Conducting Financial Audits—What That Means to the Basis of a Property’s Value

October 2015 — Asset managers must regularly evaluate each property management firm. In real estate, the economic value of each property depends directly on the net income that the property produces. If that information is unreliable, then the entire basis for the prop¬erty’s value is questionable.

An audit is typically held either once each year or every two years. Most asset management firms are large enough to employ their own internal audit group. If internal auditors are present, then audits are usually conducted on an alternating basis: one audit is conducted by the internal group, and the next one is conducted by an independent CPA or CA firm.

Types of Audits

Four of the more common types of audits that management firms use and are subject to are:

  • Compliance audits
  • Tax audits
  • Utility audits
  • Tenant audits
Compliance Audits

Compliance audits verify whether a firm is complying with policies and procedures. These audits make certain that transactions are documented properly, are on file, and are signed by the proper person in authority. They also ensure that the company adheres to bidding and purchasing proto¬cols and conflict-of-interest (or other) ethical guidelines.

Tax Audits

Tax audits are a highly specialized field devoted to reviewing records for tax compliance. Tax audits are conducted by taxing authorities who are direct government employees. Tax auditors typically inves-tigate the classification of expenses and income.

Utility Audits

Some firms specialize in auditing utility bills paid by properties. They generally work on a percentage-of-savings basis and try to find billing errors or miscalculations. These audits are typically not per-formed by CPA or CA firms, but rather by companies specializing in a particular type of utility, such as water or electricity.

Tenant Audits

Asset management and property management firms will audit a retail tenant to verify that the tenant is properly reporting sales and paying the correct percentage as a portion of rent. Most retail leases have provisions for incorrect sales reports. For example, if there is a discrepancy of more than 2 or 3 percent, then the tenant may be required to pay for the cost of the audit. In some instances, retail leases give the landlord the right to terminate the lease if sales are misreported by 5 percent or more.

Tenants may also audit their landlord to ensure that billings are cor¬rect. In general, tenant audits are looking for direct errors in calcula¬tion of the common-area expenses or other expenses not allowed by the lease. When leases do not initially include the tenant’s right to audit common-area fees, many tenants will include this in negotia¬tions. Other areas of concern that tenants may want reviewed include proper allocation of landlord’s expenses, inappropriate administrative expenses, and reasonable efforts to minimize expenses.

Basic Audit Procedures

Asset managers deal most frequently with audits of property man¬agement companies. The steps taken to do so are detailed and methodical. The basic procedure includes:

  • Pre-audit letter
  • Pre-audit interview
  • Audit
  • Exit interview
  • Post-audit letter and audit report
  • Audit response letter
The Pre-Audit Letter

The pre-audit letter establishes the date, location, and subject of the audit. Auditors use sampling techniques to review certain files of a particu¬lar property, such as the lease, accounts payable, capital improve¬ment records, rent roll, budget comparisons, and lender files. A firm is typically given between 30 and 60 days’ notice of an audit.

The Pre-Audit Interview

In general, auditors recognize that they are imposing on the man¬agement team being audited, and they use the pre-audit interview to develop a positive working relationship with its staff. During the interview, the auditor meets with the management and accounting staff of the company and uses this time to discuss concerns relating to the company. One of the specific issues that an auditor evalu¬ates is the internal control structure and the segregation of duties. Accounting functions should be separated, with one employee han¬dling bank deposits, another preparing checks, another handling bank reconciliations, and so on. At the initial meeting, an audi¬tor will identify who is responsible for specific functions and may then determine whether the work is being handled through proper channels.

The Audit

Although initially an auditor requests only a sample of documenta¬tion, he or she may explore any additional files during the process. For instance, when there are discrepancies or incomplete data in a sample, an auditor will review additional files to determine how widespread the problem is. On-site audits typically last from one day to two weeks. The time required depends on the number and complexity of properties being audited.

The Exit Interview

At the completion of the audit, the auditor schedules an exit inter¬view. At this interview, an informal discussion takes place where the auditor talks about areas of concern that developed through the audit process. These areas of concern are known as audit points and are listed in a formal letter. The company being audited wants to avoid having too many points.

In some instances, a clarification by management can eliminate audit points from being formally listed on a post-audit letter. For example, if an auditor finds that the property manager is making decisions beyond the authority provided by the management contract, the auditor should list this as an audit point. In response, management might point out that authority was granted in autho¬rization letters that the auditor had not seen. Through this type of discussion, a management firm can avoid certain formal audit points.

In addition to those items that are formally listed in an audit letter, an auditor also discusses general concerns and recommendations for improved operations.

The Post-Audit Letter and Audit Report

Soon after completing the audit and exit interview, an auditor prepares a formal post-audit letter. The letter, also referred to as an audit report, is a formal document that specifies in detail any accounting deficiencies or control problems that were uncovered through the audit. Senior manage¬ment takes audit reports very seriously—a negative report may be grounds for a contract termination.
The following is a sample list of audit points frequently encoun¬tered by an asset management company. It is fairly representative of what most firms find when they audit property management companies.

Cash/Bank Accounts
  • Deposits should be made on a timely basis. To be con¬sidered timely, deposits should be made within 24 hours.
  • Excess funds should be promptly wired to owner. Excess funds will vary with property size, but are generally con¬sidered to be anything over $2,000 to $5,000 beyond net cash outflow.
  • Monthly bank reconciliations should be prepared and signed off by the preparer and the reviewer.
Accounting Software/Backup
  • Fee manager should have at least two accounting per¬sons with a working knowledge of the accounting software.
  • A person of authority should maintain a log of system passwords that should be changed periodically.
  • Back-up disks should be kept in a secure off-site, fire¬proof location.
Vendor Invoices
  • Check signer should have invoices and approved supporting backup when signing checks.
  • Invoices should be marked “paid” when check is issued.
Management Agreements
  • An executed management contract should be on file for every property managed.
  • The schedule of the management agreement that lists reimbursable employees should match payroll ledger and require owner’s approval prior to any change.
  • Fees being charged by the property manager should agree with the management contract.
Journal Entries
  • Journal entries should have adequate explanations.
  • Nonroutine journal entries should have review sign-off.
    Escalation Billings/Accounts Payable
  • Billings should be prepared with proper calculations and within the time allowed for in the lease agreements.
  • All delinquent accounts should be regularly reviewed with appropriate workout agreements approved by owner.

It is important that asset managers be sensitive to the time, effort, expense, and stress that audits cause. If a clean audit letter is issued, it can be a thoughtful gesture to send a congratulatory note or make a phone call expressing appreciation to the firm being audited. This courtesy will help to maintain a positive working relationship.

The Audit Response Letter

It is important that a timely and thorough response be provided to the audit letter and report. An audit response letter is a property manager’s response to the formal audit report. It is management’s written defense or explanation of the audit points and a commit¬ment to correct any problems.

While in the past the accounting strength of property management firms was not carefully evaluated, it is now very important and will continue to be so in the foreseeable future. The property manage-ment firm that pays insufficient attention to accounting will find itself quickly losing institutional clients.

This article is adapted from BOMI International’s course Asset Management, part of the RPA and FMA designation programs. More information regarding this course or the new High-Performance certificate courses is available by calling 1-800-235-2664. Visit BOMI International’s website,