Accounting, Financial, Taxation

A real estate project is considered substantially completed and held available for occupancy upon completion of tenant improvements by the developer, but no later than one year from cessation of major construction activity. Once a real estate project is substantially completed and held available for occupancy, a rental project changes from non-operating to operating, with the following consequences:

1. Rental revenues and operating costs are recognized as they accrue
2. Carrying costs (such as taxes and insurance) are expensed when incurred
3. Interest capitalization ceases
4. Depreciation commences
5. Amortization of deferred rental costs commences

Paragraph 23 of FASB Statement 67 states:

If portions of a rental project are substantially completed and occupied by tenants or held available for occupancy, and other portions have not yet reached that stage, the substantially completed portions should be accounted for as a separate project. Costs incurred shall be allocated between the portions under construction and the portions substantially completed and held available for occupancy.

Judgment must be used to determine what constitutes a project and, once identified, when that project is substantially completed and ready for its intended use. For example: a company may identify separate buildings in an office complex as separate projects. However, an individual rental project, such as an office building, is considered one real estate project in its entirety, and that rental project is evaluated in its entirety of whether it is substantially complete.

The FASB considered and rejected a phase - in of depreciation and other operating costs based on a percentage - of - occupancy method over the period of lease - up of a building. 78 As such, depreciation commences for an office building held for rental in its entirety, rather than on a floor-by-floor basis. Similarly, costs incurred for property taxes and insurance relate to the building and land as a whole and, therefore, capitalization of those costs should cease when the building is substantially complete and ready for its intended use, rather than being phased in over time.

Costs Incurred Subsequent To Project Completion

For properties that are developed for a company’s own use or rental operations, costs will be incurred subsequent to the completion of the project. Questions of how to account for costs incurred subsequent to a property ’ s completion are encountered not only by real estate companies, but by all companies owning real estate.

The accounting treatment of such costs will depend on the type of costs incurred and the reason for their incurrence. Costs incurred may be start–up costs within the scope of SOP 98 - 5, Reporting on the Costs of Start - Up Activities; they may constitute normal maintenance expenses; or they may stem from renovations, remodeling, or refurbishing activities.

Normal repair and maintenance costs are commonly expensed as incurred. Questions remain, however, with respect to other costs incurred. If a company replaces the roof of a building, for example, should that new roof be capitalized?

If so, is it appropriate or necessary to write off the estimated net book value of the existing roof?

Aside from a general rule that expenditures that extend the life of the property or increase its value are capitalized and that normal recurring repair and maintenance expenditures are expensed, very little guidance exists with respect to the accounting treatment of costs incurred subsequent to project completion.

The proposed SOP, Accounting for Certain Costs and Activities Relating to Property, Plant, and Equipment, offers guidance with respect to costs incurred during the “in service stage”; however, that proposed SOP was not cleared by the FASB. Additionally, the proposed SOP introduces the concept of components, which is generally not followed in U.S. Generally Accepted Accounting Principles (GAAP).

In real estate properties that are intended for rent or sale after development is completed, leasing and selling activities generally occur throughout the acquisition, development, and construction phases of a project. Successful pre-leasing and pre-selling efforts are evidence of a project ’ s viability, and funds received from buyers are often used to finance a project ’ s development. Commissions; legal fees; closing costs; advertising costs; and costs for grand openings are examples of costs to sell or rent; however, based on the type of real estate property, leasing and sales activities — and related costs incurred — may vary.

Costs Incurred To Sell Of A Real Estate Project

Costs incurred to sell a real estate project are generally substantial. Depending on the type of selling costs incurred, they are accounted for in one of three ways:

1. Included in project costs
2. Deferred
3. Expensed

What selling cost to be included in a project? which selling cost should be deffered? what to be expensed?  read on…….

