Audit considerations for Japan real estate companies

According to report from Standard & Poor’s with regard to Japan’s property market:

“ Diversified real estate companies had strong condominium sales in fiscal 2010 but at the expense of margins. Companies cut selling prices to clear inventory despite unrealized losses on fixed assets. Earnings could come under further pressure in fiscal 2011 because of possible delays in construction completions or sales slippage due to the earthquake. Japanese real estate investment trusts have turned acquisitive after recapitalizing their balance sheets, and this has”

[Note: the paragraph above was quoted from Standard & Poor’s]

If you are the auditor of a real estate companies in country, where the economy is suffering from the global slow down, please take note of the marketing strategy adopted by your audit client. As evident above, certain real estated companies are cutting their selling prices of the properties developed at the expense of profit margins. In worst case scenario, the real estate may even incur a negative margin (ie. selling the property at losses).

There are a number of reasons, where a real estate developer may conduct the sales transactions in above patterns:

- to meet the cash flow/ working capital demand (i.e. to pay off debt due / repay vendors)

- to meet the analyst’ expectation on sales revenue; the drop in GP Margin might not be evidenced obviously, as the real estate companies may have earned positive GP Margin in previous quarters / from other projects (i.e. cushion effect)

- to minimize the risks that the inventory might not be sold in a slowing-down market

- to avoid the actual and economic costs of holding on to inventory

What will be the implication for the audit for the above scenario? There are risks that the real estate company may end up in a gross loss position from this project, if margin is too thin. “Provision for foreseeable losses” need to be recognised immediately.

How to estimate the “Provision for Foreseeable Losses”:

(a) Determine the remaining quantified (of properties) to be sold;
(b) Determine the projected / estimated selling prices and compare that to the cost-to-build for each property; if it’s a gross loss position, then provision need to be provided
(c) Total provision to be provided = remaining quantities x gross loss estimated

Please apply professional judgement and maintain professional susceptibility while reviewing the working prepared by client to ensure that all costs have been considered.

#102- Auditing operating cost- understanding cost drivers

Auditing operating costs is always not an easy task. A good audit procedure requires auditor to develp a thorough understanding of the nature of the cost,determination of fixed / variable costs, understand the cost drivers of the costs (especially for variable costs),understand the linkage between the costs and the revenues.

Significant assertion of auditing an operating cost is to ensure that the cost recorded is complete (i.e. completeness).

First of all, we need to understand the nature of the costs (i.e. what type of costs, when was the costs incurred, is the individual amount incurred significant, etc). After develop the understanding of the nature of the costs, we need to understand whether the costs is a fixed costs, or variable costs.

Then, we need to understand the cost driver of the costs. This procedure is especially important for variable costs component. Auditor need to understand what are the factors that drive the cost (for instance, transportation cost could be significant to a trading house). The cost driver for transportation cost is the level of business activities / number of deliveries completed

Auditor can analyze the company's record on number of deliverties completed for the year, and compare our expectation to the cost variation. To illustrate, while number of deliveries go up, we will expect total transportation cost to increase. A good understanding of the cost drivers allow the auditor to have complete understanding of the costs/ and develop a good audit approach to analyze the cost variation.