The Financial Accounting Standards Board (FASB) recently issued new guidance that standardizes when and how every type of company must recognize revenue. The guidance, found in Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, supersedes existing revenue recognition rules and makes significant changes to the rules for accounting for real estate sales.
Because the new ASU focuses primarily on when the transfer of control of property occurs, more transactions will likely qualify as real estate sales, and revenue will likely be recognized sooner than it has been.
5 steps … and their issues
The guidance lays out five steps that a business must follow to determine when to properly recognize revenue on its financial statements. Here’s a look at each step and its associated issues particular to real estate companies:
- Identify the contract. The guidance applies to each contract that a company has with a customer, assuming the contract meets certain criteria. In most real estate transactions, the assessment of whether a contract exists will be straightforward. That might not be the case, however, for companies that provide financing. In such cases, the seller must evaluate the collectability of the transaction price. In other words, is it probable that the seller will collect the consideration to which it will be entitled?
In the past, a seller might accomplish this by determining whether the buyer’s initial and continuing investment in the property was sufficient enough to enable the buyer to fulfill its obligation. The new guidance eliminates this approach and provides little guidance on how to determine whether the collectability threshold is met.
Contract modifications (changes in scope, price or both) pose another complication — should the modification be accounted for as a separate new contract or part of the existing contract? The ASU provides criteria for making this determination.
- Identify the company’s performance obligations.Sellers often remain involved in property that they’ve sold. For example, a seller might have agreed to erect a building on the property or to provide property management services. If a contract contains obligations to transfer more than one good or service to a customer, the company can account for each as a separate performance obligation only if the good or service is distinct or a series of distinct goods or services are substantially the same.
A good or service is “distinct” if: a) the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer, and b) the company’s promise to transfer the good or service is separately identifiable from other promises in the contract.
- Determine the transaction price. The company must determine the amount that it expects to be entitled to in exchange for transferring promised goods or services to a customer. Under the new rules, some or all variable consideration may be included in the transaction price and, therefore, recognized earlier than previously done. The transaction price also may require adjustment if the arrangement includes a “significant financing component.”
- Allocate the transaction price to performance obligations under the contract. The business will typically allocate the transaction price to each performance obligation based on the relative “standalone selling price” of each distinct good or service promised. A seller that will also provide management services, for example, generally must separately estimate the standalone selling prices of the property and the services and allocate the total transaction price proportionately.
- Recognize revenue as performance obligations are satisfied. A real estate company must recognize revenue when it satisfies a performance obligation by transferring the promised good or service to a customer. The amount recognized is the amount allocated to the performance obligation. If the performance obligation is satisfied over time (rather than at a single point in time) the company must similarly recognize revenue over time.
ASU 2014-09 will compel real estate companies to exercise more judgment than is required (or allowed) under the current, more prescriptive standards. It also requires enhanced financial statement disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from a company’s customer contracts. Real estate businesses should review their current methods of accounting for property sales and implement the changes necessary.