A key factor in the growth of the economy for many years has been real estate development. Simultaneously, the financial reporting and accounting for real estate acquisition and development continue to be very complex and require a good understanding of the industry.
Generally accepted accounting principles (GAAP) requires certain costs to be capitalized or expensed during the acquisition and development of property. There are three phases related to the development process and each phase has a different set of rules for capitalization or expense of costs. It is critical for these costs to be recorded accurately due to the material nature of the transactions.
A real estate project will typically go through three stages:
This article will delve into the first of the three stages. Preacquisition costs are defined as “costs related to a property that are incurred for the express purpose of, but prior to, obtaining that property.” Some examples of preacquisition costs include option payments that will eventually be applied to the purchase price; feasibility studies to determine if the proposed project will be profitable; environmental tests to determine the risk of environmental contamination and to evaluate other aspects of the property; and professional services of attorneys, CPAs, surveyors, engineers and the like.
According to the Financial Accounting Standards Board (FASB), these preacquisition costs should only be capitalized if all the following conditions have been met:
Costs that are directly identifiable with the property include direct costs related to planning the project, finding the land, and negotiating the price. These costs can be either internal time paid to employees or external costs paid to a contractor. Direct costs are essential to the acquisition of the project and would not be incurred if the project was not happening. Therefore, these costs should be capitalized. Any costs incurred to support these activities during the preacquisition stage would be considered indirect costs. Indirect costs are costs related to administrative and office functions. Some examples would be activities related to cost accounting records for the projects; activities needed to buy supplies and materials needed at the project site; and office rent. These and other indirect costs incurred during the preacquisition phase should be charged to expense.
The property must be available for sale, and the prospective purchaser should have the ability to finance or obtain financing for the property for the costs to be considered in the preacquisition stage. If preacquisition costs are capitalized, but subsequently (based on management’s professional judgment) it was decided the property would not be purchased, the costs would then be charged to expense.
As the above illustrates, accounting for development costs can be complicated and involves some judgement on management’s part. This is only a summary on proper GAAP accounting during the preacquisition stage. Additionally, costs are accounted for differently depending on the stage of the real estate project. The remaining two stages will be discussed in later articles.