Moore Together: Implementing Revenue Recognition for Real Estate, Part II

Moore-Together-Graphic.jpgMoore Stephens North America is comprised of 43 member firms that provide key services across a wide variety of industries and niches. This month’s “Moore Together” is part 2 of a collaboration between Nancy Cox with The Bonadio Group and Jessica Saugstad with HCVT.

As the effective date for Accounting Standards Codification 606, Revenue from Contracts with Customers (ASC 606) is fast approaching; Companies are seeking guidance on how to best prepare for adoption. Below we will dive deeper into the expected impact on the real estate industry, beginning with the five steps in the new standard.
 
Step 1: Identify the contract(s) with the customer
  • Contracts can be written, oral or implied by customary business practices
Step 2: Identify the performance obligation(s) in the contract
  • Determine which performance obligations are distinct and should be accounted for separately
  • Determine is any distinct services should be combined (service relatively the same and has the same pattern of transfer (e.g., daily))
Step 3: Determine the transaction price
  • At contract inception:
    • Estimate performance-based fees and recognize them when performance obligations are satisfied
    • Estimate variable consideration throughout life of contract
Step 4: Allocate the transaction price to the performance obligations in the contract
  • Estimate the "standalone" selling price for performing each
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation
 
Articles and guides evaluating the new standard are readily available and can be a great resource. Don’t fall into the trap of assuming that the analysis will be easy. Although there may, in fact, be no change to when and at what amount revenue is recognized, a detailed analysis in accordance with ASC 606 will need to be performed for each type of customer contract. In addition, support for management’s judgments and conclusions reached should be documented and maintained by the organization.

All industry specific revenue recognition guidance has been superseded with Accounting Standards Codification 606, Revenue from Contracts with Customers (ASC 606). There will be more judgment required when evaluating real estate sales and other real estate related contracts. The previous “bright-line” tests for real estate sales are no longer available and the new guidance is expected to significantly impact the real estate industry.
 
The most significant changes are expected to revolve around the following:
  1. The amount and allocation of sale transaction prices when performance obligations are included.
  2. Revenue recognition rules at a point in time vs. over time, as it depends on the transfer of control, as defined.
  3. Perhaps contract language to separate components and performance obligations.
  4. Expanded disclosure requirements, for example, disclose or present –
    • The amount of revenue recognized from contracts with customers separately from other sources of revenue (e.g., income from leases).
    • Opening and closing balances of receivables, contract assets and liabilities from contracts with customers.
    • Revenue recognized in the reporting period that was included in the contract liability balance at the beginning of the period.
    • Revenue recognized in the reporting period from performance obligations satisfied in previous periods.
Below are some considerations homebuilders, developers, management and real estate service companies as well as real estate own-and-operate entities my want to consider when evaluating their contracts and the impact ASC 606 will have on their company.
 
Homebuilders
Gains and losses on real estate sales will be recognized when title transfers to the customer. If seller financing is provided, the sale may not meet the criteria for revenue recognition depending on the terms of the financing. Consideration will be necessary to determine if there is an enforceable contract as defined under ASC 606 and the agreement will not meet these criteria if collection is not probable.

Costs incurred for model units, advertising and sales overhead are unlikely to qualify for capitalization under ASC 340-40, Other Assets and Deferred Costs—Contracts with Customers. Often these costs will not be considered incremental costs of obtaining a contract under the new guidance. However, costs of furniture and equipment used in sales offices and model units may qualify for capitalization under ASC 360, "Property, Plant, and Equipment."
 
Management will need to determine if warranties provided in conjunction with home or residential unit sales are assurance or service-type warranties. Service-type warranties would be evaluated as a separate performance obligation.
 
Developers 
Most developer fees from third parties or investees will be recognized over a period of time, rather than at a point in time, due to the fact that (i) the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced and (ii) the asset under construction has no alternative use and the developer has an enforceable right (throughout the contract) to payment from the customer for performance completed to date. Management will need to determine the appropriate measure of progress that will be used to recognize revenue over time (e.g., input method based on development costs incurred).
 
Land developers often earn a profit on future home sales (e.g., lots sold to a homebuilder subject to a profit participation clause). Incentives and bonuses included in developer agreements are variable consideration and should be included in the estimated transaction price using either the ‘most likely’ or ‘expected value’ method. This will result in earlier recognition than previous accounting. However, Developers will need to consider any constraints on such variable consideration and make determinations if the variable consideration is subject to a risk of significant revenue reversal. It is expected that the constraint will often not result in the variable considerations being reduced to zero. It is not reasonable to default to a conclusion that the variable consideration is fully constrained until the uncertainty is resolved.
 
Land developers will need to consider if there is more than one performance obligation at lot sale (e.g., two performance obligations, one being the lot sale and two being the performance of construction or development services.)
 
Property Management Fees
Many property management agreements will be accounting for under the ‘series’ guidance as (i) the services are for a period of time and (ii) considered a single performance obligation composed of a series of distinct services that are substantially the same and that have the same pattern of transfer to the customer. However, management will need to consider if there are other performance obligations such as leasing and tenant improvement services separate from the day-to-date management services that need to be considered as a separate performance obligation.
 
Own and Operate Real Estate Entities
Management will need to carefully evaluate all lease contracts to identify substantial services that are within the scope of ASC 606. Contract consideration will need to be separated between the lease (scoped out) and other performance obligations (within the scope of ASC 606). Examples of non-lease components are CAM services, utilities and trash removal. At contract inception, consideration for these separate components will need to be estimated and allocated over the term of the lease as the lessor provides services (e.g., "transfers control" as discussed previously).
 
ASC 606 addressed sales of real estate to customers. ASC 610-20, Other Income-Gains and Losses from the Derecognition of Nonfinancial Assets (which was amended with the new revenue recognition standard), addresses sales of real estate to noncustomers. If the asset is not an output of the entity’s ordinary activities, the party that gets control of the asset does not meet the definition of a customer. Therefore, selling real estate for some own-and-operate real estate entity will be within the scope of ASC 610-20.
 
Concluding Thoughts
The real estate industry will see changes in how revenue is recognized and will need to modify the revenue recognition processes in their organization. Moreover, other processes and controls may need updated including internal controls, IT controls and operational and business processes. Identify all contracts with customers, review contract language, determine the appropriate accounting and document conclusions.

To learn more about implementing revenue recognition for real estate, please contact Nancy Cox with The Bonadio Group or Jessica Saugstad with HCVT.

We’re great alone, but we’re “Moore Together!” If you would like to collaborate with other members, or if you have a topic you would like to address, please contact Laura Ponath.