[1]. Selling Costs To Be Included In Project Costs

Selling costs are included in project costs if all of the following criteria are met:

1. They are reasonably expected to be recovered from the sale of the project or from incidental operations.
2. They are incurred for tangible assets that are used directly throughout the selling period to aid in the sale of the project, or services that have been performed to obtain regulatory approval of sales.

Examples of costs that generally qualify as project costs are:

1. Costs of model units and their furnishings
2. Costs of sales facilities
3. Legal fees for the preparation of prospectuses
4. Costs of semi-permanent signs

[2]. Selling Costs To Be Deferred

FASB Statement No. 67 provides for the deferral of certain selling costs. It is important to note that deferred selling costs are not part of project costs. If the percentage-of-completion method were applied, the incurrence of selling costs would not increase a project’s percentage of completion. Additionally, deferred selling costs are not part of qualifying expenditures for interest capitalization.

Selling costs are accounted for as prepaid costs; that is, they are deferred if they meet the following criteria: They must be directly associated with successful sales efforts, and their recovery must be reasonably expected from sales. FASB Statement No. 67 provides for the deferral of such selling costs until the related profit is recognized.

If profit is recorded under the accrual method of accounting, a deferral of selling costs is generally not necessary, as the selling costs are incurred in the period of sale. For example: a seller may incur brokerage commissions at the time of closing.

If profit from a real estate sale is recognized under a method of accounting other than the accrual method, such as the deposit or installment method. Paragraph 18 of Statement 67 provides for cost deferral until the related profit is recognized.

If a sales contract is canceled or if the receivable from a real estate sale is written off as uncollectible, any related unrecoverable deferred selling costs are charged to expense.

[3]. Selling Costs To Be Expensed

Costs that do not meet the criteria for capitalization as project costs or for cost deferral are expensed as incurred.

Costs Incurred To Rent A Real Estate Project

Costs to rent a real estate project under operating leases fall in one of two categories:

1. Initial direct costs; and
2. Other than initial direct costs.
3. Costs to rent projects under direct financing or sales - type leases are treated like costs to sell.

FASB Statement No. 67 does not apply to initial direct costs. Initial direct costs are incremental direct costs incurred by the lessor in negotiating and consummating leasing transactions, and certain costs directly related to specified activities performed by the lessor. The accounting for such costs is provided in FASB Statement No. 13, Accounting for Leases.

Costs other than initial direct costs to rent real estate projects under operating leases that are related to and are expected to be recovered from future rental operations are deferred (capitalized). Examples of such costs are costs of:

1. Model units and their furnishings
2. Rental facilities
3. Semi-permanent signs
4. Grand openings
5. Unused rental brochures

Deferred rental costs that are directly related to a specific operating lease are amortized over the lease term. Deferred rental costs not directly related to revenue from a specifi c operating lease are amortized over the period of expected benefit. The amortization period of capitalized rental costs begins when the project is substantially complete and held available for occupancy. Any amounts of unamortized capitalized rental costs associated with a lease or group of leases that are estimated not to be recoverable are charged to expense when it becomes probable that the lease or group of leases will be terminated.

The Advertising Cost

Costs of advertising, which include the costs of producing advertisements (such as the costs of idea development, artwork, printing, and audio and video production) and communicating advertisements that have been produced (such as the costs of magazine space, television airtime, billboard space, and distribution costs) are accounted for based on the provisions of SOP 93 - 7, Reporting on Advertising Costs.

Costs of advertising are expensed, either as incurred or the first time the advertising takes place (e.g., the first public showing of a television commercial or the first appearance of a magazine advertisement) with the following two exceptions provided for in paragraphs 26 and 27 of that SOP:

Direct-response advertising whose primary purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising and that results in probable future economic benefits. Costs of direct response advertising that are capitalized should be amortized over the period during which the future benefits are expected to be received.

Expenditures for advertising costs that are made subsequent to recognizing revenues related to those costs. For example: a company may assume an obligation to reimburse its customers for some or all of the customers’ advertising costs (cooperative advertising). In that scenario, revenues related to the transactions creating those obligations are earned and recognized before the expenditures are made.

