New rules are poised to take effect that could fundamentally change how many in the real estate industry will account for their revenue. Public companies must apply Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, in 2018, while compliance for private companies that follow U.S. Generally Accepted Accounting Principles (GAAP) begins in 2019.
The updated standard makes some significant changes to the way revenue from real estate sales is recognized. Specifically, the guidance lays out the following five steps that a company must follow to determine when to properly recognize revenue on its financial statements.
- Identify the contract
The guidance applies to each contract that a company has with a customer that meets certain criteria. The assessment of whether a contract exists will be relatively straightforward for most real estate transactions.
However, if the contract includes financing, the seller must evaluate the collectibility of the transaction price, or the probability that the seller will collect the consideration. The new guidance discards the current test — whether the buyer’s initial and continuing investment in the property was sufficient so that the buyer would fulfill its obligation — but provides little guidance on how to determine if the collectibility threshold is met.
As a result, a high degree of judgment will be necessary. And developers must continually re-evaluate an arrangement to see if it has become sufficiently collectible to qualify as a contract.
- Identify performance obligations
If a contract contains obligations to transfer more than one good or service to a customer, the developer can account for each as a separate performance obligation only if the good or service is distinct or is a series of distinct goods or services that are substantially the same. A contract, for example, might include the sale of property and its development.
If those are deemed separate performance obligations, the revenue attributable to the sale generally will be recognized at closing of the sale, with the revenue for development recognized over time. If they aren’t separate, the revenue from the sale will be deferred until the development is complete.
- Determine the transaction price
The company must determine the amount that it expects to receive in exchange for transferring promised goods or services to the customer. The transaction price should include an estimate for variable consideration, including performance bonuses and shared-savings arrangements. That estimate should be recorded only if it’s probable that the company won’t need to reverse the amount of cumulative revenue recognized when it resolves the uncertainty associated with the variable consideration.
Under the current rules, variable consideration is estimated and recognized throughout the contract term as it’s collected from the customer. So, revenue from variable consideration might be recognized earlier under the new ASU.
- Allocate the transaction price
The transaction price is allocated based on the relative standalone selling price of each specific good or service promised to the customer. For example, if a developer promises both property and management services, it must estimate the standalone selling price for each component and allocate the price accordingly.
- Recognize revenue
Revenue is recognized as the seller satisfies a performance obligation by transferring control of the promised good or service to the customer. Under the current rules, the focus is on whether the usual risks and rewards of ownership have been transferred, not control. According to the updated standard, when a performance obligation is satisfied over time, rather than at a single point in time, the company also must recognize the related revenue over time. (See “Recognizing revenue over time or at a point in time.”)
Compliance with the new revenue recognition rules will require many real estate entities to collect information they aren’t currently gathering. They may need to modify or even replace existing systems, processes and procedures, as well as add new internal control procedures. Many real estate transactions will be affected by the updated standard, so it’s important for developers to start the implementation process today, rather than wait until the last minute.