Real Estate Development

Accounting Challenges

By CA. Ramakrishna Prabhu

 Agenda
Understanding the
industry
What is real estate
development?
Property development
cycle
Development versus
construction
Development business
risks
Accounting considerations
Auditing a real estate
2
developer
 What do we mean by real estate development?

Activity that is intended to create or add value to a real

estate asset

A developer owns the asset during construction, sets the design,

provides development finance and arranges for the building works

They may manage the project themselves and provide labour and
materials on site. However, many developers subcontract all or part
of the construction work.

Developers range from high volume house builders to large single

project joint ventures

Real estate developers may have land banks of undeveloped land,

held for strategic purposes to facilitate future developments

This module considers development for sale (held as inventory)

and development to be held for long term capital appreciation or
rental income (held as investment property)
 What do we mean by real estate development?
Accounting definitions
In accounting terms real estate development can include a number of
alternatives The accounting approach depends on intentions for use of
the asset under development:
Assets under development to be held by the developer for long-
term rental income and/or capital appreciation = Investment
property, accounted for under AS 13 (IndAS 40) Investment
properties
Assets under development for sale = Inventory (AS2)(IndAS2)
Assets under development for use by the developer (owner-
occupied property) are accounted for under AS 10 (IAS 16
Property, Plant & Equipment). This is out of scope of this module.
The above applies to new build (development of bare land) and to
redevelopments of existing buildings
 Property development critical
success factors
Effective cost control
Understanding government policies and their
implications
Production of goods currently favoured by
the market
Pre-development leases or sales
Difference between development
and construction
Developer exposed to both revenue and cost risk
Construction is a service. Development is the sale of a good
Constructor usually has no equity (i.e. ownership interest) in a project
Developer usually has equity interest in project (i.e. own money at
risk)
Developer engages constructor
Constructor is engaged to build a specific asset and their involvement
in a project is completed once the asset is completed and handed over
to their client
Developer devises a strategy for the asset, commissions the
development works and markets the asset for sale and/ or lease to
tenants.
Different risk profiles
 Property development cycle
Plan:

Identify property Develop Initial

asset for development concept project
feasibility

Execute:

Appoint architects,
Acquire Obtaining
project managers, other
property funding
consultants and
constructor

Finalise:
Market for
Secure approvals, sale/ lease Finalise
i.e. local council (pre-sale Construction sale
and internal targets for
residential)

7
 Parties to a development
Local council Financing
Loan
agreement  Mezzanine
Development and Joint venture
agreement  First mortgage debt
construction
approval (DA & BA)  Equity
 JV parties

Landowner Developer Purchaser

Sales/
leasing
 Development agreements  Corporates
agreement
Construction  End Users
 Own land (land
contract  Investors/on-sellers
purchase contract)

Construction
company

8
 Development business risk often
speculative in nature
What are the two main categories of risks?
Revenue Cost
 Realisation of value  Risk of cost blow-
Market risk
out
 Funding risk
Settlement risk
 Approval risk
 Completion risk

9
 Development business risk
risk of cost blow out
Key risks
Construction risk
Design risk
Schedule risk
Finance and holding costs
Developers risk management
Committing costs early
Use of fixed price/lump sum contracts
Updating and reviewing forecast costs and progress against
project feasibilities regularly
Adequate project contingencies
10
 Development business risk
market risk
Most fundamental risk matching timing and nature of developments with market
demand
Fluctuations in property cycles
Commercial
Retail
Industrial
Residential
Factors impacting property cycle
Market sentiment
Interest rates
Competing supply (other developers)
Legislation, e.g. Incentive under tax law
Demographics
Economics
Developers risk management:
11 Development lead time, i.e. Hold short/[med] term
Pre-commitments, i.e. sales, leasing
 Development business risk
funding risk
Risk of not being able to fund the development or fund at a commercially viable rate

