Accounting, Financial, Taxation

Investments in real estate projects require significant amounts of capital. For real estate properties that are developed and constructed, rather than purchased, project costs include the costs of tangible assets, such as land and other hard costs (sometimes referred to as “bricks and mortar”); intangible assets and other soft costs, such as architectural planning and design; and interest and taxes. Costs are often incurred before the actual acquisition of the project, which raises certain questions — for example: from what point in time should costs be capitalized? What types of costs are capitalizable?

Determining what types of costs to capitalize in the pre-acquisition, acquisition, development, and construction stages of a real estate project has been an issue for many years. Several decades ago, the “American Institute of Certified Public Accountants (AICPA)” issued the following accounting guidance relating to cost capitalization, reacting to significant diversity in practice:

1. Industry Accounting Guide, Accounting for Retail Land Sales , issued in 1973
2. Statement of Position (SOP) 78 - 3, Accounting for Costs to Sell and Rent, and Initial Rental Operations of, Real Estate Projects , issued in 1978 SOP 80 - 3, Accounting for Real Estate Acquisition, Development, and Construction Costs , issued in 1980
3. In 1982, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 67, Accounting for Costs and Initial Operations of Real Estate Projects , extracting the accounting principles provided by these AICPA pronouncements.

Nevertheless, diversity in practice has continued to exist in some areas, including the capitalization of indirect costs during the development and construction period and the treatment of repair and major maintenance costs incurred subsequent to the completion of real estate projects.

The AICPA undertook another project to develop a comprehensive framework for cost capitalization and, in 2003, issued for public comment the proposed Statement of Position, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment. That proposed SOP was approved by the AICPA Accounting Standards Executive Committee (AcSEC), in September 2003; however, a fi nal SOP was never issued. In April 2004, the FASB decided not to clear that proposed SOP, mainly for the following stated reasons:

1. Lack of convergence with International Accounting Standards
2. The concept of componentization, particularly the amount of judgment allowed, which could potentially result in lack of comparability
3. Implications for the capitalization of major overhaul expenses

FASB Statement No. 67 provides the primary authoritative guidance for the cost capitalization of real estate project costs. That Statement divides the costs incurred to acquire, develop, and construct a real estate project into pre-acquisition and project costs. Pre-acquisition costs encompass costs incurred in connection with, but prior to the acquisition of, real estate. Project costs include costs incurred at the time of the real estate acquisition, as well as costs incurred during the subsequent development and construction phase.

Real estate developed by a company for use in its own operations other than for sale or rental is not within the scope of Statement 67. 1.  Because — aside from the proposed SOP, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment — there is no authoritative literature relating to the capitalization of costs for properties used by an enterprise in its own operations, the guidelines in Statement 67 are generally also applied to properties used by an enterprise in its own operations.

On the next post, we are going talk in more detail about “PREACQUISITION COST”

After a business decides on the format for reporting its income statement (multi-step or single-step), the next main decision concerns how much information to disclose about its expenses. Public companies are subject to financial disclosure rules issued by its national securities exchange commission.

A publicly owned business has no choice but to abide by these rules. Otherwise, trading in its stock shares could be suspended by the SEC.

Income statement disclosure standards for nonpublic businesses (that is, those not subject to the SEC’s jurisdiction) are surprisingly vague and permissive. Generally accepted accounting standards (GAAP) say little about how much information should be disclosed about expenses in the income statement. Generally speaking, businesses that sell products report their cost of goods sold expenses, and almost all businesses report their interest and income tax expenses. But, it’s much more difficult to generalize about the disclosure of other expenses.

Okay, “expenses“….Some businesses disclose only this expense because they’re very stingy about revealing any more detail about their operating expenses. Other businesses report five or ten operating expenses in their income statements.

In deciding how much expense disclosure should be included in income statements, businesses make three main considerations:

Confidentiality: Many businesses don’t want to reveal the compensation of the officers of the business, for example. They argue that this information is private and personal.

Materiality: Most businesses don’t see any point in reporting expense information that’s relatively insignificant and would only clutter the income statement.

Practicality: Businesses limit the income statement contents to what fits on one page. A business can put additional detail about expenses in the footnotes to its financial statements, but many argue that shareowners and lenders have only so much time to read financial statements and putting too much information in their financial reports is counterproductive.

Assume that you are one of the major shareowners of the private business whose annual income statement is shown in. You aren’t a manager of the business or on its board of directors, but as an outside investor, you’re vitally interested in how the business is doing financially. So you carefully read the business’s financial statements, especially its income statement.

