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.

Following on my previous post about Cost/Benefit Analysis Of ERP Implementation, here is the more chocolate. The example! To illustrate the process, let’s create a hypothetical company with the following characteristics:

Annual sales: $500 million
Employees: 1000
Number of plants: 2
Distribution centers: 3
Manufacturing process: Fabrication and assembly
Product: A complex assembled make-to-order product, with many options
Pre-tax net profit: 10 percent of sales
Annual direct labor cost: $25 million
Annual purchase volume (production materials): $150 million
Annual cost of goods sold: $300 million
Current inventories: $50 million

Now, let’s take a look at its projected costs and benefits both for a combined ERP/ES implementation and then for an ERP only project.

First, a warning!:

Beware! The numbers that follow are not your company’s numbers. They are sample numbers only. They may be too high or too low for your specific situation. With that caution, let’s examine the numbers. Below figure contains our estimates for the sample company. Costs are divided into one time (acquisition) costs and recurring (annual operating) costs . . . and are in our three categories: C = Computer, B = Data, A = People.

Note that we have not tried to adjust the payout period or the rate of return for the obvious tax consequences of expenses versus capital.

This is for simplicity (but also recognizes that the great majority of the costs are current expenses and that expenses considered as capital investment represent a relatively small number). You may want to make the more accurate, tax-sensitive calculation for your operation. These numbers are interesting, for several reasons.

First, they indicate the total ERP/ES project will pay for itself in seven to eight months after full implementation.

Second, the lost opportunity cost of a one-month delay is $1,049,250. This very powerful number should be made highly visible during the entire project, for several reasons:

1. It imparts a sense of urgency (“We really do need to get ERP and ES implemented as soon as we can”).

2. It helps to establish priorities (“This project really is the number two priority in the company”).

3. It brings the resource allocation issue into clearer focus. Regarding this last point, think back to the concept of the three knobs from my previous post—work to be done, time available in which to do it, and resources that can be applied. Recall that any two of these elements can be held constant by varying the third.

Too often in the past, companies have assumed their only option is to increase the time. They assumed (often incorrectly) that both the work load and resources are fixed. The result of this assumption:

A stretched-out implementation, with its attendant decrease in the odds for success.
Making everyone aware of the cost of a one-month delay can help companies avoid that trap. But the key people really must believe the numbers. For example, let’s assume the company’s in a bind on the project schedule. They’re short of people in a key function. The choices are:

1. Delay the implementation for three months. Cost: $3,147,750 ($1,049K x 3).

2. Stay on schedule by getting temporary help from outside the company (to free up the company’s people to work on ERP and ES, not to work on these projects themselves). Cost: $300,000.

Few will deny $300,000 is a lot of money. But, it’s a whole lot less than $3,147,750. Yes, we know this is obvious, but you would be amazed at how many companies forget the real cost of delayed benefits.

So far in this example, we’ve been talking about costs (expenses) and benefits (income). Cash flow is another important financial consideration, and there’s good news and bad news here.

First, the bad news: A company must spend virtually all of the $8 million (one-time costs) before getting anything back. The good news: Enormous amounts of cash are freed up, largely as a result of the inventory decrease.

The cost/benefit analysis for the total effort projects an inventory reduction of $10 million (10 percent of $25 million raw material and work in progress and 30 percent of $25 million in finished product). This represents incoming cash flow. (See the worksheet for details.)

The company does have negative cash flow in year 1 since most costs occur (as with virtually every project) before savings materialize. However, while the cumulative cash position is still negative at the end of year 2, the project will have generated over $5 million of cash for that year. By year 3, you are generating cash in a big way.

How many large projects has your company undertaken that have no cash impact in the second year with full savings in the third? We bet not many. For our example company, ERP and ES appear to be very attractive: An excellent return on investment (193 percent) and substantial amounts of cash delivered to the bank.

