A Closer Look at the Real Estate and Construction Industry's Updated Audit Risk Alert

The recently released Audit Risk Alert (ARA) Real Estate and Construction Industry Developments identifies recent market trends, risks and accounting developments that these entities face. Here’s an overview of what’s on your real estate and construction auditor’s radar in 2015.

Background

Accountants use ARAs, published by the American Institute of Certified Public Accountants (AICPA), to learn about industry trends and recent professional developments that may affect their clients. In turn, business owners and managers can use these alerts to anticipate inquiries and additional procedures that will occur during the upcoming audit season. 

ARAs also provide an overview of industry-specific accounting rule changes that in-house accounting personnel should know about before audit season begins. The annual ARA for the real estate and construction industry is one of the most detailed that the AICPA publishes.

Market conditions

The real estate and construction ARA reports that the residential real estate market, specifically the single family housing market, has been experiencing a modest recovery in recent quarters and continues to show signs of improvement. The industrial, retail, office and hospitality real estate markets continue to grow as well. Some stronger geographic markets have rebounded to prerecession levels — or higher. 

Data collected by the Associated General Contractors of America (AGC) shows the uneven nature of the construction sector’s recovery. One reason for the inconsistency is uncertainty about federal funding for a range of infrastructure and construction programs.

Despite continued uncertainty, several positive reports came out over the summer. In June, year-over-year growth in construction spending was up 5.5% compared to the previous year. June statistics on new housing permits and starts indicated that there’s a growing appetite for further new construction in the housing market. The AGC also reported that construction employment in July 2014 reached its highest level since May 2009. 

Risk factors

ARAs help auditors identify significant risks that may result in the material misstatement of financial statements, whether due to inadvertent error or intentional fraud. Major risk factors that real estate and construction companies currently face include:

Financing. The Federal Reserve expects interest rates to remain near historic lows for the foreseeable future. However, financing continues to pose significant risk. Although the rate of foreclosures is slowing, some banks refuse to even consider real estate and construction firms as potential borrowers. 

If a business renegotiates the terms of its debt, the ARA recommends that auditors closely review the following five specific modifications:

1. Changes in yield, 
2. Timing of payments, 
3. Changes in obligor and security, 
4. Changes in the nature of the instrument, and 
5. Changes or modifications of covenants. 

Often these criteria signify a “significant modification” and, therefore, result in a taxable event. The ARA suggests that auditors monitor debt covenant compliance closely this audit season. Many banks are requiring stricter terms from borrowers and may be less willing to issue waivers for covenant breaches. 

Joint partner and subcontractor performance issues. Some contractors are joint venturing with competitors and subcontractors to cope with financing challenges and improve their bonding capacity. But these relationships often present risks. If a joint venture partner goes out of business, the contractor may be unable to complete its jobs. The ARA recommends that contractors exercise “abundant caution” with business partners, especially those for which they may have abandoned their standard bonding requirement. Auditors will closely monitor these relationships during fieldwork.

Low margins. Many contractors are currently working on projects that were bid over the previous several years at extraordinarily low gross profit margins. Contractors with significant low-margin backlogs may be unable to take on new work that is being bid at a higher gross profit margin. This will delay the recovery period for contractors that have longer-term projects. 

Shortage of qualified job supervisors. Although there are more projects to bid on than in previous years, many contractors no longer have the level of experienced and qualified supervision they once had, due to downsizing efforts during the recession. But remedying the problem by adding supervisors to the payroll could increase a contractor’s fixed overhead costs and further erode its margins.

Accounting developments

Over the last year, the Financial Accounting Standards Board (FASB) has made several changes to U.S. Generally Accepted Accounting Principles that could significantly affect real estate and construction entities. The ARA identifies the following developments that your in-house accounting staff should know about when they prepare your year-end financial statements:

• Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, 
• ASU No. 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements (a Consensus of the Private Company Council), 
• ASU No. 2014-04, Receivables — Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a Consensus of the FASB Emerging Issues Task Force), and 
• ASU No. 2014-01, Investments — Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects (a Consensus of the FASB Emerging Issues Task Force).

In addition, industry participants should be aware of the proposed changes to accounting for leases that would require a lessee to recognize assets and liabilities for the rights and obligations created by leases of more than 12 months. If issued in its current form, the updated lease standard could have a significant impact on the real estate and construction entities, including their abilities to obtain bonding and comply with loan covenants.

Professional guidance

Does your CFO or controller understand these accounting developments and how they apply in a real estate or construction context? If additional clarification is needed, contact your accounting advisor immediately to understand how the changes will affect financial reporting for 2014 and beyond.

© 2014