You depend on the business making a profit in order to pay dividends from profit to its shareowners. Are you satisfied with the extent of expense disclosure in the income statement? Do you want the income statement to report one or more of the following expenses?

1. Compensation of officers
2. Salaries and wages of employees
3. Repairs and maintenance
4. Bad debts
5. Rents
6. Taxes and licenses
7. Depreciation
8. Advertising
9. Pension and profit-sharing plans
10. Employee benefit plans

In all likelihood, the business keeps accounts for these expenses because they have to be reported in its annual income tax return. So the information is available and could be reported in the business’s income statement. When giving a consultation to a management team, who was on the stage to just about present income statement to their shareholder, I found the Income Statements reports all these expenses. On the other hand, I saw many income statements (by other management team) that didn’t disclose these expenses.

If I were a major outside shareowner in this business, I would request that, either in the income statement itself or in the footnotes to the financial statements, information be reported about four expenses: repairs and maintenance, advertising, pension and profit sharing plans, and employee benefit plans.

Why these four?

Repairs and maintenance expense can be manipulated by management to push profit up or down for the year.

Advertising is a very discretionary expense that I’d want to compare to sales revenue.

Pension and profit-sharing plans and employee benefit plans can be very large encumbrances on a business.

In a financial report, the income statement may seem like a tub standing on its own feet, disconnected from the balance sheet and the statement of cash flows. Nothing is further from the truth. The three financial statements set are interdependent and interconnected. For example: if sales-revenue or one of the expenses had been just $5 different than the amount reported in the income statement, a $5 difference would appear somewhere in the balance sheet and statement of cash flows.

As you know, an income statement reports sales revenue, expenses, and profit or loss. But an income statement doesn’t report how sales revenue and expenses change the financial condition of the business. Example: a $26,000,000 sales revenue is reported in the annual income statement of a business. The business also reports $24,310,000 total expenses for the year. How did the sales revenue and expenses change its financial condition? The income statement doesn’t say.

Business managers rely on their accountants to explain how sales and expenses change the assets and liabilities of their businesses. Business lenders and shareowners also need to understand these effects in order to make sense of financial statements.

Suppose you’re the chief accountant of the business whose income statement is presented. The president asks you to explain the financial effects of sales revenue and expenses reported in its latest annual income statement at the next meeting of its board of directors. To help organize your thoughts for the presentation, you decide to prepare summary sales revenue and expense journal entries for the year. Based on your analysis, you prepare summary journal entries for sales revenue and for each of the four expenses reported in the income statement.

Sales - Revenue:

[Debit]. Cash = $25,000,000
[Debit]. Accounts Receivable = $1,000,000
[Credit]. Sales Revenue = $26,000,000

The business makes credit sales. When recording a credit sale, the asset account accounts receivable is debited. When the customer pays, accounts receivable is credited. The business collected $25,000,000 from customers. Therefore, its accounts receivable balance increased $1,000,000.

Inventory:

[Debit]. Inventory = $16,300,000
[Credit]. Cash = $14,500,000
[Credit]. Accounts Payable = $1,800,000

The business purchases $16,300,000 of products during the year, so, its inventory increased $16,300,000. It didn’t pay for all its $16,300,000 of purchases. Its accounts payable for inventory purchases increased $1,800,000. Therefore, cash outlay for products during the year was $14,500,000.

Interest Expense:

[Debit]. Interest Expense = $400,000
[Credit]. Cash $350,000
[Credit]. Accrued Expenses Payable $50,000

The business paid $350,000 interest during the year. The amount of unpaid interest at yearend increased $50,000. A general liability account for accrued expenses is shown in this entry (The business may credit a more specific account, such as accrued interest payable).

Income Tax Expense:

[Debit]. Income Tax Expense = $910,000
[Credit]. Cash = $830,000
[Credit[. Accrued Expenses Payable = $80,000

At the end of last year, the business didn’t owe any income tax. During the year, it made $830,000 installment payments toward its estimated income tax (as required by law). Based on the final determination of its income tax for the year, the business still owes $80,000, which will be paid when its return is filed. The general liability account for accrued expenses is shown in this entry. (The business may credit a more specific account, such as income tax payable).

These four summary entries aren’t actual journal entries recorded by a business; they simply help summarize the effects of sales and expenses on the assets and liabilities of the business. Also, I should point out that to develop the information for these entries, the accountant has to analyze the balance sheet accounts affected by sales and expenses, which takes time.