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.

#49- Impairment on Property

We received the following query from our reader:

".. other than an independent valuation, what other alternative method can we use to test for impairment on property.."

Before we proceed to answer the following question, let's assume that the property above relates to building, land or any other commercial related building employed by the Company in the course of doing ordinary busines..

To answer your question, if the property is involved in the ordinary course of business ( e.g. shophouse where a business do its trading), then the alternative method includes:
1) Discounted Cash Flow Analysis
2) Profitability forecast for the next 5 years
3) Obtained market price of the similar property in the area nearby

To elaborate on point 1 and 2 above, if the business is able to generate sufficient cash flow and be in profit position. The auditor can conclude that there is no indcation of impairment on the property. As the asset employed is sufficient to sustain the business operations of the Company, and hence no impairment.

Besides that, the auditor could obtained the last transation price of the similar property in nearby area to compare the market price to book value of the property, in order to assess the existence of indication of impairment.