Chapter 47 Auditing Real Estate Companies.docx

Chapter 47 Auditing Real Estate Companies.docx

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Chapter47AuditingRealEstateCompanies

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47

AuditingRealEstateCompanies

47.1OVERVIEWOFTHEINDUSTRY   

（a）OrganizationalForms,   

（i）LimitedPartnerships,   

（ii）LimitedLiabilityCompanies,   

（iii）PartnershipAgreements,   

（b）RealEstateInvestmentTrusts,   

（c）RegulatoryFramework,   

47.2ACCOUNTINGPRINCIPLESANDPRACTICES   

（a）EquityInvestments,   

（b）RealEstatePropertiesandDeferredCosts,   

（c）ImpairmentandValuationofRealEstateAssets,   

（d）Leasing,Sale,andOperationalPeriod,   

（e）ProfitRecognitiononSalesofRealEstate,   

（f）AccountingbyParticipatingMortgageLoanBorrowers,   

（g）ExtinguishmentofDebt,   

（h）OperatingRentalRevenues,   

47.3AUDITSTRATEGY   

47.4SUBSTANTIVETESTS   

（a）Developer'sReceivables,   

（b）PropertyAcquisitionandDevelopmentCosts,   

（c）RealEstateSales,   

（d）OperatingRentalRevenues,   

（e）DepreciationExpense,   

47.1OVERVIEWOFTHEINDUSTRY

Theboundariesoftherealestateindustryaredifficulttodefinebecausemanyentitiesthatengageinrealestatetransactionsalsoderivesubstantialrevenuesfromothersources.Forthepurposesofthischapter,arealestatecompanyisonethatderivesitsprincipalrevenuesfromactivitiesinvolvingthecontrol,ownership,orsaleoflandandbuildings.Thisdefinitionencompassescompaniesthatengagein:

∙Owningundevelopedlandforwholesaleorretailsale

∙Landdevelopment

∙Improvingandsellingrealpropertyasaprimaryproduct（e.g.,ahomebuilder）

∙Acquiringandimprovingpropertytobeheldasaninvestmentfortheproductionofcurrentincomeandforfutureappreciation

Manycompaniesareinvolvedinmorethanoneofthoseactivitiesand,inaddition,deriverevenuesfromavarietyofancillaryservicesassociatedwithrealestate,suchasfinancing,propertymanagement,insurance,subcontracting,andbrokerage.Inaddition,anumberofothertypesofbusinesses,suchasbrokerage,leasing,management,andfinancing,arecloselyassociatedwithrealestateownershipandoperations.

（a）OrganizationalForms

Companiesintherealestateindustryareorganizedundervariouslegalforms,includingsoleproprietorships,limitedpartnerships,limitedliabilitycompanies,generalpartnerships,corporations,jointventures,andtrusts.Theformoforganizationisgovernedlargelybytheobjectivesofthebusiness.Forexample,acontractororbuildernormallyselectsthecorporateformoforganizationtoobtainthebenefitsoflimitedliabilitybecauseofthebusinessrisksassociatedwiththistypeofoperation.Ownersofanindividualprojectmayorganizeasalimitedpartnershiptoobtainthebenefitsofbothlimitedliabilityforthepassiveinvestorsandthepass-throughoftaxlossesthatmaybedeductibleincertainsituations.

Realestateisparticularlysensitivetochangesineconomicconditions,andrealestatecompaniesusuallyavoidassemblinglargecentralstaffsandmakingheavycapitalinvestments,sothatoverheadcanbereducedtoaminimumduringdifficulteconomictimes.

（i）LimitedPartnerships.Thelimitedpartnershipformoforganizationisespeciallywellsuitedtorealestateventures.Ithasmanyofthefavorabletaxattributesofageneralpartnership,butprovideslimitedliabilityforthelimitedpartners.Theselimitedpartnersgenerallyareresponsibleonlyforthecapitalthattheyhavecommittedtothepartnership,althoughinsomeinstancestheymayberequiredtoreturncashpreviouslywithdrawnfromthepartnership.Thelimitedpartnershipformenablesthegeneralpartners,whoareusuallydevelopers,toobtainequityfromoutsidesourcesforrealestateprojectsandmaypermitlimitedpartnerstoselltheirinterests（e.g.,thetradingunitsinamasterlimitedpartnership）,thusprovidingthelimitedpartnerswithliquidity.

Investorsinalimitedpartnershipreceiveashareofthepartnershiplosses,whichtheycanusetooffsettaxableincomefromothersourcesincertaincircumstances.Incomefromthesaleofrealestateresultsinacapitalgain,whichreceivespreferentialtaxtreatment.UndertheTaxReformActof1986（TRA86）,lossesfromaninvestmentinalimitedpartnershipareclassifiedaspassivelossesthatcanoffsetonlyotherpassiveincomeandmaysubjecttheinvestortothealternativeminimumtax.

（ii）LimitedLiabilityCompanies.Manystateshavepassedlegislationallowingfortheformationoflimitedliabilitycompanies.Theseorganizationsprovidemembers（shareholders）withtheprotectionofacorporationbutfortaxpurposesaretreatedaspartnerships.Theadvantageofalimitedliabilitycompanyoveralimitedpartnershipisthatitprovidestheshareholderswhofunctionasgeneralpartnerswiththesamelimitedliabilityasthosewhofunctionaslimitedpartners.Thistypeoforganizationeventuallymaybecomethepreferredmethodofownershipofrealestate. 

