July 28, 2015
By Isaac Mansoura, CPA
Here’s a real-life auditing story. This past busy season, we performed our first-time audits for a new real estate client. Our engagement was, as usual, simply to audit the financial statements. As part of our initial audit procedures, we performed extensive revenue testing specifically related to operating expense reimbursements and escalation charges to determine whether all revenue had been billed/accrued pursuant to the various tenant leases.
Due to incorrect interpretation of lease clauses and miscalculations, this is an area rife with the potential for error (or even fraud). As such, we devote significant attention to it. Our procedures included a thorough review of various tenant leases focusing on, among other things, base years, base amounts, inclusions and exclusions to operating expense pools, etc.; as well as examination and recalculation of expense pools all the way down to specific tenant billings.
During the year, this particular client performed substantial Local Law 11 work (brick pointing required under NYC law). After careful and thorough review of various leases and numerous discussions with the client, it was determined that the Local Law 11 expenditures clearly fell within the definitions as repair and maintenance cost includible in the operating expense pools used to determine escalation billings.
There was just one problem: These expenditures had not been included in the expense pools for the property. Accordingly, we had the client update their calculations and the result was an excess of $1 million of additional billings to tenants — just from that one particular property. It was material to the financial statements, but more importantly, it represented real cash that the landlord would be able to recover. Needless to say, our client was very pleased.
So, to all you landlords out there, our advice is to pay extra attention to your billing/rental department and provide the training so your staff understands the nuances of various lease clauses applicable to operating expense escalations and reimbursements. Be sure to understand the various lease terms and definitions and when in doubt, speak with your auditors. As this situation clearly demonstrates, there can be unexpected benefits from a financial statement audit beyond the compliance aspect.