Increase in risk

Increase in interest rate

12
 Development business risk
funding risk (cont.)
Lender requirements for debt
Project viability (robust feasibility)
Minimum level of developer equity
Security
Pre-commitments
Interest rate
Advances and covenants
Developers risk management
Pre-sale commitments
13
Project feasibilities
 Development business risk
Approval risk
Risk that approvals to commence the
development or a stage within the
development are not received
Development approval (DA)
Building design
Property zoning
Environment clearance
Construction approval (CA)

14
 Development business risk
completion risk
Risk that development not ready for intended use by forecast completion
date
Implications
Potential fall over of pre-commitments
Sunset dates in sales contracts
Lease agreements, e.g. rental guarantees
Blow out of holding and financing costs
Developers risk management
Pass on to builder
Early completion incentive
Liquidated damages
Program float (buffer between contracted completion and
sunset dates)
15
 Development business risk
settlement risk
The risk that sales
(exchanges) will not
complete (i.e. not
settled in cash)
Developers risk
management
Exit strategy
Enforceable sales
contracts
Assessment of credit
risk
Deposits (e.g. 10% cash
16
or deposits bonds)
 Accounting challenges
Which accounting standard valuation?
Cost accumulation and allocation
Borrowing costs
Which accounting standard - revenue?
Revenue recognition

17
 Accounting considerations
Which accounting standard valuation?
Valuation
AS 2 Inventories development for sale
Inventory measured at lower of cost and NRV
AS 13(IAS40) Investment Property development to hold for long
term capital appreciation or rental income
Asset measured at fair value OR depreciated historic cost
Revision to IAS 40 eliminated potential different treatment
between new development and redevelopment of existing
investment property
AS 10/IAS 16 Property, Plant and Equipment development by owner
occupiers
Asset measured at fair value OR depreciated historic cost

18
 Accounting considerations
Key questions Accounting impact/considerations
1. What is the nature of the entitys
investment in the development?
Asset  Inventory
Subsidiary  Consolidation The answer to
Joint venture  Equity accounting/proportionate
each of these
Joint agreement consolidation questions
drives the
 Proportional consolidation
accounting
2. How is the project funded?  Debt (on or off balance sheet) treatment
 Equity

3. How does the developer acquire the  Upfront

land?  Instalments
 Land release/ related sale of lot/
property
4. What purpose is the property being  Outright sale (pre-commitment)
developed for?  Hold and lease
19  Progressive sell down
 Accounting considerations
Cost accumulation

AS2/IAS 2 Inventory
Costs must relate to that development
Capitalised costs must be directly attributable (be
careful with marketing costs)
Inventory property held for resale
Cost of acquisition
Development costs capitalised
Other costs: rates, taxes and interest
Current versus non-current

20
 Accounting considerations
Cost allocation

1. Project level (total basis)

2. Township level (area basis)
3. Subdivision (revenue basis)
Decision based on methodology followed
Consider what are the direct and allocated costs
Consider retrospective catch up standard does not
prescribe
whether prospective or retrospective approach can be used
Must be applied consistently

21
 Accounting considerations
Borrowing costs

AS 16 Borrowing Costs (revised)

Attributable borrowing costs should be capitalised into the cost of the
project
Includes interest
amortisation of discounts or premiums and ancillary costs
finance charges
exchange differences
Specific borrowings versus general borrowings (allocation on a reasonable
basis)
Capitalisation
commencement
suspension
Cessation

22
 Accounting considerations
Which accounting standard - revenue?

IFRIC 15 Agreements for Construction of Real Estate

is applied to determine whether a contract is in
scope of either
AS 7 Construction Contracts
AS 9 Revenue Recognition
Guidance Note Real Estate Revenue
 Accounting considerations
Revenue recognition: IAS 18 Revenue

Revenue recognition criteria sale of a good

1. Significant risks and rewards have transferred
2. Does not retain continuing managerial involvement
usually associated with ownership
3. Amount of revenue can be measured reliably
4. Probable economic benefit will flow
5. Costs can be measured reliably

