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.

A daily question faced by managers is whether the right components and services will be available at the right time to ensure that production can occur. Additionally, the inputs must be of the appropriate quality and obtainable at a reasonable price. Traditionally, companies ensured themselves of service and part availability and quality by controlling all functions internally. However, there is a growing trend toward “outsourcing” (buying) a greater percentage of required materials, components, and services.

This outsourcing decision (make-or-buy decision) is made only after an analysis that compares internal production and opportunity costs with purchase cost and assesses the best uses of available facilities. Consideration of an in-source (make) option implies that the company has available capacity for that purpose or has considered the cost of obtaining the necessary capacity. Relevant information for this type of decision includes both quantitative and qualitative factors. Here is lists the top motivations for companies to pursue outsourcing.

Top Ten Reasons to Outsource

1. Reduce and control operating costs.
2. Improve company focus.
3. Gain access to world-class capabilities.
4. Free internal resources for other purposes.
5. Obtain resources not available internally.
6. Accelerate reengineering benefits.
7. Eliminate a function difficult to manage/out of control.
8. Make capital funds available.
9. Share risks.
10. Obtain cash infusion.

Source: The Outsourcing Institute, Survey of Current and Potential Outsourcing End-Users

And below figure presents factors that should be considered in the outsourcing decision. Several of the quantitative factors, such as incremental direct material and direct labor costs per unit, are known with a high degree of certainty. Other factors, such as the variable overhead per unit and the opportunity cost associated with production facilities, must be estimated. The qualitative factors should be evaluated by more than one individual so personal biases do not cloud valid business judgment.

Outsource Decision Considerations

Relevant Quantitative Factors:

1. Incremental production costs for each unit
2. Unit cost of purchasing from outside supplier (price less any discounts available plus shipping, etc.)
3. Number of available suppliers
4. Production capacity available to manufacture components
5. Opportunity costs of using facilities for production rather than for other purposes
6. Amount of space available for storage
7. Costs associated with carrying inventory
8. Increase in throughput generated by buying components

 

Relevant Qualitative Factors:

1. Reliability of supply sources
2. Ability to control quality of inputs purchased from outside
3. Nature of the work to be subcontracted (such as the importance of the part to the whole)
4. Impact on customers and markets
5. Future bargaining position with supplier(s)
6. Perceptions regarding possible future price changes

 

Although companies may gain the best knowledge, experience, and methodology available in a process through outsourcing, they also lose some degree of control. Thus, company management should carefully evaluate the activities to be outsourced. The pyramid shown below is one model for assessing outsourcing risk.

Factors to consider include whether:

(1) a function is considered critical to the organization’s long-term viability (such as product research and development)

(2) the organization is pursuing a core competency relative to this function; or

(3) issues such as product/service quality, time of delivery, flexibility of use, or reliability of supply cannot be resolved to the company’s satisfaction.

Case Example: Outsource Decision

Here is information about inkjet printers produced by Online Computers. The total cost to manufacture one case is $5.50. The company can purchase the case from a chemical products company for $4.30 per unit. Online Computers’ cost accountant is preparing an analysis to determine if the company should continue making the cases or buy them from the outside supplier.

Production of each case requires a cost outlay of $4.10 per unit for materials, labor, and variable overhead. In addition, $0.50 of the fixed overhead is considered direct product cost because it specifically relates to the manufacture of cases.

This $0.50 is an incremental cost since it could be avoided if cases were not produced. The remaining fixed overhead ($0.90) is not relevant to the outsourcing decision. This amount is a common cost incurred because of general production activity, unassociated with the cost object (cases). Therefore, because this portion of the fixed cost would continue under either alternative, it is not relevant.

The relevant cost for the in-source alternative is $4.60—the cost that would be avoided if the product were not made. This amount should be compared to the $4.30 cost quoted by the supplier under the outsource alternative. Each amount is the incremental cost of making and buying, respectively. All else being equal, management should choose to purchase the cases rather than make them, because $0.30 will be saved on each case that is purchased rather than made. Relevant costs are those costs that are avoidable by choosing one decision alternative over another, regardless of whether they are variable or fixed. In an outsourcing decision, variable production costs are relevant. Fixed production costs are relevant if they can be avoided when production is discontinued.