For purposes of applying SOP 93-7, those obligations should be accrued and the advertising costs should be expensed when the related revenues are recognized.

Example - Selling Cost

Developer X sells developed lots. The buyers of the lots have made only nominal down payments, and X has determined that the application of the deposit method of accounting is appropriate. X intends to defer the following five types of costs incurred in connection with X’s efforts to sell the lots:

1. Wages and commissions paid to sales personnel, and related insurance, taxes, and benefits for sales personnel

2. Costs for the corporate sales department

3. Radio and newspaper advertising expenses

4. Telephone, hospitality, meals, and travel costs for customers and prospective customers

5. Title insurance and professional fees incurred in the sale

X intends to defer these costs, as they are incurred in connection with D’s efforts to sell the lots. The question is: “Is a deferral of these costs appropriate?” Here is the answer set:

1. To the extent the costs for wages and commissions to sales personnel relate directly to successful sales efforts, their deferral (together with the deferral of any related insurance, taxes and benefits) is appropriate.
2. Costs of the corporate sales department are not directly associated with successful sales and should not be deferred.
3. For advertising costs, the guidance in SOP 93-7 should be followed.
4. To the extent that telephone, hospitality, meals, and travel costs for customers and prospective customers are incurred directly for successful sales efforts, their deferral is appropriate.
5. Title insurance and professional fees are incurred directly in connection with the sales; their deferral is appropriate.

The AICPA has issued SOP 04-2, Accounting for Real Estate Time-Sharing Transactions, which includes guidance relating to the deferral of costs for the sale of time-sharing intervals. That guidance may provide additional insights when considering what types of selling costs to defer.

One is sometimes called upon to make sales forecasts or verify those made by the sales and marketing departments. One of the better approaches for doing this is to extend the past history of sales volume forward into the periods being projected. Though this method of prediction is like trying to drive a car by looking in the rear view mirror, it is still one of the best tools available, as long as it is supplemented by detailed conversations with the sales staff to see what is really happening in the marketplace.

There are two formulas provided by Excel that result in forecast information:

The first, and simplest, is the TREND command. This one superimposes a trend line on an existing set of time-sequenced data points to arrive at an expected sales level for a specified future period.

To illustrate the command, we return once again to the income statement shown earlier in my previous post [Financial Statement Proportional and Ratio Analysis with Excel Spreadsheet]. We will use a new worksheet within the same spreadsheet, called Trend, and reference in it all of the monthly sales figures from the previous income statement. This is shown in below figure, along with a graph that shows the added trend line.

In the above worksheet, we already know all sales data points from January through August, and want to calculate a trend line that extends an additional month to give us a prediction for September sales. Accordingly, in the table of months and historical sales figures noted in the Trend worksheet, there is an additional cell next to the “August” sales period. In that cell we enter the following formula:

TREND(B4:B11,A4:A11,A12)

Though it looks complicated, this is a relatively simple command. The trend line is based on the data points contained in cells B4 through B11 for the date ranges contained in cells A4 through A11. The date for the period to be forecast is noted in cell A12. The formula generates a number that is the extension of the trend shown by the previous data elements and will deposit this number in the B12 cell.

Another way to state the formula is to ignore the dates and just ask for the next number in sequence. The formula, based on the previous example, looks like this:

TREND(B4:B11, ,{9})

Under this variation, we are using the same set of data points, but ignoring the dates (hence the two commas in the formula with no data in between), and a number in brackets which represents the trend for the ninth number in the sequence of data elements. Since the original set of data only included eight data elements, this will be the next revenue figure after the last month of actual data. If the requested trend were for the month of December, the number in brackets would change to {12}, since this would represent the twelfth data point in the series.  However, to add a trend line overlay to the presented data, click on the completed graph, move the cursor to the revenue line on the chart, and press the right mouse button. Then click on the Add Trend line option, and pick from six available types of trend lines that can be added to the graph.

