New Revenue Recognition Standard – Real Estate Sales
In May 2014, the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) jointly issued the new revenue recognition standard. This standard, Accounting Standards Update 2014-09 (“ASU” or “Standard”), establishes the core principle that an entity will recognize revenue upon the transfer of goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods and services. The ASU will impact many entities across many different industries, including real estate.
Sales of real estate that are not part of a sale-leaseback transaction will be subject to the guidance in the ASU. The current guidance under U.S. GAAP requires an evaluation as to the consummation of a sale, the buyer’s initial and continuing involvement (with some bright line measures), collectability of the sales price and any potential future subordination on the seller’s receivable, and the seller’s continuing involvement. Although the new Standard will eliminate the existing bright line measures, all of the above listed concepts have in substance been incorporated in the accounting treatment under the new Standard. As a result, application of this new guidance may result in earlier profit recognition based on the assessment of when control of the real estate transfers and when collectability of the exchange consideration is deemed probable, but for most transactions is not materially affected after the accounting result.
For public entities, this ASU is effective for annual reporting periods beginning after December 15, 2016. Nonpublic entities have the option to apply the Standard using the same effective date as public entities or postpone adoption for year (i.e., for annual reporting periods beginning after December 15, 2017). Early application is not permitted. Upon adoption of this Standard, entities will be required to apply the guidance using either a full retrospective approach or a modified retrospective approach. The modified retrospective approach will be applied retrospectively with the cumulative effect of initially applying the Standard recognized at the date of initial application, with an adjustment to the opening balance of retained earnings.
In April 2015, the FASB issued a proposal to defer the effective date of the Standard by one year. The comment period on this proposal ended May 29, 2015. If the proposal is adopted, the effective date for public entities will be for annual reporting periods beginning after December 15, 2017 and for nonpublic entities annual reporting periods beginning after December 15, 2018. The proposal would permit both public and nonpublic entities to adopt the Standard early, but not prior to annual periods beginning after December 15, 2016.
This principles-based revenue model includes the following five steps:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
The second step, as outlined above, refers to the performance obligations in the contract. A performance obligation is a promise in a contract with a customer. An entity should account for each promised good or service as a performance obligation only if it is (1) distinct or (2) constitutes a series of distinct goods or services that are substantially the same and have the same pattern. A good or service is considered distinct if the customer can benefit from the good or service either on its own or together with other resources and the promise to transfer the good or service is separately identifiable from other promises in the contract. If an entity identifies separate performance obligations, then the total transaction price should be allocated and revenue is recognized when each separate good or service is transferred to the entity. Although the concept of meeting the performance obligation criteria is specifically identified in the new Standard, it does not represent a new concept under currently existing U.S. GAAP. Companies will need to assess whether separate performance obligations exist and if the criteria are met in order to determine the timing and amount of recognition of revenue.
This Standard may create various challenges for entities accounting for real estate sales. First, there is an increased effort required whereby management must identify all performance obligations and determine any necessary allocation of the transaction price. Second, the retrospective application will require an entity to start to gather the necessary data to properly account for these transactions prior to the effective date and initial application. Finally, in order to gather and track this data, management will need to assess whether their current systems and processes are sufficient to be able to gather and track the requisite data.
Although the effective date of this Standard is several years away, entities should start to think ahead and carefully determine the impact that this new revenue recognition guidance will have on proposed transactions and ensure that their systems, recordkeeping, etc. will be up to the task.