A Starter’s Guide for Real Estate Controllers
September 20, 2021
Individuals responsible for financial reporting of real estate entities, typically with the title “controller,” can often find themselves with numerous responsibilities. Depending on the size of the entity and the nature of its operations, a controller may report to a chief financial officer and have supporting staff, such as bookkeepers, or they may bear nearly all financial reporting responsibilities and report directly to ownership. Regardless of the makeup of the accounting team, a controller should focus on core responsibilities that enable them to effectively manage the entity’s accounting records, produce financial reports, and coordinate all accounting functions. Below are four areas of responsibilities along with specific suggestions for which every controller should integrate into their overall duties.
Understanding the Entity and Financial Reporting Requirements
While the day-to-day accounting functions of real estate entities may not appear overly complex, the entity may be governed by, and subject to, legal documents and reporting requirements that may not be readily apparent. To understand this critical information, a controller should:
- Review the entity’s legal documents such as operating agreements, management agreements and loan documents. These documents typically dictate financial reporting requirements including, but not limited to, the nature of any required level of financial statement assurance (i.e., audits and reviews), specific timeframes for providing financial statements with or without a required level of assurance, and the specific parties to which they are provided. Additionally, these documents may include other relevant information to financial reporting, such as the required basis of accounting, the entity’s fiscal year, description of different classes of equity, distribution methodologies, fees earned by certain members of the entity (or their affiliates), and/or financial covenants which require compliance.
- Understand the operations and nature of the entity. In essence, what is the controller accounting for? While it may be easy to disconnect the accounting function from the day-to-day operations of the asset, a controller should maintain an understanding of its economics. Keeping regular communication with relevant individuals such as property managers, asset managers, and billing managers will help a controller make accounting determinations which require judgement. A property manager can provide insight to the nature of an expenditure at a property, which may need to be capitalized and depreciated, whereas a billing manager will know the current collection status of a tenant receivable, which may need to be reversed or written off. Individuals involved with leasing will be familiar with the nuances of lease agreements with tenants, which often include free rent periods, lease incentives, and calculation methods for recovery of the property’s operating expenses (typically known as common area maintenance or “CAM” revenue). Maintaining a current organizational chart can also assist a controller in understanding the scope of the entity’s operations.
- Be familiar with the entity’s general ledger system. A general ledger system should meet the needs of the entity. The system may offer functions or modules which can improve efficiencies, such as a fixed asset module, which can track fixed asset costs and calculate and post recurring monthly depreciation expense entries. In contrast, a system may not provide the necessary functions to maintain complete and accurate accounting records. In this scenario, a controller may perform certain calculations or reconciliations in a manual spreadsheet, which may take more time and could lead to unintended errors.
- Work with property and asset managers to develop operating budgets, forecasts, and fluctuation analyses. This can help find large and unexpected variances during the financial close process, which could be indicative of accounting errors. These reports may also ultimately be requested by senior management or ownership.
Basis of Accounting
A controller should obtain an understanding of the basis of accounting required for the entity’s financial reporting needs. If the entity’s legal documents do not explicitly dictate a required basis of accounting, a controller should work with other individuals responsible for financial reporting to choose a basis of accounting which best suits the needs of the entity. Real estate entities typically report in accordance with generally accepted accounting principles (“GAAP”) or income tax basis (“ITB”) but may also require reporting in accordance with international financial reporting standards (“IFRS”) or a special purpose basis of accounting. Each basis of accounting has specific nuances which should be considered. For real estate operating entities, some of the most common differences between GAAP and ITB are as follows:
- Revenue recognition: Under ITB, revenue is generally recognized at the earlier of when earned or received, whereas under GAAP, a lessor’s revenue from operating leases is recognized on a straight-line basis over the term of the related lease.
- Uncollectible tenant receivables: In accordance with ITB, a tenant receivable may only be written off to bad debt expense once all collection attempts have been exhausted and there is no probability of collection. In accordance with GAAP, a controller should first assess the probability of collection of a tenant receivable prior to recognizing revenue. Refer to specific guidance of ASC 840 or ASC 842, as applicable, for the specific accounting treatment of tenant receivables whose collectability is not probable.
- Fixed asset capitalization and depreciation policies: Under ITB, a determination should be made if an expenditure meets the criteria to be capitalized in accordance with tangible property regulations or as qualified improvement property. If it does not meet this criterion, it should be expensed to operations as repairs and maintenance. Capitalization rules, useful lives, and depreciation methods under ITB are often inconsistent with GAAP. Regardless of the basis of accounting utilized, a controller should adopt and maintain fixed asset capitalization and depreciation policies in accordance with the required basis of accounting and apply such policies consistently.