ERP Only

The major difference between doing ERP and ES together or doing just ERP is the enhanced speed and accuracy of information flow when using an ES. Every decision from forecasting to sales to production will be more accurate and faster and will thus generate added benefits.

However, you can still have an impressive change in your business with ERP even with a non-integrated information system. Presumed that the ERP project would fund one of several attractive supply chain software packages available but this would be a standalone assist to the forecasting/planning effort. There may be some added costs if ES comes after ERP due to the need to connect the ERP wiring to ES. However, this cost should be relatively small compared to the rest of the project.

Here’s a familiar question: “Does size matter?” In terms of the payout, not as much as you might think. For a very small company, the challenge usually is resources. There are simply too few people to add a major effort such as this without risk to the basic business. Too often, small companies (and, to be fair, large ones also) will hire consultants to install ES and will ignore the ERP potential. These companies are usually very disappointed when they realize the costs have not brought along the benefits.

Large, multinational companies should be able to allocate resources and should find that the benefits are even more strategic. The problem with larger companies is trying to get all parts of the company, worldwide, to adhere to a common set of principles and practices. If pulling together all aspects of the company is difficult, it is recommended that the project be attacked one business unit at a time. The impact for the total company will be delayed but the more enlightened business units that do install the total project will see rapid results.

Here are a few final thoughts on cost/benefit analysis (in the case you are attempting to implement ERP and are on the stage to calculate the cost/benefit):

1. What it has been trying to illustrate here is primarily the process of cost/benefit analysis, not how to format the numbers. Use whatever format the corporate office requires. For internal use within the business unit, however, keep it simple—two or three pages should do just fine. This is a format I found to be most helpful for operational and project management purposes.

2. We’ve dealt mostly with out-of-pocket costs. For example, the opportunity costs of the managers’ time have not been applied to the project; these people are on the exempt payroll and have a job to do, regardless of how many hours will be involved. Some companies don’t do it that way. They include the estimated costs of management’s time in order to decide on the relative merits of competing projects. This is also a valid approach and can certainly be followed.

3. Get widespread participation in the cost/benefit process. Have all of the key departments involved. Avoid the trap of cost justifying the entire project on the basis of inventory reduction alone. It’s probably possible to do it that way and come up with the necessary payback and return on investment numbers. Unfortunately, it sends exactly the wrong message to the rest of the company. It says: “This is an inventory reduction project,” and that’s wrong. We are talking about a whole lot more than that.

4. We did include a contingency to increase costs and decrease savings. Many companies do this as a normal way to justify any project. If yours does not, then you can choose to delete this piece of conservatism. However, it is encouraged the use of contingency to avoid distractions during the project if surprises happen. Nothing is more discouraging than being forced to explain a change in costs or benefits even if the total project has not changed in financial benefit.

Cost control must be exercised over manufacturing and non-manufacturing costs. Costs should only be incurred for necessary business expenditures that will provide revenue benefit to the firm.

How Can Manufacturing Costs Be Controlled?

The purpose of cost control is to obtain an optimum product consistent with quality standards from the various input factors, including material, labor, and facilities. The input–output relationship is crucial. In other words, the best result should be forthcoming at the least cost. The office should be shut down when the factory is not in operation. Since most costs are controllable by someone within the organization, responsibility should be assigned.

Changes in standard prices for material, labor, and overhead should be noted along with their effects on the unit standard cost of the product. Perhaps there is a need for material substitutions or modifications in specifications or processes.

Labor control should be jointly developed between staff and management. Line supervisors have prime responsibility to control labor costs. Actual performance of labor should be compared against a realistic yardstick. Unfavorable discrepancies should be followed up.

