As many industries scramble to fully grasp the implications of the new revenue recognition standard, it is important for those who work within the commercial real estate (CRE) sector to understand that they, too, should be thinking about this upcoming change to the accounting rules.
The Financial Accounting Standard Board (FASB) issued ASC Topic 606, Revenue from Contracts with Customers, in 2014 and its effective date is quickly approaching. For public entities, the standard is applicable for annual reporting periods beginning after December 15, 2017. For nonpublic entities, the standard gives one additional year with an effective date for annual reporting periods beginning after December 15, 2018 (calendar 2019).
The new revenue recognition rules in ASC Topic 606 will likely result in differences that impact both timing and amount of revenue (and costs) that get recognized, as well as economic behavior within the sector.
A Deeper Dive into Revenue Recognition
ASC Topic 606 presents a five-step model for revenue recognition:
- Identify the contract with the customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when the entity satisfies a performance obligation.
To identify if you have a contract with a customer you must first determine if your transaction is with a customer. ASC Topic 606 defines a customer as “a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.”
Similar real estate assets can be sold, and in one instance the buyer could be a customer, and in yet another instance the buyer would not be a customer. A very basic example would be a CRE developer that builds and sells an industrial warehouse to a manufacturing company. The CRE developer’s ordinary business is to develop real estate assets and, accordingly, the manufacturer is a customer. Let’s now assume that several years later this same manufacturer is relocating and it sells the warehouse to another entity. In this case, the manufacturer is not ordinarily engaged in the business of developing and selling real estate, thus the new buyer is not a customer.
The distinction between customer and non-customer determines which set of rules must be followed to recognize revenue. If you have a transaction with a customer, ASC Topic 606 applies. If you enter into a transaction with a non-customer, the accounting for the transaction may be dictated by ASC Topic 610-20, Other Income – Gains and Losses, or potentially ASC Topic 810-10, Consolidation. Although ASC Topic 610-20 refers back to ASC Topic 606 for certain steps, it does not include all of the same criteria as ASC Topic 606. If the real estate sold constitutes a group of assets that would be defined as a business activity, ASC Topic 810-10 may apply.
However, it should be noted that with the recent issuance of FASB ASU 2017-01, Business Combinations – Clarifying the Definition of a Business, you should expect to see a decrease in the number of real estate transactions that fall into the ASC Topic 810-10 accounting requirements.
The example above for determining whether you have a customer is relatively clear; however, defining your customer can be a challenge. For example, consider real estate fund managers. The fund manager earns fees, but who is their customer? Is the customer the real estate fund itself or the actual investor(s) within the fund? Unfortunately, the answer is, it depends. The structure of the fund and the fund management agreements would need to be closely reviewed to determine which party is truly the customer. Additionally, any side-letter arrangements could also impact this determination.
Applying the New Revenue Recognition Model
Assuming you determine that you are in fact entering into a transaction with a customer, Step 1 of the new revenue recognition model requires you to determine if you have a true contract that meets the accounting definition of a contract. To meet the definition of a contract under ASC Topic 606 an entity must be able to support that collectability of the consideration is probable. Under the current accounting guidance, terms such as “buyer’s initial investment,” “buyer’s continuing investment” and “seller’s continuing involvement” have become well known as key points for consideration when determining if a real estate transaction meets the criteria for a sale.
The current accounting guidance provides very prescriptive rules that dictate the timing and amounts of revenue to recognize when encountering these situations. However, under ASC Topic 606, those rules have been eliminated and judgment must be applied to determine if collectability is probable. This will be a significant issue within the CRE industry, and entities should be preparing now for the judgments they will need to make upon adoption of the standard. Ultimately, if it is determined that you do not have a contract, all consideration received would be recorded as a liability until one of the following two conditions is met:
- The entity has no remaining obligations to transfer goods or services to the customer and substantially all of the consideration promised by the customer has been received by the entity and is nonrefundable, or the contract has been terminated and the consideration received from the customer is nonrefundable; or
- The consideration received is nonrefundable and for goods and services the entity has already transferred, the entity has stopped transferring goods or services and has no remaining obligation under the contract to transfer additional goods and services.
Step 2 of the new revenue recognition model requires an entity to identify all the performance obligations within the contract. A performance obligation is simply the promises made within the contract. Most performance obligations are clearly identified goods or services that will be delivered under the terms of the contract. It is not uncommon within the real estate sector for a single contract to have multiple performance obligations. For example, a single contract may include property development, asset management and maintenance services. Another example could be an obligation to construct amenities in addition to the primary assets or complete infrastructure development. If the real estate entity provides extended warranties, it is possible that these could be separate performance obligations that could impact the time period for recognition of revenues.
Step 3 of the new revenue recognition model requires the determination of the transaction price. For most real estate entities the terms of the contract will clearly identify a fixed price. However, ASC Topic 606 requires an entity to include variable consideration within the transaction price. Some common examples of variable consideration include performance bonuses, shared savings arrangements and performance-based property management fees.
Under current accounting guidance, the variable consideration would not be recognized until all performance conditions have been satisfied. However, ASC Topic 606 requires that the variable consideration be estimated and recognized throughout the contract term. This means that it is possible that revenue could be recognized earlier under ASC Topic 606 than under previous guidance.
Step 4 of the revenue recognition model requires an entity to allocate the transaction price determined in Step 3 to each of the performance obligations identified in Step 2. The allocation should be based upon the amount of consideration the entity would be entitled to for the specific goods or services provided to the customers. This is generally accomplished by allocating the transaction price based upon the standalone selling prices for each of the performance obligations within the contract.
Step 5 of the revenue recognition model is to actually recognize the revenue upon the fulfillment of a performance obligation. This is accomplished using one of two methods:
- Record revenue over the period of time that control is transferred; or
- Recognize revenue at a specific point in time when the customer obtains control over the promised goods or benefits from the services provided.
In order to recognize revenue over time, the goods or services must meet one of three criteria:
- The customer has a right to the benefits provided by the contract as the provider of the good or service fulfills the contract;
- The entity providing the good or service modifies an asset (work-in-progress) that the customer controls; or
- The providing entity does not have an alternate use for the asset being created or transferred, and it has a right to payment for the work already completed.
Don't Delay Revenue Recognition Implementation
Hopefully by now you are noticing that ASC Topic 606 will require a significant amount of judgment. Entities should be analyzing their current contacts and business practices to determine what impact the new revenue recognition standard will have on their financial reporting. Different judgments could be modeled now to determine which judgments most accurately present the entity’s financial statements. Additionally, this will allow time for entities to adjust future contracts as necessary to avoid any unintended consequence upon adoption of ASC Topic 606.
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