（iii）PartnershipAgreements.Thepartnershipagreementisasignificantdocumentforrealestatecompaniesorganizedaspartnerships.Theagreementidentifiesthescopeofactivitiesinwhichthepartnershipmayoperate,setsforththepartnership'stermofexistence,definestheconditionsunderwhichthepartnershipmaybeterminatedordissolvedbeforethestatedterminationdate,anddetailstherespectivepartners'rightsandresponsibilities.Theagreementaffectsnotonlytheaccountingforthepartnership,butalsotheprofitrecognizedbythedeveloper/generalpartner.Thefollowingprovisionsofatypicalpartnershipagreementareofparticularinteresttotheauditor:

∙CapitalContributionsandBorrowings.Theagreementsetsforththetotalamountofthepartner'sinvestmentandthepaymentscheduleonwhichcapitalcontributionsaretobemade.Theamountandtimingofcontributionsmateriallyaffectboththeinvestor'sreturnontheinvestmentandthecostoftheproject.Normally,aninvestorisrequiredtosignapromissorynoteforthecapitalcontributionsthatarepayableafterthedateofadmission.Termsofdefaultandremediesforthegeneralpartnersaredefined,andnormallytheuseofallcapitalcontributionsisspecifiedinthepartnershipagreement.Mostagreementsalsograntthepartnershiptherighttoborrowmoneyfromothersourcesandestablishcertainrequirementsforandlimitationsonsuchborrowings.

∙CapitalAccounts,ProfitsandLosses,CashFlow,andDistributions.Theagreementstatestheaccountingmethod（cashoraccrual）andthefiscalyearofthepartnership（whichisnormallyacalendaryear）.Cashflowandprofitsandlossesnormallyaredefined,andthemethodofallocationamongpartnersisstated.Inaddition,theallocationofgainorlossandoftheproceedsonasaleoftheprojectandthedistributionofproceedsfromarefinancingarespecified.

∙RightsandResponsibilitiesofPartners.Theagreementdefinestherightsandresponsibilitiesofthelimitedpartners.Limitedpartnersusuallyhavetherighttocallmeetings,voteforamendmentstothelimitedpartnershipagreement,andvoteforremovalorsubstitutionofthegeneralpartners;participationinmanagementbythelimitedpartnersusuallyisprohibited.Inaddition,theagreementsetsforththegeneralpartners'responsibilitiesformanagingthepartnership.Thesegenerallyincludethepowertoappointthemanaginggeneralpartnerandtherighttoacquirepropertyandtoexecuteamortgagenote,constructioncontract,managementagreement,andotherdocumentsrequiredinconnectionwiththeconstructionandoperationoftheproject.Inaddition,theagreementgenerallyspecifieswhetheranauditorreviewoffinancialstatementswillbeprovidedwithinaspecifiedtimeframe.Themostrelevantprovisionsfromtheauditor'sviewpointrelatetothegeneralpartners'righttopayorreceivespecifiedfeesascompensationfororganizinganddevelopingthepartnershipandformanagingtheconstructionphaseoftheproject.Alsosignificantarethegeneralpartners'obligationstoinitiateandsupportrentaloperations.Usuallythegeneralpartnersandmanaginggeneralpartnerdonotreceiveanycompensationformanagingtheaffairsofthepartnershipintheircapacityasgeneralpartners.Theymay,however,receivefeesthroughrelatedparties,suchasmanagementfeestoaffiliatedmanagementcompanies,forprovidingservicesotherthanthosethatarepartoftheirroleasgeneralpartners.

Thespecifictermsofpartnershipagreementsvarywidely.Theauditorshouldbefamiliarwiththepartnershipagreementtodeterminewhethertheaccountingprinciplesappliedbythepartnershipareinconformitywiththeagreement,andwhetherthegeneralandlimitedpartnershavecompliedwiththerestrictiveprovisionsoftheagreement.Thetermsofthepartnershipagreementcansignificantlyaffecttheamountandtimingoftheprofitadeveloper/generalpartnermayrecognizeonatransactionwiththepartnership.

（b）RealEstateInvestmentTrusts

RealEstateInvestmentTrusts（REITs）arecorporationsthatallowinvestorstopurchasestockatastatedpricepershare.Thestockmaybelistedonanexchangeandactivelytraded,thusprovidinginvestorsameansofliquidity.Aninvestorgenerallyreceivesadividendeachyear,sincetheREITrulesrequirethat95percent（90%commencingin2001）oftaxableearningsbedistributed.IncomefromaREITisconsideredportfolioincomeandthuscannotbeusedtooffsetpassivelosses.

AcommontypeofentitythatholdsrealestateisknownasanUmbrellaPartnershipRealEstateInvestmentTrust（UPREIT）.AnUPREITisanoperatingpartnershipthatownspropertyandhasaREITasitssolegeneralpartner.Thesellerofpropertyhasanoptiontoreceiveoperatingpartnershipinterests（units）orsharesinthe