4 Lessons Learned from ASC 606 Adoption for Homebuilders
December 07, 2021
By Angela Veal
If you are a homebuilder who has already adopted Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers (“ASC 606”), but recently entered into new revenue arrangements that require further evaluation; or a new homebuilder who is adopting ASC 606 for the first time, there are a handful of lessons learned in relation to other homebuilders’ application of ASC 606 during their implementations. As background, FASB deferred the effective date for adopting ASC 606 to January 1, 2021 for calendar year-end private entities. Many companies have already adopted ASC 606 prior to this deferral. Please also note that this article generally applies to instances where the homebuilder owns the land that the home is being built upon.
Lesson Learned #1: Evaluation on whether revenue falls under ASC 606
Identifying a contract is the first step in the five-step model approach under ASC 606. If a contract does not meet any of the five criteria under ASC 606, there is no enforceable contract under ASC 606 and the arrangement falls outside the scope of ASC 606.
Collectibility is one of the five criteria that may require significant judgment due to the complexity of home financing. The homebuilder should evaluate the buyer’s (the “buyer” or “customer”) ability and intent to pay substantially all of the consideration. For example, if a home is financed through a third-party lender, the homebuilder will need to evaluate the buyer’s ability during a pre-approval process by reviewing the buyer’s financial status and credit score, etc. If there is no issue, then collectibility is deemed probable at the time of executing the purchase agreement and assuming all other criteria are met, this is a contract under ASC 606. If not, the homebuilder will need to reassess at a later point until the sale is closed. Alternatively, when the homebuilder receives the purchase price in cash from the buyer (via the lender), the collectibility criterion will be met.
Commitment from both parties is another criterion that may require further analysis, especially a buyer’s commitment. For example, if the buyer is only required to pay a nominal amount as a down payment that is non-consequential to the buyer or includes terms that allow the down payment to be refunded if the buyer terminates the contract, then this criterion is not met and there is no contract under ASC 606. The consideration received will be recognized as a liability. It will only be recognized as revenue when the homebuilder has transferred control of the house to the buyer.
Also, if you are a homebuilder who sells home and land, the land sale may be in the scope of ASC 610-20, Other Income – Gains and Losses from the Derecognition of Nonfinancial Assets.
Lesson Learned #2: Timing of recognizing revenue
Home sales are generally recognized at a point in time by a homebuilder when there is a transfer of control to the buyer. The “transfer of control” is a new concept under ASC 606. Simplistically speaking, when the legal title and physical possession of the home is transferred to the buyer (e.g., at sale closing), this is the point whereby the transfer of control is deemed to have occurred.
However, the homebuilder should also evaluate other indicators of control such as physical possession and existence of repurchase agreements. For example, if the transfer of the title has occurred, but the buyer does not have physical possession of the house or the homebuilder has the right to repurchase the property, then the transfer of control may not have occurred at this point.
Another example is if the buyer does not pay cash at closing and the homebuilder (seller) provides a purchase-money mortgage, additional evaluation is necessary for whether the closing meets the criteria of ability and willingness to pay the transaction price. A purchase-money mortgage (also known as seller financing) is a mortgage issued to the borrower by the seller of a home as part of the purchase transaction. This is usually done in situations where the buyer cannot qualify for a mortgage through traditional lending channels.
Lesson Learned #3: Understanding of warranties and related obligations
New homes typically come with certain warranties provided by homebuilders, for example a structural warranty that provides coverage for workmanship, distribution systems and structural defects on new construction. As a homebuilder, you would need to evaluate the nature of these warranties to determine if they are assurance-type or service-type warranties.
Homebuilders typically provide assurance-type warranties. Service-type warranties are uncommon. However, if there are service-type warranties, they would be considered a separate performance obligation to which part of the transaction price will be allocated to it, and the associated revenue will be recognized as the warranty obligation is fulfilled over the term of the warranty.
Unlike an assurance-type warranty (e.g., assurance that the new home will not have any structural defects to the original structure or something that is required by law), a service-type warranty provides additional benefit to the buyer (e.g., certain home service contracts that cover repairs and maintenance of built-in household appliances pertaining to normal wear and tear). Therefore, such a service-type warranty is considered a distinct performance obligation.
Lesson Learned #4: Accounting for contract costs
Historically, homebuilders can capitalize costs such as marketing and building model homes under the legacy guidance of ASC 970, Real Estate – General. Certain parts of the legacy guidance remained unchanged upon adoption of ASC 606, such as common area improvements, which would be systematically allocated to project phases and individual homes.
However, parts of this legacy guidance were updated or replaced by the new revenue standard which prescribes that a homebuilder should now refer to ASC 340-40, Other Assets and Deferred Costs – Contracts with Customers for guidance relating to contract costs.
For example, only costs that are incremental in obtaining a contract and are recoverable can be capitalized. These capitalized costs are amortized on a systematic basis that is consistent with the transfer to the customers. As an example, broker commissions paid for a home sale may represent incremental costs that meet the criteria for capitalization if the costs would not have been incurred if the contract had not been obtained. However, since the broker commissions are usually paid at closing, the related expense is recognized immediately upon the closing of the sale when revenue is recognized.
Costs incurred for general marketing should be expensed. However, certain costs relating to the construction and furnishing of a model home may be capitalized.
Other costs also include allocable costs such as design and engineering, zoning and entitlement costs, sewer permits, and other such expenditures. These are allocated to the individual lots and written off when the property is sold. Capitalized costs would be evaluated for impairment.
Additionally, prepaid expenses such as real estate taxes and/or insurance are amortized over the period, or written off when paid if the related period is less than one year.
Summary of lessons learned
In summary, even if ASC 606 has already been adopted by a homebuilder, the homebuilder should continue to stay cognizant of new contracts and even consider revisiting existing and complex ones. It should determine if each arrangement indeed meets the definition of a contract under ASC 606, what the performance obligation(s) are (e.g., how do the warranties work) and when and how revenue should be recognized. Lastly, the homebuilder should also focus on contract costs as the adoption of ASC 606 has resulted in some notable changes on how they should be accounted. Your analysis may vary from the above based on specific facts and circumstances, so please consult with your accounting advisors accordingly.