The Controller and CFO may assist in controlling labor costs in these ways:

1. Prepare an analysis of overtime hours and cost. Make sure overtime is approved in advance.
2. Prepare a report on labor turnover, training cost, and years of service.
3. Determine the standard work hours for the production program.
4. Establish procedures to limit the number of employees placed on the payroll to that called for by the production plan.
5. Make sure that an employee is performing services per his or her job description. Are high-paid employees doing menial work?
6. Consider overtime hours and cost, turnover rate, output per worker, and relationship between indirect labor and direct labor.
7. Improve working conditions improved to enhance productivity.
8. Analyze machinery to ensure it is up-to-date.

Because most overhead items are small in amount, proper control may be neglected. Of course, in the aggregate, overhead may be substantial. Areas to look at include the personal use of supplies and photocopying and the use of customized forms when standardized ones would suffice.

In order to control overhead, standards must be established and compared against actual performance. Periodic reports of budget and actual overhead costs should be prepared to identify problem areas. Overhead costs can be preplanned, such as planning indirect labor staff (e.g., maintenance), to avoid excessive hours. The preplanning approach may be beneficial when significant dollar cost is involved, such as in the purchase of repair materials and supplies. A record of purchases by responsibility unit may be helpful. Purchase requirements should be properly approved.

The cost of idle equipment should be determined to gauge whether facilities are being utilized properly. A good question to ask; what is the degree of plant utilization relative to what is normal?

What Can Be Done To Minimize Manufacturing Costs?

The control of distribution costs is a much more difficult problem than the control of manufacturing costs. In distribution, we have to consider the varying nature of the personality of seller and buyer. Competitive factors must be taken into account. In production, however, the worker is the only human element. In marketing, there are more methods and greater flexibility relative to production. Several distribution channels may be used. Because of the greater possibility for variability, distribution processes are more difficult to standardize than production activities. If distribution costs are excessive, who and where does the responsibility lie? Is it a problem territory? Is the salesperson doing a poor job?

Distribution costs and effort must be planned, controlled, and monitored. Distribution costs can be analyzed by functional operation, nature of expense, and application of distribution effort.

In functional operation, distribution costs are analyzed in terms of individual responsibility. This is a particularly useful approach in large companies. Functional operations requiring measurement are identified. Examples of such operations might be circular mailing, warehouse shipments, and salesperson calls on customers.

In looking at the nature of the expense, costs are segregated by month, and trends in distribution costs are examined. The ratio of distribution costs to sales over time should be enlightening. A comparison to industry norms is recommended. In looking at the manner of application, distribution costs must be segregated into direct costs, indirect costs, and semi-direct costs.

Direct costs are specifically identifiable to a particular segment. Examples of direct costs assignable to a salesperson are salary, commission, and travel and entertainment expense. But these same costs may be indirect or semi-direct if attributable to product analysis. An expense that is direct in one application may not be in another.

Indirect costs are general corporate costs and must be allocated to segments (e.g., territory, product) on a rational basis. Examples are corporate advertising and salaries of general sales executives. Advertising may be allocated based on sales. General sales executives’ salaries may be allocated based on time spent by territory or product. Here, a time log may be kept.

Semi-direct costs are related in some measurable way to particular segments. Such costs may be distributed in accordance with the services required. For example, the variable factor for warehousing may be weight handled. Order handling costs may be in terms of the number of orders. The allocation base is considerably less arbitrary than with indirect costs.

A comparison should be made between actual and budgeted figures for salesperson salaries, bonuses, and expenses. The salary structure in the industry may serve as a good reference point.

An examination should be made as to the effect of advertising on sales. Perhaps a change in media is needed.

Telephone expense may be controlled in these ways:

1. Prior approval for long-distance calls
2. Controls to restrict personal use of the telephone, such as a key lock
3. Discarding or returning unnecessary equipment

The trend in warehouse expense to sales should be analyzed. Increasing trends may have to be investigated.

To reduce dues and subscription expenses, a control is necessary, such as having a card record of each publication by subscribed to, by whom, and why. If another employee must use that publication, he or she knows where to go.

There should be centralized control over contributions, perhaps in the hands of a committee of senior management. A general policy must be established as to amount and for what purposes.