Accounting, Financial, Taxation

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.

Success of a business depends on the business owner or the financial management. Too much reliance on the lending institution to help run the business may prove disastrous. There should, therefore, be flexibility in the agreement to let the business grow and be successful. Advice and help from the lender should not be overlooked. Lenders may have had experience with other similar businesses, and you can profit from that experience. As a borrower, you should request these considerations in the lending agreement:

1. There should be an option available to you to refinance at any time. Often the lender will qualify this provision to permit refinancing only after a certain period of time or with a prepayment penalty. You may need this provision in order to take advantage of lower prevailing interest rates should they occur.
2. A conversion agreement should allow for more favorable loan conditions once certain “growth forecasts” have been met. This provision takes into consideration the fact that as your business grows, its risks may decrease. Because interest rates should be tied to perceived risk, as you prove your viability and success, you are entitled to pay less of an interest premium; arguably, your riskiness has been reduced.
3. Agree on no prepayment penalty. Changing financial conditions may provide you with sufficient cash to prepay the loan. This may be done to realize significant tax benefits, as a requirement for the obtaining of additional financing, or to put you in a better business posture. Prepayment generally will work no hardship on the lender other than to take away the guarantee of expected future earnings. There would be nothing to stop the lender from reloaning this money to other individuals and thus recovering the future earnings from someone else. The lender’s risk is that the money cannot be reloaned at equal or better rates.
4. Request limitation on interest rates. Banks prefer to charge a variable interest rate. You should negotiate limitations or caps on rates and make this a major consideration in determining whether to enter into the financing agreement. Agree on the possibility of an increased loan based on meeting certain tests. Often, if you are successful and the business is growing within certain predictable ranges, additional debt financing may be necessary to continue the growth pattern. As such, you may want the loan agreement to provide for additional advances of debt to aid in sustaining that growth. A lender should consider itself an ongoing business partner in these agreements. As you grow, so does the income of the lender. Some loans have an absolute upper credit limit, and you may borrow up to that limit without further formal application.
5. The agreement should specify identifiable assets that are pledged as collateral.
6. Seek a loan “grace” period of 30 to 60 days for noncompliance with debt arrangements. Very often this provision requires you to notify the lender in advance that you will use the provision. There probably will be a limit on how frequently this can be done.

Lenders may be more willing to permit minimum defaults when you submit a plan showing how you will make it up after appropriate notice to the lender. The worst thing you can do is surprise your lender. In most cases, a lender would rather work out a mutually agreeable accommodation than seek legal redress.

When an institution is considering making substantial loans to a company, it often requires, as part of the loan, agreements to control the business activities and obtain reports about the current status of the firm. Typically these arrangements include:

Limitations on the purchase of new assets - Some lenders have a policy to keep additional expenditures low after a loan has been made. This has the effect of slowing or stopping growth. Negotiate with the lender to ensure that this is not an absolute limitation on acquisition of new assets. Be sure that additional new assets can be purchased on a regular basis if there is provable growth associated with the need for those purchases. Show the lender that through planned growth, the risk of default is lessened. Planned growth can be accomplished only by the acquisition of additional assets based on a good business plan.

Limitations on additional debt - Once again, a lender may try to restrict the incurring of additional debt. This too has the detrimental effect of limiting growth. When negotiating with the lender, make it clear that additional debt may have to be incurred in order to sustain regular growth. An adequate business plan will certainly help as bargaining leverage for the execution of the appropriate terms in the lending agreement. The selling point to the lender is that additional debt supports additional income through growth. As the company grows, so does the lender’s security of repayment.

Salary restrictions - Because salaries of chief executives and other executives are a direct expense, lenders typically will want some restriction on these salaries so they do not skyrocket. Large increases in these salaries will dig into the profits of the firm, sometimes radically increasing expenses. Counter with a reasonable alternative, which may include tying the increases to the profitability of the firm. This also has the beneficial effect
of motivating management.

Dividend restrictions - If the company pays dividends, you should attempt to negotiate a reasonable formula for payment. The company is confronted with the competing interests of debt holders and holders of equity. The lender may prohibit the payment of any dividends. This allows for the additional retained earnings to be used for debt servicing. But it may have a chilling effect on the raising of additional equity capital. A company’s attraction as an equity investment opportunity is based on two factors: its absolute growth in net worth and the income stream of dividends. A no-dividends policy reduces the attractiveness of an equity investment possibility. Typically firms will be required to provide lenders with regular financial reports. Lenders generally will require financial statements accompanied by a certified public accountant’s (CPA’s) report. Audited reports certified by CPAs are costly and time-consuming documents to prepare. Look to reduce the requirement to a cheaper alternative such as a review or a compilation. Some people think that when they incorporate, they absolve themselves of any personal liability for the debt incurred by the business in its operation. Legally, that might be true.

However, lenders too have learned that people try to limit their personal liability by incorporating and often require certain personal guarantees by the business owner. Some banks may want you to sign a general guarantee of the business loan as a sign of “good faith” or as a “personal commitment” to the business. Here are some points to consider regarding collateral and loan guarantees:

1. Specific personal assets - It is not wise to risk everything you own. If a pledge of “good faith” is required by the lender, pick one particular asset to risk. Do not risk more than you are willing to lose in any situation.
2. The value of business collateral already offered - Typically lenders will require as much collateral as they can reasonably get. They may even seek collateral that is unreasonable. In such cases, it may be beneficial to prepare reports showing the extent and valuation of those assets pledged to secure the loan. Often appraisals by independent groups as to the value of real estate and other assets tend to dissuade the bank from seeking further collateral.
3. Stock in the business as collateral - If the business has some attractiveness and a reasonably high probability of success, the lender may take back some stock as collateral. Be wary that you are not giving up so much stock that you lose control of your business.