The opportunity cost of the facilities being used by production is also relevant in this decision. If a company chooses to outsource a product component rather than to make it, an alternative purpose may exist for the facilities now being used for manufacturing. If a more profitable alternative is available, management should consider diverting the capacity to this use.

Assume that Online Computers has an opportunity to rent the physical space now used to produce printer cases for $90,000 per year. If the company produces 600,000 cases annually, there is an opportunity cost of $0.15 per unit ($90,000:600,000 cases) from using, rather than renting, the production space. The existence of this cost makes the outsource alternative even more attractive.

The opportunity cost is added to the production cost since the company is foregoing this amount by choosing to make the cases. Sacrificing potential revenue is as much a relevant cost as is the incurrence of expenses.

The next figure shows calculations relating to this decision on both a per-unit and a total cost basis. Under either format, the comparison indicates that there is a $0.45 per-unit advantage to outsourcing over in-sourcing.

Another opportunity cost associated with in-sourcing is the increased plant throughput that is sacrificed to make a component. Assume that case production uses a resource that has been determined to be a bottleneck in the manufacturing plant. Management calculates that plant throughput can be increased by 1 percent per year on all products if the cases are bought rather than made. Assume this increase in throughput would provide an estimated additional annual contribution margin (with no incremental fixed costs) of $210,000. Dividing this amount by the 600,000 cases currently being produced results in a $0.35 per-unit opportunity cost related to manufacturing. When added to the production costs of $4.60, the relevant cost of manufacturing cases becomes $4.95.

Based on the above information (even without the inclusion of the throughput opportunity cost), Online Computers’ cost accountant should inform company management that it is more economical to outsource cases for $4.30 than to manufacture them. This analysis is the typical starting point of the decision process—determining which alternative is preferred based on the quantitative considerations.

Managers then use judgment to assess the decision’s qualitative aspects. Assume that Online Computers’ purchasing agent read in the newspaper that the supplier being considered was in poor financial condition and there was a high probability of a bankruptcy filing. In this case, management would likely decide to in-source rather than outsource the cases from this supplier. In this instance, quantitative analysis supports the purchase of the units, but qualitative considerations suggest this would not be a wise course of action because the stability of the supplying source is questionable.

This additional consideration also indicates that there are many potential long run effects of a theoretically short-run decision. If Online Computers had stopped case production and rented its production facilities to another firm, and the supplier had then gone bankrupt, the company could be faced with high start-up costs to revitalize its case production process. This was essentially the situation faced by Stonyfield Farm, a New Hampshire-based yogurt company. Stonyfield Farm subcontracted its yogurt production, and one day found its supplier bankrupt—creating an inability to fill customer orders. It took Stonyfield two years to acquire the necessary production capacity and regain market strength.

These costs should be referred to as long-run variable costs because, while they do not vary with volume in the short run, they do vary in the long run. As such, they are relevant for long-run decision making.

For example: assume a part or product is manufactured (rather than outsourced) and the company expects demand for that item to increase in the next few years. At a future time, the company may be faced with a need to expand capacity and incur additional “fixed” capacity costs. These long-run costs would, in turn, theoretically cause product costs to increase because of the need to allocate the new overhead to production. To suggest that products made before capacity is added would cost less than those made afterward is a short-run view. The long-run viewpoint would consider both the current and “long-run” variable costs over the product life cycle. However, many firms expect prices charged by their suppliers to change over time and actively engage in cooperative efforts with their suppliers to control costs and reduce prices.

Outsourcing decisions are not confined to manufacturing entities. Many service organizations must also make these decisions. For example, accounting and law firms must decide whether to prepare and present in-house continuing education programs or to outsource such programs to external organizations or consultants.

Private schools must determine whether to have their own buses or use independent contractors. Doctors investigate the differences in cost, quality of results, and convenience to patients between having blood samples drawn and tested in the office or in an independent lab facility. Outsourcing can include product and process design activities, accounting and legal services, utilities, engineering services, and employee health services.

Outsourcing decisions consider the opportunity costs of facilities. If capacity is occupied in one way, it cannot be used at the same time for another purpose. Limited capacity is only one type of scarce resource that managers need to consider when making decisions.