The Financial Accounting Standards Board (FASB) recently issued new guidance that standardizes when and how every type of company must recognize revenue. The guidance is found in Accounting Standards Update (ASU) No. 2014-09. It relates to Revenue from Contracts with Customers. Further, it supersedes existing revenue recognition rules and makes significant changes to the rules for accounting for real estate sales.
The guidance lays out five steps that a business must follow. These are used 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:
1. Identify the contract. The guidance applies to each contract that a company has with a customer. In some cases, two or more contracts might be combined for financial reporting purposes. A change order (a modification to the contract’s scope, price or both) is an example of a contractual issue that could complicate matters. For example, should a change order be accounted for as a separate new contract or part of the existing contract? The ASU provides criteria for making this determination.
2. Identify the company’s performance obligations. Sellers often remain involved in property that they’ve sold. For example, a seller might have agreed to provide property management services, improve roads or erect a building on the property sold. If a contract contains obligations to transfer more than one good or service to a customer, the company can account for each good or service as a separate performance obligation only if it is: 1) distinct, or 2) a series of distinct goods or services that are substantially the same.
A good or service is “distinct” if: a) the customer can benefit from the good or service on either 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.
3. 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 contingent consideration (such as incentive payments) 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.”
4. 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.
5. Recognize revenue as performance obligations are satisfied. A 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. Ways to measure progress include output methods (such as surveys or appraisals) and input methods (such as cost-to-cost or labor hours). These methods are generally expected to yield results similar to those of the existing percentage-of-completion method.
ASU 2014-09 will compel real estate companies to exercise more judgment. Morethan is required (or allowed) under the current, more prescriptive standards. It also requires enhanced financial statement disclosures regarding customer contracts.
Additionally, Real estate businesses should start reviewing their accounting methods now to prepare for the changes. Fortunately, there is time. For nonpublic companies, compliance isn’t required yet. Moreover, your requirements are not until annual reporting periods beginning after Dec. 15, 2018.
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