GAAP Principles for Real Estate Pros
Suppose everyone involved in the accounting process followed their system or no system at all. In that case, there’s be no way to tell whether a company was profitable or not, honestly.
Most real estate professionals – especially those that deal with banks for financing – follow generally accepted accounting principles or GAAP.
Understanding GAAP is not easy. Here are thousands of pages of rules and exceptions defining the proper accounting principles for nearly every scenario. This is on top of the thousands of pages in the Internal Revenue Code. However, unless a company states otherwise, anyone reading a financial statement can assume that the company has used GAAP. And if you don’t disclose that you are not, you may be opening yourself to liability.
Suppose GAAP is not the principle used for preparing financial statements. In that case, the real estate pro needs to make clear which other form of accounting they’re used and are required to avoid implying or stating in its financial statements anything that could mislead the person examining it. These different accounting forms are often known as OCBOA (Other Comprehensive Basis of Accounting) and must be consistently applied.
GAAP standards are the gold standard for preparing financial statements and the expectation that any sophisticated user of the financial statements will expect you to provide. Not disclosing that you used principles other than GAAP makes you legally liable for any misleading or misunderstood data.
These principles have been fine-tuned over decades and have effectively governed accounting methods and the financial reporting systems of businesses. Different principles exist for various business entities, and real estate brokerage and investment businesses are no exception.
GAAP standards are not black and white, however. They’re guidelines and are often open to interpretation. Frequently, it would be best if you made estimates on liabilities and collectability, as well as the expected life of an asset (real estate businesses often have high levels of an estimated expense known as depreciation). Then estimates have to be made, and they require good faith efforts towards accuracy.
You’ve undoubtedly heard the phrase “creative accounting,” and this is when a company pushes the envelope to make their business look more or less profitable than it might be – depending on whether they are looking for money or reducing their taxes. We also call this massaging the numbers. This can get out of control and quickly turn into accounting fraud. The results of these practices can be devastating and ruin hundreds and thousands of lives, as in the cases of Enron, MCI, and others.
Applying GAAP in a real estate setting is a fine line between fraud and permissibly aggressive in your financial and tax positions. Without taking the time to understand issues like cost segregation, property tax impacts, revenue and expense recognition and timing, the differences between bonuses, salaries, and dividends, as well as the effects of deferred rents, incentive payments, TI’s and other issues, it can overwhelm the non-accountant real estate pro very quickly. You must learn the critical areas of real estate accounting, the danger zones and have an excellent working knowledge of yourself or a team to assist you in making sure you stay in GAAP compliance.
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