If the above criteria are met then revenue can be

recognised

24
 Accounting/Audit
Key considerations revenue recognition matter of judgement
Assess who is exposed to majority
Recognise revenue of risks and benefits of ownership
 Cash collected of asset
 Title transferred
 No terms/
Defer revenue
conditions attached
recognition
to sale
 Cash deferred and
 No continuing
amount is contingent
involvement
 Title does not transfer
 No bonding
What if (is retained)
 Conditions attached to
 Seller of land is also
contracted to develop the sale, e.g. yield
land for the purchaser? guarantee
 Involved in assets
ongoing management
(continuing
involvement)
25
 Accounting considerations
Revenue recognition example

Land sale Rs. 100 Crore being fair value of land

Cash received at date of completion of contract
Land sale contract cannot be rescinded based on
non performance of development agreement
Separate development agreement fee (is fixed
determined on budgeted cost plus normal
commercial margin (e.g. 10%))
Seller can be terminated as developer if given 4
weeks notice, normal compensation under
agreement as opposed to large penalty for
26 termination
 Accounting considerations
Practical application of revenue recognition rules

Type of
product Revenue recognised when:
Land /plot sale  Substantially complete (meaning sewer,
water and roads are complete)
 Title obtained from authorities
 Enforceable agreement entered in to for
sale and Settled (in cash by purchaser)
Built form  Sold apartments on percentage completion
residential, achieved (100% complete)
Commercial  Completion certificate from authorities.
space

27 2
7
 Accounting considerations
Disclosures

Presentation as completed inventory or development work in progress

Presentation as development property or investment property
Investment property under construction accounting policy choice under
AS 13/IAS 40 to hold at cost or fair value. But beware if choose cost,
there is still a requirement to disclose fair value.
Disclosure relating to the varying forms of joint ventures, joint
arrangements and other forms of collaboration among developers.
Disclosure requirements relating to financing
Also:
Large number of statutory financial statements common in many
jurisdictions due to structure of real estate development groups, where
each development project may be held in a separate statutory entity for
tax, organizational or other reasons.

28
 Auditing a real estate developer
Inventory
Recoverability of inventory is the most
fundamental audit consideration
Requirements of AS 2 Measure inventory at lower of
cost and NRV
Also consider cost accumulation, cost allocation,
capitalization of borrowing cost
How do we assess this?
Project reviews

29
 Specific Issues
Accounting for infrastructure cost in respect of
megha township project and working out its
impact on final product.
Sale of land and construction under two
separate agreements
Perpetual ownership of infrastructure with
developer having continuous revenue stream
Deferred payment facilities.
 Auditing a real estate developer
Inventory
Total population
Select specific projects for testing
Apply specific item sampling to select projects for
detailed assessment by project review based upon
quantitative and qualitative factors:
linked to inherent risk (higher risk projects)
total project value greater than x
forecast profit/ loss greater than x
movement in forecast profit/ loss greater than x
management suggestions
unique or unusual arrangements
complexity, specifications, regulatory
environment
The extent of coverage over
Audit residual the total project related
population balances through project
reviews is a key judgment
Perform procedures to identify misstatements >
performance materiality in residual population,
such as:
consider level of reliance that can be placed
on tests of the operating effectiveness of
managements key controls over the whole
population, such as internal project reviews
analytical procedures: compare project
revenue and margin against expectation
(based on prior periods)
inspect internal management project reports
high level discussions with management as
to project status
 Auditing a real estate developer
Project reviews

Understand the development and risks borne by developer through

discussions with project and finance management
Inspection of management reports (e.g. Project control group meeting minutes)
detailed examination of all relevant contracts (including development agreement,
construction contract, financing and joint venture agreements)
bank covenants
Detailed analysis of the project feasibility, understanding movements and obtaining corroborative
evidence for:
sales rates and prices
escalation applied
time phasing
forecast construction costs being in line with contract
external valuations

32
 Auditing a real estate developer
Revenue recognition

Inspect sale & purchase agreements

Vouch cash receipts
Inspect relevant documentation regarding pre-
sales
Examine the revenue recognition principles
Examine the method of valuation of inventory

33
Any questions?

???

3
4