The second type of forecasting tool provided by Excel is REGRESSION ANALYSIS. This is a powerful tool for determining the trend line that best fits a disparate set of data, and is most useful when dealing with a set of numbers that are widely scattered, and show no apparent pattern.

In essence, the method determines the trend line that minimizes the sum of all squared errors between all data points and the line. Rather than delve into the formula for this method, it is easiest to plot the data elements and proceed immediately to a graph, on which Excel will superimpose a regression trend line.

In the above figure, the second half of the presentation includes the regression analysis. In it, we have plotted twenty data items for twenty periods that are wildly different from each other, and have no apparent pattern. The first step in the analysis is to create a graph. Then use the same steps just described for the TREND analysis to add a trend line to the chart. The result is shown in the bottom half of the above figure, where we find that there is a slight upward trend line to the data used to compile the regression trend line.

Of the two methods presented, the TREND formula is of the most use, for one will find that most data being analyzed in the financial arena has a lengthy and steady trend line of data. Only for the most unusual analyses, involving wildly disparate data items, will the regression analysis be necessary.

The following list shows some of the trend lines that you may consider and try when measuring a company’s operations using the TREND formula in excel spreadsheet:

1. Trend of amount of utilized storage space. This trend can spotlight many contributing problems, such as obsolete inventory, returned goods, scrapped parts, and excess finished goods.
2. Trend of cost of distribution channels. This analysis should include the net margins earned on each sales channel.
3. Trend of cost of freight. A company may extend into new geographical regions without considering the cost of shipping product into those areas. This analysis should be conducted by region to spot such problems.
4. Trend of cost of sales calls. In particular, one should compare the relationship between the sales received from high-volume customers and the cost of making sales calls to them. It is common to find a few high-maintenance customers who are not worth the sales effort from a cost-benefit perspective.
5. Trend of design cycle iterations required. Increases in the number of design iterations indicate serious problems in the design process, while a drop in the trend indicates good design management (though it can also indicate that an insufficient number of product reviews are being made).
6. Trend of direct labor rates. This can be used in comparison to a market survey to see if company pay rates are varying from those offered by other firms. After a layoff, it can change suddenly if people whose pay varies substantially from the mean have been laid off.
7. Trend of engineering change notices issued. A jump in the number of change orders can signal the presence of quality problems, as well as a likely increase in inventory, as some components are rendered obsolete.
8. Trend of gross margins. Investigate margins by both product and volume.
9. Trend of inventory, bill of material, and labor routing accuracy. These three items require very high levels of accuracy in order to operate a production planning system. Any drop in these trends will likely result in production snafus.
10. Trend of number of product options per product family. Changes in this trend can refer to a deliberate attempt at product proliferation as a marketing strategy (if it increases) or a rationalization of engineering tasks (if it declines).
11. Trend of overhead capitalization. If the amount of overhead shifted into a capital account, such as inventory, is changing, this may signal a deliberate attempt by management to alter the reported level of earnings.
12. Trend of pricing. Track the sensitivity of sales volume to changes in pricing.
13. Trend of product returns. A sudden change in this trend can signal a quality problem in the product, or that the distribution pipeline is full.
14. Trend of ratio of overhead to production labor. Overhead can balloon rapidly, and this is a prime early indicator of the problem.
15. Trend of return on shareholders’ equity and return on assets. A significant decline in these measures signals reduced cash flow, more difficult borrowing covenants, and a host of other problems, such as reduced margins and increased expenses.
16. Trend of sales quotas. This trend can be compared to actual sales per salesperson to see if the quotas are unrealistically high or low.
17. Trend of sales volume. Examine sales volume by both territory and product.
18. Trend of utilized plant capacity. This is a good indicator of the need for additional production shifts, increased maintenance, or more facilities.