As real estate projects often span long
time periods until their completion, it is of critical importance to evaluate
at the outset of a real estate project whether — for cost allocation purposes —
a project should be divided into two or more phases. For example: a real estate development company
may purchase a large tract of land to be developed over several years; portions
of the land will be developed and sold before the project as a whole is
completed. If that real estate development project is not divided into
phases, the appropriate allocation and monitoring of costs is diffi cult, and
project costs relating to the earlier stages of the development may
inappropriately be allocated to a later stage, thereby overstating profits in
the earlier years. Certain project costs may benefit one individual
unit (such as a lot, home, or condominium unit) or a group of units within one
phase; other costs may benefit one or more phases of a project or more than one
project, such as utilities or access roads. As such, the allocation of costs to
individual units, between different phases of one project, or to different
projects generally involves several cost pools and multiple steps.
When allocating project costs, one needs
to consider costs already incurred, as well as costs to be incurred in current and
future periods. For example:
in a master - planned community, individual homes are often sold before
amenities (for example, golf courses, swimming pools, or parks) have been
completed. To appropriately reflect the cost of sales that relates to
one individual home sold, a portion of the costs expected to be incurred in
future periods for the construction of the amenities must be allocated to that
home.
Selecting an appropriate cost allocation
method requires judgment. As a general rule, costs should be allocated to the
portions of a project that benefit from the costs. The intent is to
achieve a constant gross margin on sales for the project, irrespective of the
point in time sales occur. FASB Statement No. 67 outlines three
different ways to allocate costs:
- Specific identification method
- Relative value method
- Area methods or other value methods
Specific
Identification Method
Where practicable, the costs of a real
estate project are assigned to individual components of a project based on
specific identification. The specific identification method is
most frequently used for “the allocation of acquisition
costs and direct construction costs in small projects“. For example: costs charged by a
contractor to install a staircase in a new home directly relate to that home.
The amount invoiced by the contractor should be included in the cost basis of
that home.
Relative Value
Method
If specific identification is not
feasible or is impracticable, as is the case for indirect costs or common
costs, costs should be allocated based on the relative value of the components,
if possible. Under this method, costs are allocated
based on the relative fair values of the individual components of a project,
based on either “Allocation Based on Relative Fair Value
before Construction“. Land costs and all other common costs
incurred before construction occurs (including the costs of any amenities) are
allocated to the land parcels benefited, with cost allocation based on the
relative fair value before construction. For
example: a developer that purchases a tract of land on
which to build a master planned community, a shopping center, and an office
building would allocate the cost of the land based on estimates of the relative
fair value of the land parcels of (1) the master - planned community,
(2) the shopping center, and (3) the office building,
prior to the construction of the structures. A cost allocation based
on the size of the parcels would not reflect any differences in values and is
generally not considered appropriate. Unusable land and land that is donated to
municipalities or other governmental agencies that will benefit the project are
allocated as common costs of the project.
Allocation Based on the Relative Sales
Value of the Units. Under the relative value method, construction
costs for a project, such as a condominium complex, are allocated to the
individual units (for example, homes, condominium units) based on the relative
sales value of the units. 56 When allocating costs based on the relative value
method, the sales values of the units must be comparable. This is achieved by
assuming that all of the units will be completed and ready for sale at the same
point in time; any expected price increases for units that will be completed in
future periods are not taken into consideration.
The relative sales value method results
in allocating greater costs to more valuable components of a project. In
practice, the relative value method is often implemented through
the application of a “gross profit method“.
Under the gross profit method, a cost - of - sales percentage is calculated by
dividing the sum of capitalized project costs and project costs to be incurred
in the current and future periods by the estimated sales value of the unsold
units. When a unit is sold, the cost - of - sales amount attributable to that
sale is determined by multiplying the sales value of that unit by the cost - of
- sales percentage.
Area Methods Or
Other Value Methods
If the relative value method cannot be
applied, as would be the case if a real estate development company has not
determined the ultimate use of the land, another method for cost allocation has
to be used. FASB Statement No. 67 suggests the use of the area method,
such as the allocation of costs to parcels based on square footage, or “another
reasonable value method”.
Under the area method, costs are allocated based
on lot sizes, the square footage of a structure, or the number of units in a
development. The use of the area method is appropriate only if the allocation
is not materially different from an allocation that is based on relative value
methods, or if the application of the relative value method is impracticable.
Cost Allocation
Case Example
Developers C purchases land for $10 million,
which it intends to divide into three parcels. On Parcel 1, which is along the
highway, it plans to construct a shopping center. On Parcel 2, which is behind
the shopping center, C plans on building a row of 40 townhouses. Parcel 3 will
be developed into a master-planned community. The fair value of the land before
construction has been determined to be $4 million, $1 million and $5 million
for parcels 1, 2, and 3, respectively. The sales prices for the shopping
center, the town houses, and the master-planned community are estimated to amount
to $40 million, $12 million, and $100 million. How
much land cost should be allocated to Townhouse Unit 1, which has an estimated
sales price of $500,000?
The first step is to allocate the cost of
the land to the individual parcels based on the relative fair value before
construction; accordingly, an amount of $1 million is allocated to
Parcel 2. The land value allocated to the parcel on which townhouses are to be
constructed then becomes part of the common cost pool for the townhouse, which
is allocated to each townhouse based on its relative sales value. As such,
Townhouse Unit 1 will be allocated land costs of $41,667. That amount is
calculated as follows:
The sales value of Townhouse Unit 1 divided by
the sales value of all Townhouses, multiplied by the cost of land allocated to
the townhouse development: $0.5 million/$12 million multiplied by $1 million.
The allocation of costs needs to be
reviewed every reporting period to ensure that changes in circumstances, such
as a change in estimate of project costs or sales prices or in the design of
the project, are taken into consideration. Cost reallocations within or between
phases of a project are not uncommon, as the design of a project may evolve.
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