What You Need to Know About Revenue Recognition for Real Estate Companies
March 02, 2022
By Isaac Mansoura
For auditors and real estate companies alike, the financial reporting season is upon us. For each audit, the auditor must perform risk assessment procedures to target those account balances and related assertions that require special audit consideration (i.e., identification of significant accounts, classes of transactions and disclosures, relevant assertions, and the incremental audit procedures necessary to address the identified risks).
When we think of revenue recognition for a real estate company, the first things that come to mind are a tenant lease agreement and base rental revenue. That sounds simple enough, but as it relates to commercial properties, what may be overlooked are other tenant-related revenues within the lease agreement. These include common area maintenance (“CAM”) or other reimbursements of property operating expenses (“OPEX”), which typically require complex calculations. As auditors, we know that there is a presumption of fraud in revenue recognition and that presumption is generally not rebuttable. However, you should consider whether you’ve identified fraud risks in the correct revenue stream and ensure you are giving attention and applying sufficient incremental audit procedures to those revenue streams. Base rent is generally a stipulated amount in a lease; there’s nothing complex about it. However, it’s the other revenue streams that have the potential for material error or fraud. In addition to CAM and OPEX, companies reporting in accordance with U.S. GAAP or IFRS are required to adjust rental revenue on a straight-lined basis (“SL Rent”). While this sounds straightforward, SL Rent schedules can be complex and may include tedious calculations that could pose a fraud risk.
If management wants to perpetrate a fraud related to revenue recognition, it could manipulate calculations and record adjustments for/to CAM, OPEX or SL Rent. In addition, tenants could be fraudulently overbilled for CAM and OPEX. Unless the auditor identifies these revenue streams during the planning stage and applies sufficient incremental audit procedures, a defalcation could go undetected by the auditor. Every client is different, and fraud risks should be assessed based on the facts and circumstances.
Auditors have repeatedly discovered material errors relating to CAM that require material adjustment to the financial statements. Why does this occur? Whether by the preparer (e.g., company/client) or the auditor, lease agreements aren’t being analyzed in sufficient detail to capture all the includable expense items or identify those that are excludable to properly calculate CAM and OPEX, nor are the various nuances of the lease understood and applied in the calculations. These nuances include base years, base amounts, tenant’s proportionate share, gross-ups, direct billings such as for electric that may be double counted, expense pools that vary from lease to lease, and the financial reporting framework described in the lease. These reimbursements are generally calculated on massive Excel schedules that become susceptible to preparer error and are not reviewed in sufficient detail to identify and remediate such errors. Furthermore, near the conclusion of the audit, expense pools aren’t updated with adjusted balances to adjust CAM and OPEX at year-end, causing a potential misstatement. These errors can result in overstatements or understatements of revenue.
One of the most common errors that auditors identify in the CAM calculation is a result of the client erroneously including or excluding certain expenses in the operating expense pool. This may result in an overbilling or underbilling to tenants. Other errors have resulted from incorrectly calculating interim true-up adjustments to CAM to account for interim fluctuations in recoverable operating expenses.
SL Rent is another revenue item where auditors commonly discover material errors. It may sound simple, but there can be inherent risks that contribute to calculation errors. These errors often relate to lease modifications that are not accounted for appropriately on prospective basis. Free-rent periods, whether explicit in the lease, are another cause for material error. Significant free-rent periods can exacerbate the magnitude of the error. The most important thing related to this is identifying the tenant’s possession date for the space, regardless of what is explicitly stated as free rent in the lease. For example, there are instances where a tenant takes possession of their space to improve it. They are not being charged rent during this period, and there is no explicit language in the lease calling this a free-rent period. The lease states rent commencement is some date subsequent to the completion of the tenant’s improvements. This is, in substance, a free-rent period and must be accounted for in the straight-lined rent calculation.
From an audit perspective, CAM, OPEX and SL Rent should be considered to determine if a fraud risk or, at minimum, a non-fraud significant risk exists. This is also very important for those in a financial reporting role. Take extra care when preparing and reviewing CAM, OPEX and SL Rent schedules. Lease clauses can be complex and, if necessary, preparers of these schedules may wish to consult with their controllers, legal counsel or other professionals who have an intimate understanding of these leases. Annual true-ups of prior year’s CAM and OPEX should be done on a timelier basis to accurately estimate current period billings on which they are based. At minimum, some estimate should be made at or near year-end to adjust CAM and OPEX to avoid material error.
The aforementioned are things to keep in mind regarding the calculations of CAM, OPEX and SL Rent for both auditors and those in a financial reporting role. As the auditor, consider your client, the size of the leased space and complexities of lease agreement. Bigger and more complex lease agreements create opportunities for bigger errors. Think about what can go wrong and assess risk to specific revenue streams accordingly.