PRE 04: AUDITING SPECIALIZED INDUSTRIES

AUDIT OF CONSTRUCTION AND REAL ESTATE INDUSTRY

Overview

Once successful business in the construction world is the real estate industry which covers various aspects of
the property such as development, leasing, appraisal, marketing and management of commercial, residential,
agricultural and industrial properties.

Nature Background of the industry

Construction. The construction industry comprises of building, alteration, and/or repair. Examples include
residential construction, commercial construction, bridge erection, roadway paving, excavations, demolitions,
and large scale painting jobs.

• Residential construction refers to the building or renovation dwellings. The vast majority of residential
construction jobs are small renovations, such as addition of a room or renovation of a bathroom or kitchen.

• Commercial construction includes apartments, office and retail buildings, hotels, schools, public buildings,
industrial and manufacturing buildings, highways and bridges, sewers, pipelines, power lines, power plants,
and other civil engineering projects.

Real estate is any real property consisting of land and improvements such as fixtures (i.e., access door,
lighting, awnings, etc.), buildings, roads, structures, and even utility systems.

4 types of real estate:

1. Residential - includes both new construction and resale. A common category of residential real estate is
single-family homes. Other residential real estate’s include condominiums, co-ops, townhouses,
triple-deckers, high-value homes, duplexes, quadplexes, vacation, and multi-generational homes.

2. Commercial - Included in this type of real estate are strip malls, shopping centers, educational and
medical buildings, hotels, and offices. Apartments, although used for residences, are often considered
commercial since they are owned to produce income.

3. Industrial - includes manufacturing buildings and property, including warehouses. There can be various
uses for industrial buildings such as research, production, distribution, and storage of goods. However,
buildings where goods are distributed, are considered as commercial real estate

4. Land - can either mean vacant land, ranches, or working farms. Subcategories of this kind of real estate
include undeveloped, early development or reuse, subdivisions, and site assembly.

How the Real Industry Works

1. Development
Real estate development is the process of purchasing raw land, rezoning, renovation and construction of
buildings, as well as sale or lease of finished products to end-users. Real estate developers end profit by
adding value to the land such as creating buildings or improvements or rezoning and taking a risk in financing
a project.

2. Sales and Marketing

Firms that focus primarily on sales and marketing work with developers to sell buildings and units that they
create. Commissions are earned by these firms for creating all marketing material and using sales agents to
sell completed units. Sales and marketing firms focus more on new units.
3. Brokerage
A brokerage is a firm with a team of real estate agents or realtors as employees. The real estate agents help
in facilitating a transaction between buyers and sellers of property. One of their jobs is to represent either
party and help them achieve the purchase or sale with the best possible team.

4. Real Estate Lending

Lenders include banks, private lenders, credit unions, and government institutions. They play a huge role in
the real estate industry since all properties and developments use debts to finance their business.

5. Property Management
Property management firms play a role in helping real estate owners rent out the units in their buildings.
Some of their jobs include collecting rent, fixing deficiencies, performing repairs, showing units, and
managing the tenants. They charge a fee which is a percentage of the rent to property owners.

6. Professional services
There are a variety of real estate professionals who work in the industry and help make it function. The most
common examples (other than the ones listed above) are accountants, lawyers, interior designers, stagers,
general contractors, construction workers, and tradespeople.

Overview, Updates, Statistics of the Specialized Industry in the Philippines

The construction sector is one of the important industries that the government has been focusing on since
2016.

One of the big tickets in the government's infrastructure development plan is the Metro Manila Subway
Project, which would be managed by the DOTr, which would cost around 357 billion Philippine pesos. Its
targeted completion year is on 2025, and the construction would commence in six to eight months from
February 2020. Other high-valued tickets in the pipeline that would begin construction in six to eight months
are the North-South Commuter railway extensions (PNR North 2, PNR South commuter), PNR South long haul,
Bataan-Cavite interlink bridge, Panay-Guimaras Negros bridge, Taguig integrated terminal exchange and the
New Manila International Airport.

Regulators
• Construction Industry Association of the Philippines (CIAP
o Philippine Construction Accreditation Board (PCAB)
o Philippine Overseas Construction Board (POCB)
o Construction Manpower Development Foundation (CMDF)
• Local Government Units (ensuring compliance with minimun safety standards under R.A. 6541 of the
National Building Code)

Drivers
A growth in the number of multinational companies and BPO’s, increasing urbanization and expansion in the
real estate construction projects are the major drivers for the real estate sector in the Philippines. More
number of Filipinos are moving to urban areas and are adopting better ways of living and the difference
between the rich and the poor is on the decline leading to growth in the middle-class population that can
afford to buy properties. Moreover, a large chunk of the population works in the large number of BPO’s and
MNCs, which are expected to rise, leading to an increase in the demand for commercial spaces.

