MODULE 4

Auditing Construction and Real Estate Industry

Overview:

One successful business in the construction world is the real estate industry. This industry covers
many aspects of the property such as development, leasing, appraisal, marketing, and management
of commercial, residential, agricultural, and industrial properties. The industry fluctuates depending
on the economies but at the same time remains consistent since people always need homes and
businesses need commercial space.

While Covid-19 has thrown the Philippines’ economy into flux, early indications suggest that
construction and real estate is one of the most resilient sectors and could provide a platform for
national recovery. However, with construction projects delayed by lockdowns during the second
quarter of 2020, and demand for office space and high-end residential developments weakened by
mobility restrictions, the sector still faces headwinds. At the same time, the disruption of the
pandemic is giving rise to new opportunities. For instance, with the pandemic inducing a significant
shift towards working from home as companies adhere to social-distancing measures, co-working
spaces are emerging as a solution for firms seeking to decentralize while ensuring a sound operating
environment for employees. Agile real estate developers have the chance to establish a first-mover
advantage and capitalize on emerging opportunities as tenants and buyers seek projects that meet the
demands of the new normal.

Module Objectives:
• Know the nature and background of the particular specialized industry;
• Learn the overview, statistics, and updates of the specialized industry in the Philippine setting;
• Identify the different audit considerations and trends for the industry.
Nature and Background of Specialized 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.

Here are the four types of real estate:

1. Residential - This 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 - This kind of real estate 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 - 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. With the aim to build more infrastructure construction to help ease traffic and trade
across all regions, 100 infrastructure flagship projects have been prepared by the public sector as of
February 17, 2020. The majority of these developments would be enforced by the Department of
Public Works and Highways and the Department of Transportation. The DPWH would manage 38
projects and 42 projects from DOTr.

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.

The" Build Build Build" program which significantly introduces the administration's intent to propel the
country in achieving more developed and connected life among Filipinos, have so far increased the
number of licenses for building contractors in the Philippines. In 2018, approximately
4.8 thousand permits were issued for general engineering contractors, around three thousand for
general building, nearly two thousand for trade contractors, and around one thousand for specialty
contractors, respectively. In addition, the number of building permits has been on the rise since 2016.
For non-residential building permits alone, there were approximately 24.4 thousand permit issuances
in 2018 compared to only 17.9 thousand licenses in 2016.
Within the private sector, the motivation to construct buildings is driven not only by the "Build build
build" program but also by the income potential in the real estate business. Private construction
caters both to residential and non-residential unit consumers. Different business sectors occupy a
large amount of office space in the country, especially in the National Capital Region for their
operations. Across the region, the Philippine Offshore Gaming Operators (POGO) occupied about
738 thousand square meters of office space while businesses engaged in information technology
occupied around 573 thousand square meters. Other companies not belonging to these categories
occupied only 379 thousand square meters.

In terms of residential units' supply, the number of condominium units within the major districts of
Metro Manila has shown a different kind of appetite on property investments. At the end of 2018, the
supply of condominium units among the highly urbanized cities of Fort Bonifacio, Makati, Bay area,
and the Ortigas Center were higher compared to Alabang, Araneta Center and Rockwell Center.

The Philippines real estate market has been penetrated with high investments arising from the
presence of both, domestic and international players, in the market. The Philippines real estate
market is expected to post revenues of USD XX billion by 2020 due to the increasing urbanization
and expansion in the real estate construction projects. The demand is expected to rise due to
growth in the number of multinational companies and a number of BPO’s. The real estate market in
Philippines is poised for growth at an estimated CAGR of XX.X% over the forecast period, from
2016 to 2021.

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.

Audit Considerations

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 project accounting, revenue recognition and
valuation issues. 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. There are some steps management
and owners can take now to help make those audit kick-off discussions as productive as possible.

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 (e.g., Topic 606 Revenue
Recognition and Topic 842 Leases).
• 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 ITB, once all collection efforts are exhausted, write off any uncollectible
accounts receivable directly to operations. An allowance for doubtful accounts is not
permitted. For GAAP, record an allowance for doubtful accounts against any receivable
that may not be collectible.
• 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.

In a year where nothing has been ordinary in the real estate industry, spending time discussing
business activities and planning with your auditors could help make the year-end audit process as
efficient as possible.

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.

PFRS 15 Revenue from Contracts with Customers Considerations

• How are different goods and services within a contract identified?

• Should contract costs be capitalized?
• Should Revenue be Recognized Over Time or at a Point in Time?
• Should revenue be adjusted for the effects of the time value of money?
• What is the impact if a contract is modified?
• When should variable or uncertain revenues be recognized?
• Differences of PAS 11 Construction Contracts and PFRS 15.
• See PIC Q&A 2018-12 for more details.

Republic Act (RA) 6552 - The Realty Installment Buyer Act, more commonly known as the Maceda
Law, 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, under the Act, notice of cancellation and then
the refund (twin requirements) should be completed before cancellation of
the contract to sell can be carried 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.

Assessments:

1. State the nature and background of the specialized industry.

2. What are the relevant statistics, and updates of the specialized industry in the Philippine setting?
3. Identify the different audit and accounting considerations and trends for the industry.
4. Look for at least 2-3 audited financial statements of companies under the specialized industry in
the Philippines and list down your observations from audit report to the financial statements.