- Other differences: Financial reporting requirements of ITB and GAAP are developed by two different governing bodies which provide the rules for each basis of accounting. While a controller may understand their basics, there are complex nuances for each requiring significant analyses, calculations and estimates in connection with, for example, an acquisition or disposition of a property, or a modification or extinguishment of a loan. GAAP further requires, among other things, considerations of asset impairment and certain fair value estimates, which are not applicable under ITB. If a transaction or event arises which requires an assessment of its facts and circumstances to determine the accounting treatment in accordance with the entity’s basis of accounting, this analysis, including the citing of specific guidance, should be memorialized by a controller for future reference.
Financial Reporting and Close
Although the financial reporting and close process occurs on a monthly, quarterly, and/or annual basis, it is an incredibly time-consuming process for a controller, and one of the most important responsibilities within overall financial reporting. When working through this process, a controller should consider the following:
- Who is the reporting entity and how are its subsidiaries accounted for? While it may be clear which asset(s) are being accounted for, real estate assets are often owned through complex ownership structures, which may result in, depending on the basis of accounting, certain assets and their operations being accounted for through consolidation or through the equity method of accounting. These ownership structures often require multiple trial balances and general ledgers to be maintained. In this instance, a controller should ensure the consistent use of one uniform chart of accounts for all trial balances and maintain detailed records of intercompany and/or related party transactions, which may need to be eliminated and/or disclosed for financial reporting purposes. Both maintaining and understanding a current organizational chart can greatly assist a controller in making these assessments.
- Are the financial statements complete and accurate? In essence, a controller should establish procedures to ensure that the accounting records reflect all activity of the entity, and its subsidiaries, during the period being reported on. There may be additional adjustments needed beyond the day-to-day accounting, such as straight-line rent adjustments, adjustments to CAM revenue, assessments and reclassifications of expenditures between fixed assets and repairs and maintenance, intercompany eliminations, and other fair value estimates. A controller should maintain detailed support and documentation for these calculations. All general ledger sub-ledgers, such as accounts receivable and accounts payable, should be reconciled to the general ledger, and material account balances should be supported by underlying documentation and calculations.
Highlighted by the accounting scandals of the early 2000s, internal controls over financial reporting is an integral responsibility of those in charge of financial reporting. These individuals, including a controller, are responsible for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of the entity’s financial statements that are free from material misstatement, whether due to fraud or error. While designing these controls, considerations should be made of the fraud triangle: opportunity, pressure, and rationalization. Controls and process steps should be formally documented in a narrative or flow chart, indicating who performs the control activity and who reviews it. This can be broken down into three main components:
- Business process controls: Controls should be in place surrounding major business process cycles, such as cash receipts, cash disbursements, fixed assets, debt, and financial reporting and close, which should include internal controls over the process of entering, posting, and reviewing journal entries posted to the general ledger. A controller should assess financial reporting risks related to the operations of the entity, and then consider controls, or lack of controls, in place to reduce these risks. Considerations should include: i) Are there proper segregation of duties? ii) Are these internal controls both effectively designed and implemented? iii) Are the individuals performing the control activities competent? iv) Is there proper review and approval, and evidence of such review and approval, within the design of the internal control?
- Information technology controls: If the network or data of a Fortune 500 company can be compromised, so can the network or data of a private real estate entity. Often overlooked, IT controls are just as critical as business process controls, as they are put in place in an effort to maintain the integrity and security of the entity’s accounting data. While these tasks can be outsourced to a third-party IT consultant, appropriate oversight should be provided. To start, a controller should take inventory of all programs, systems, and networks used to edit, access, and store critical accounting data, and then design and implement controls. This may include, for example, strengthened password settings and restricted access for network, system, and program users; two-factor authentication for network, system, and program logins; periodic review of restricted access to networks, systems and programs; periodic data backups; and the use of virtual private networks, network firewalls and anti-virus programs. Special considerations should be made if the entity utilizes cloud-based software, which hosts the entity’s accounting data. Utilizing these third-party services does not relieve a controller from all responsibilities. These third parties are typically audited on an annual basis and issue a Service Organization Control (“SOC”) report. This report, which should be obtained and reviewed by a controller, will detail any findings by their auditor, as well as the responsibilities of the entity.
- Entity-level controls: These controls are designed and implemented to ensure that the directives of management and ownership are carried out. Such controls typically come in the form of policy and procedures manuals, a code of conduct, whistle-blower hotlines, tone-setting, and reporting and communicating with ownership and/or the board of directors, if applicable.
While those responsible for financial reporting of real estate entities often wear many hats in a given day, they should be mindful of their position’s key responsibilities, some of which are highlighted above. The purpose of this article is to provide recommendations to those individuals, primarily a controller, and is not intended to be inclusive of all possible considerations and requirements for each entity.