Restraints and Challenges

Currently, it is important for the real estate developers to meet the growing demand for properties in the
Philippines. It is necessary to solve the problem of housing backlog in the market. Moreover, the major
challenge the government faces is to boost the infrastructure spending and provide more incentives to the
real estate developers so that they shift their focus towards socialized housing. The fear of property bubble
has been around for some time now and has limited the growth of the market.

Opportunities
Investing in real estate is considered as one of the best investments, globally. The size and scale of the real
estate market make it an attractive and lucrative market for many investors, who can invest directly in
physical real estate or choose to invest indirectly through managed funds. Investing directly in real estate
involves purchasing residential or commercial properties to generate income or for resale at a future time.
The Philippines, being a developing economy, will never be short of opportunities and in addition, more
people are adopting urban lifestyles.

Types of Contracts
• Fixed-price contract
• Cost-plus contract
• Time-and-materials contract
• Unit-price contract

Risk Assessment
• Size of project
• Type of project – complex / not within the contractor’s expertise
• Timing and scheduling - penalties for late completion
• Location
• Weather
• Owner/investor
• Subcontractors
• Bid spread
• Profit fade
• underbilling
• type of contract
• claims
• material costs
• compliance risk (environmental concern, process risks, workplace, health (OSHA) and safety)
• inaccurate cost estimate risk
• changing the scope of work risk
• contractual disputes risk - legal fees , damage to reputation
• safety and liabilities issue risks - inherent dangers

Key Audit Considerations

In construction industry the
• Work is performed under contractual arrangements with customers
• Company normally obtains the contracts that generate revenue or sales by for
specific projects
• The company may be exposed to significant risk in the performance of a contract
• Customers may require a contractor to post a performance and payment bond
• Costs and revenues are typically accumulated and accounted for by individual contracts or contract
commitments extending beyond one accounting period

1. Revenue recognition
2. Cost accounting and project budgeting
3. Work in progress and percentage of completion
4. Contractual obligations and change orders
5. Project delays and claims
6. Inventory and equipment valuations
7. Compliance with regulatory requirements
8. Cash flows and working capital management
The construction and real estate industry differs in many ways from other types of business. Both can be quite
cyclical and require a strong understanding of
They also require investors/financial institutions, builders, developers and brokers to focus heavily on the
future, constantly examining new trends in development, monitoring population shifts, and adapting to
fluctuations in the market.

Steps management and owners can do for a productice audit kick-off discussions:

1. Plan ahead for discussions with auditors regarding:

• The current status and forecast of operations.
• Status of ongoing negotiations with tenants or lenders (e.g., loss of tenants, lease modifications,
COVID-19-related relief received or provided, debt modifications or refinances).
• Audit timing. Consider and anticipate any delays or inefficiencies due to the current work-from-home
environment.
• Status of any legal or regulatory issues, including communications with an attorney regarding potential or
pending legal matters.
• Subsequent events, such as tenant vacancies, which may require adjustments to financial statements or
related disclosures.
• Delays in adopting applicable accounting standard updates • Changes to deadlines, including SEC filings,
and the impact of the amended definition of accelerated filers.
2. Review major transactions and changes to internal controls and processes:
• Update internal control narratives for any changes during the current year, such as any changes as a result
of working from home or key staff turnover.
• Provide detailed explanations, along with all supporting executed legal documents, for transactions that
have occurred during the year, such as executed lease amendments or a loan-closing binder.

3. Prepare for changes in audit requests:

• Anticipate new requests, such as virtual meetings with property managers, or cash flow projections.
• Use the auditor’s secure site, to view and upload documents. Management should verify that all necessary
personnel can access the site during planning discussions with the auditors.
• Discuss and walkthrough processes and procedures remotely.
• Determine if remote access to general ledger systems exists within the system.

Going Concern Considerations While going concern is always an audit consideration, consider the pandemic
and, at a minimum, discuss with the audit team. An entity’s ability to continue as a going concern may be
impacted by a variety of adverse conditions, such as loss of a major tenant, negative operating cash flows, or
non-compliance with loan terms and covenants.

Technical Accounting Considerations There are considerations for entities reporting on either the income tax
basis (“ITB”) of accounting or generally accepted accounting principles (“GAAP”).

