How Can Real Estate Businesses Prepare for the New Model of Revenue Recognition? by Robert C. Aldir, CPA
Posted on November 10, 2017
The new model for how businesses across all industries will need to recognize revenue from customer contracts in 2018 for public companies and in 2019 for nonpublic companies is a game changer. While privately held companies have an additional year to come into compliance, they must begin preparations now to account for the substantial changes in the timing and amount of income and expenses they will report on an annual basis in the future. Moreover, adopting the new standard will bring with it significant complexities that will impact virtually all areas of a business’s operations, including contracting, sales, lending and financing, information technology, policies and procedures, and financial reporting.
Unlike the current requirements under the U.S. Generally Accepted Accounting Principles (GAAP), the Accounting Standards Update (ASU) No. 2014-09 provides businesses in all industries and all jurisdictions with one singular and consistent five-step model for recognizing and reporting the “nature, amount, timing, and uncertainty of revenue and cash flows arising from a contract with a customer.” More specifically, the new model represents a shift from more rules-based accounting standards toward one that will require businesses to assess the unique facts and circumstances of each customer contract and exercise significant judgment when determining the amount and timing of revenue recognition. This will be especially difficult for businesses in the real estate and construction industries to navigate and may lead to devastating consequences if they do not apply judgment in a manner that is consistent with the new model.
Step One: Identify the Contract with a Customer
Under the new regulations, a contract will exist when there is an agreement between and approved by two or more parties that creates and specifically identifies both 1) the enforceable rights to goods and services and 2) the related payment terms, including transaction price, which an entity can expect to collect in exchange for delivering those goods and service. While this definition appears simple and precise, it is important for businesses to understand that there are nuances to a contract that could create a separate and distinct contract or significantly modify the terms of an existing contract.
For example, in the world of real estate, a change order can, in some instances, create a new, separate contract. Similarly, the collectability factor of a real estate contract can be a complicated judgment call, especially when an entity offers pricing concessions or seller-provided financing to the customer.
Should it be determined that a contract does not exist based on the new revenue recognition standard, an entity will need to report all payments it received as liabilities until the point in time when all parties meet their contractual obligations.
With these concerns in mind, it is critical that real estate businesses engage the services of experienced legal counsel to properly draft contract agreements that meet the requirements of the new regulations and to explain how the new standards will affect when and how they recognize revenue. This will not only impact a business’s bottom line and create disparities between similar real estate companies, it will also have significant influence over a business’s loan covenants and access to capital.
Step 2: Identify the Performance Obligations
Performance obligations are contractual promises to deliver to a customer distinct goods or services or a combination of goods and service. While there are specific rules for defining performance obligations, the key challenge for most businesses will be identifying whether multiple performance obligations are distinct from each another in the context of the contract.
In the real estate industry, a single contract may include multiple performance obligations. For example, a developer building a condominium tower may contract to construct and sell individual units. It may also promise to provide customers with amenities, such as pools and tennis courts, extended warrantied for appliances and building maintenance and/or management services. In this example, the developer must first have systems in place to more easily capture and identify all distinct performance obligations and related stand-alone costs that they would need to carve out from their existing sales contracts.
In some instances, businesses may need to bundle together multiple services into one performance obligation. In other situations, goods and services may need to be unbundled into separate obligations. This would undoubtedly alter when the developer may recognize revenue from each good and service it delivers, and it would require the assistance of certified accountants to make an educated judgment and project the actual financial impact these changes would create.
Step 3: Determine the Transaction Price
Determining the transaction price, or the amount that real estate developers can expect as payment in return for transferring goods or services to a customer, requires consideration of following elements: non-cash considerations; pricing discounts, credits, price concessions, returns, or performance bonuses and penalties; the existence of significant financing components; and consideration payable to the customer. Ultimately, each of these factors will impact the final numbers.
In real estate deals, it is not uncommon for a transaction price to be less than a contracted price. This is especially true when there exists a contract concession that affects when and how much revenue a business may account for in the transaction price. Under these circumstances, a business will need to use an appropriate method to estimate at the time of contract the discounts and ultimate transaction price it is entitled to receive at the end of each reporting period. This will require businesses to develop new models for projecting revenue in the future as well as updating their current forecasts. In some instances, recognition of revenue may be accelerated or delayed when compared to current requirements under GAAP.
Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract
To allocate an appropriate transaction price to each performance obligation, a real estate business must first determine at contract inception the stand-alone selling price of each distinct product and service it promises to deliver. For example, the real estate developer building a multi-family apartment project with clubhouse, park and retail facilities, would need to allocate the total contract price to each separate performance obligation (i.e. the multi-family homes, the clubhouse, the park and the retail facilities).
These prices may not be easily recognizable due to volume discounts or bundling. In these instances, businesses will need to develop new processes and procedures for estimating stand-alone selling prices of the goods and services to be delivered.
Step 5: Recognize Revenue When (or As) the Entity Satisfies a Performance Obligation
Under the new standard, real estate businesses will no longer recognize revenue when they transfer the risks and rewards of ownership to a buyer. Rather, they will account for revenue when they fulfill a performance obligation, either at a point in time or over an extended period of time.
Under the ASU, businesses will need to evaluate whether or not they satisfied a performance obligation (and can, therefore, book revenue) based upon 1) the customer’s rights to the benefits provided by the contract, 2) whether or not the businesses created or enhanced an asset that a customer controls, and 3) whether or not the businesses created or customized an asset that only the customer can use and has an enforceable right to payment for performance completed to date.
Applying these methods of measurement for satisfying an obligation that occurs over time further requires businesses to identify the moment at which they transfer control, which may be when the customer accepts the asset and takes significant risks and rewards of ownership, when the customer takes physical possession or legal title to the asset, or when the business has a present right to payment for the asset.
Consider, for example, a property management company with contracts that contain multiple performance obligations that they perform for one contract price. Certain performance obligations, such as property maintenance and repairs, will be delivered over time. Others, such as leasing services, will be performed at one point in time. Under the new standard, the company would be required to allocate the lump sum of its “transaction price” between these separate performance obligations.
Privately held businesses in all industries, including real estate and construction, have a narrow window of opportunity to plan and prepare for the new model of revenue recognition, which will go into effect on Jan. 1, 2019, for annual reporting entities. The first step should be a meeting with legal and tax advisors and accountants to understand how the new standard will ultimately impact an organization’s existing processes, policies, systems, and profits.
About the Author: Robert C. Aldir, CPA, is an associate director of Audit and Attest Services with Berkowitz Pollack Brant, where he provides accounting, auditing and litigation-support counsel to public and privately held companies located throughout the world. He can be reached at the firm’s Miami office at (305) 379-7000 or via email at email@example.com.