –
settlement risk– The risk that sales
(exchanges) will not
complete (i.e. not
settled in cash)
– Developers risk
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– Developers risk
management
• Exit strategy
• Enforceable sales
contracts
• Assessment of credit
risk
• Deposits (e.g. 10% cash
or deposits bonds)
Accounting challenges
– Which accounting standard – valuation?
– Cost accumulation and allocation
– Borrowing costs
– Which accounting standard - revenue?
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– Which accounting standard - revenue?
– Revenue recognition
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
18
• 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
Accounting considerations
Key questions Accounting impact/considerations
1. What is the nature of the entity’s
investment in the development?
− Asset
− Subsidiary
− Joint venture
� Inventory
� Consolidation
� Equity accounting/proportionate
The answer to
each of these
questions
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− Joint agreement consolidation
� Proportional consolidation
2. How is the project funded? � Debt (on or off balance sheet)
� Equity
3. How does the developer acquire the
land?
� Upfront
� Instalments
� Land release/ related sale of lot/
property
4. What purpose is the property being
developed for?
� Outright sale (pre-commitment)
� Hold and lease
� Progressive sell down
questions
drives the
accounting
treatment
– 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
Accounting considerationsCost accumulation
• Inventory – property held for resale
– Cost of acquisition
– Development costs capitalised
– Other costs: rates, taxes and interest
• Current versus non-current
20
Accounting considerationsCost allocation
1. Project level (total basis)
2. Township level (area basis)
3. Subdivision (revenue basis)
• Decision based on methodology followed
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• 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
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
22
– finance charges
– exchange differences
• Specific borrowings versus general borrowings (allocation on a reasonable
basis)
• Capitalisation
– commencement
– suspension
– Cessation
Accounting considerationsWhich 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 7 Construction Contracts
– AS 9 Revenue Recognition
– Guidance Note –Real Estate Revenue
Accounting considerationsRevenue 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
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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
Accounting/Audit
Key considerations – revenue recognition matter of judgement
‘Assess who is exposed to majority
of risks and benefits of ownership
of asset’
Recognise revenue
� Cash collected
� Title transferred
� No terms/
conditions attached
to sale
� No continuing
Defer revenue
recognition
� Cash deferred and
25
� No continuing
involvement
� No bonding
� Cash deferred and
amount is contingent
� Title does not transfer
(is retained)
� Conditions attached to
sale, e.g. yield
guarantee
� Involved in asset’s
ongoing management
(continuing
involvement)
What if
� Seller of land is also
contracted to develop the
land for the purchaser?
Accounting considerations Revenue recognition – example
– 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
26
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 Revenue recognised when:
Land /plot sale � Substantially complete (meaning sewer,
water and roads are complete)
� Title obtained from authorities
2
727
� 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.
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
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– 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.
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,
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– Also consider cost accumulation, cost allocation,
capitalization of borrowing cost
– How do we assess this?
• Project reviews
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 • 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
Select specific projects for testingAudit residual
population
The extent of coverage over
the total project related
balances through project
reviews is a key judgment
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
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 management’s 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
reviews is a key judgment
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
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• 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
Auditing a real estate developer Revenue recognition
– Inspect sale & purchase agreements
• Vouch cash receipts
– Inspect relevant documentation regarding pre-
sales
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– Examine the revenue recognition principles
– Examine the method of valuation of inventory
Any questions?
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