1. Rent Concessions:
• ITB – If tenants received rent concessions, they would directly offset revenue and the corresponding
account receivable.
• GAAP – The Financial Accounting Standards Board (“FASB”) has allowed for certain instances of rent relief
to tenants due to COVID-19 as if such relief was already included in the original lease agreement. Thus, the
entity may recognize the rent concession in the current period as opposed to accounting for it as a lease
modification.
2. Rent Deferrals:
• ITB – If tenants received rent deferrals, this would merely impact the timing of cash collection from the
tenant and not impact when revenue is recognized by the entity.
• GAAP – There are generally two options regarding COVID-19-related rent deferrals. Account for the
deferral as if there are no changes to the lease contract, but merely a delay in cash receipts; account for
such deferral as an offset to revenue during the deferral months.

3. Tenant-Related Assets:
• Accounts Receivable – Perform a thorough evaluation of the collectability of accounts receivable. Under

. An . For

• Tenant Improvements – For ITB and GAAP, identify tenant improvements relating to tenants who have
vacated and terminated their lease agreement during the year. Can these assets provide any future economic
benefit? Is the carrying amount of these assets recoverable over their remaining useful life? Are these assets
tenant specific? Should the carrying amount of these assets be written off?
• Deferred Leasing Costs – For ITB and GAAP, identify deferred leasing costs related to tenants who have
vacated and terminated their lease agreement during the year. Write off the remaining unamortized costs.
4. Deferred Financing Costs: If the entity entered into a transaction to extinguish or modify its debt,
management should perform an analysis to determine the treatment of both any existing and/or new
financing costs. The basis of accounting for which the entity is reporting on may contain nuances that dictate
the treatment of financing costs.
• Extinguishment – Generally, write off the carrying amount of existing deferred financing costs as of the date
of extinguishment. New costs incurred are capitalized and amortized over the term of the new loan.
• Modification – Generally, amortize over the term of the modified loan the carrying amount of existing
deferred financing costs as of the date of modification. Expense any new cost in the period of the
modification. However, under GAAP, capitalize new costs incurred and paid directly to the lender.

5. Asset Impairment: For entities reporting under GAAP, perform an impairment analysis of assets if
management determines a “triggering event” has occurred. A triggering event may include, for example, the
loss of a major tenant or the occurrence of negative operating cash flows. Management should determine if
any such triggering events have occurred and, if one has, determine if the carrying amounts of any assets are
not recoverable over their remaining useful lives. This is not a consideration under the ITB.

Best Practices There are several things to keep an eye on in any year that will facilitate a successful audit
season.
1. Management’s responsibilities:
• Review financial statements, whether prepared by management or an external party.
• Design, implement and maintain internal controls relevant to the preparation and fair presentation of
financial statements.
• Prepare and review a complete financial reporting package of schedules and relevant documents that will
be provided to the auditors.

2. Designate an audit point person from your team.

3. Verify the listing of accounts to be confirmed, including cash, debt and investment accounts. Sign all paper
confirmations or give electronic authorization prior to year-end, if possible.
4. If the business has hard-to-value investments, prepare detailed supporting schedules and documentation.
This should include a comprehensive write-up of the valuation methodology.

5. Discuss with your auditors if there are schedules or documentation you can provide in advance for possible
interim testing.

Main Industry Issues

• Distressed assets, in particular residential and commercial properties are in need of restructuring.
• PFRS, legal and other regulatory compliance
• Careful planning can optimize the tax position for real estate projects.
• Cost control and strong project management are essential to maximize potential returns on real estate
projects.
• Measures to optimize cash flow can reduce the impact of the global economic downturn.
• A strong focus on quality and compliance maximizes financing and sale opportunities.

Republic Act (RA) 6552 - The Realty Installment Buyer Act, more commonly known as the ,
provides remedies should the buyer default from payment based on the payment schedule initially agreed
with the developer. Under this law, in the event of buyer’s default, the buyer should be given grace period and
refund of 50 percent to 90 percent of what has been paid (provided that the buyer has paid installments for
at least 2 years). Also
out. Some legal opinions will say that
without such cancellation, the contract between buyer and developer remains valid.

With these provisions on cancellation (cancellation right of the developer), there is a chance that the real
estate companies can sustain its legal right to payment. The discussion in the new revenue standard explains
that, notwithstanding that an entity may choose to waive its right to payment in similar contracts, an entity
would continue to have a right to payment to date, if in the contract with the customer, its right to payment
for performance to date remains enforceable. This legal position on enforceability of right to payment to
support the recognition of revenue on sale of real estate is currently being reviewed by the real estate
industry