In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, later codified as Accounting Standards Codification (ASC) Topic 606. This major overhaul of revenue recognition (effective for fiscal years starting after December 15, 2017 for public companies) affects almost every industry, and real estate is no exception. Many of the five steps of revenue recognition may be complicated due to the numerous services that may be involved in a single contract, variable consideration involved, and customized products often found in real estate contracts.
The AICPA and the major accounting firms have assembled industry task forces to research the industry-specific accounting issues within ASC 606, and we will draw from the guides they have published as we provide a brief explanation of the key issues the real estate industry faces when applying ASC 606. For more information on any of these issues, see:
We will also provide references to other RevenueHub articles for more detailed explanations of related ASC 606 topics. For general information on the basics of revenue recognition, see our RevenueHub article, The Five-Step Method.
The following are the issues that companies in the real estate industry commonly face:
1. Identifying the contract with the customer—and contract combination
While identifying the contract with the customer, the first step of the revenue recognition model, may seem straightforward, there are times when companies will need to exercise professional judgment to complete this step. Specifically, in the real estate industry, companies sometimes encounter complexity when identifying contracts with regard to the FASB’s guidance requiring that certain contracts be combined.
According to the FASB, companies should “combine contracts entered into with the same customers at or around the same time if the contracts were negotiated together with a specific objective in mind, the amount the company will receive depends on the amount or performance of another contract, or the goods or services in the contract are a single performance obligation.” Companies should consider each of these criteria as they review the circumstances surrounding each contract when determining if two or more contracts should be combined.
For more analysis on contract combination please see the following RevenueHub article: Combining Contracts
2. Contract modifications
Companies in the real estate industry frequently enter into agreements that change over the course of the contract. For accounting purposes, contract modifications occur when there is a change in the scope and/or price of a contract. When contracts change, companies should account for them as either new contracts or changes to the original contract. ASC 606 suggests that a contract change is accounted for as a new contract if the change adds distinct goods or services and the new price reflects the value of those goods or services. The FASB has provided three ways for companies to account for a contract modification:
- If the goods and services to be transferred after the contract modification are distinct from the goods or services transferred on or before the contract modification, the entity should account for the modification as if it were the termination of the old contract and the creation of a new contract
- If the goods and services to be transferred after the contract modification are not distinct from the goods and services already provided and, therefore, form part of a single performance obligation that is partially satisfied at the date of modification, the entity should account for the contract modification as if it were part of the original contract
- A combination of the two approaches above: a modification of the existing contract for the partially satisfied performance obligations and the creation of a new contract for the distinct goods and services
According to this guidance, companies must determine if the additional goods and services are distinct from the goods or services they were previously contracted to provide. This determination will be the deciding factor when considering if a contract modification should be accounted for as a new contract or a change to the original contract.
For more detailed information on contract modifications please see the following RevenueHub articles: Contract Modifications Part I – Separate Contracts, Contract Modifications Part II – Contract Modification Treatment, Contract Modification Part III – The Hindsight Expedient
3. Distinguishing between performance obligations
Contracts in the real estate industry often include multiple goods and services within a single arrangement. When identifying the performance obligations within a contract, it is important for companies to distinguish between goods and services that are distinct and those that should be bundled with other goods and services. According to ASC 606, a good or service is considered distinct if the customer can receive benefit from the good or service independent of other goods or services, and if it is separately identifiable from other goods or services in the contract.
Consider this simple example: As part of a contract, a real estate company provides a house, home-owner’s insurance, and a few pieces of furniture. The company must now determine which of these goods, if any, provide value to the customer independent of the other goods. In this example it may be reasonable to determine that the house on its own provides value to the customer independent of the other goods or services, but the insurance provided to the customer likely does not provide value to the customer without the house. As such, the insurance performance obligation would be bundled with the house to properly recognize revenue.
For additional information about performance obligations please see the following RevenueHub articles: Distinct Within the Context of the Contract, Distinct Goods or Services: Case Studies, Series of Distinct Goods or Services
4. Determining the transaction price
Under ASC 606, the transaction price should be the amount of consideration the entity expects to receive in exchange for the goods and services it is providing. While this is simple for contracts that involve fixed payment plans, complexity arises when a company’s contracts include variable amounts of payment that are predicated upon certain events or performance criteria. For example, contracts with variable payments, such as construction arrangements with bonuses for faster completion, are common in the real estate industry.
When determining the transaction price of contracts with variable payment arrangements, companies are required to estimate the amount of variable consideration they are likely to receive and combine that with any fixed payment portions of the contract. The FASB provides two methods that companies should use when estimating the amount of variable consideration in a contract: the most likely amount method and the expected value method. When applying these methods, it is important to remember that companies should only recognize amounts of variable consideration to the extent that they are confident a significant reversal of revenue will not occur. As always, it is important for companies to exercise sound judgment when estimating revenues.
For more information on estimating and accounting for variable consideration, please consider the following RevenueHub articles: Magnitude of the Constraint on Revenue, Variable Consideration and the Constraint
5. Progress toward satisfaction of a performance obligation
Many contracts in the real estate industry require years to complete and can be highly customized, which often presents complex issues regarding the timing of revenue recognition. Under ASC 606, companies may only recognize revenue when (or as) they satisfy performance obligations. Understanding when a company satisfies a performance obligation is particularly important for real estate contracts. The standard requires that companies either recognize revenue at a point in time (when the good or service is delivered) or over time (as the good or service is being completed). Under ASC 606, a performance obligation is satisfied at a point in time unless:
- The customer receives and consumes the benefits of the performance obligation as the entity performs the obligation,
- The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced,
- The entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.
If the performance obligation meets any of these criteria, then it is satisfied over time rather than at a point in time and revenue should be recognized ratably. Judgement is required as companies must consider each performance obligation individually when determining if the obligation is satisfied over time or at a point in time.
For more analysis on satisfying performance obligations please see the following relevant RevenueHub article: Determining the Transfer of Control
6. Contract costs
Under ASC 606 companies are required to capitalize and amortize incremental costs the entity incurred to obtain (e.g., sales commissions) and fulfill (e.g., equipment costs) a contract. The costs of obtaining a contract are recognized as an asset if the entity expects to recover them. The standard provides a practical expedient that allows immediate expensing of these contract costs if they would otherwise be fully amortized in one year or less. A company should only capitalize and amortize the costs to fulfill a contract if (1) the costs relate directly to a specific contract, (2) the costs generate or enhance resources that will be used to satisfy performance obligations in the future, and (3) the entity expects to recover the costs. These capitalized costs should be amortized as the entity transfers the designated goods or services to the customer.
For more analysis on satisfying performance obligations please see the following relevant RevenueHub article: Costs to Fulfill a Contract
It is likely that many other issues and questions will arise within the real estate industry as entities adopt ASC 606. This article serves as a base reference point for your research into some of the focal issues anticipated by industry experts. Similar industry-specific issues, discussions, and resources are available on the RevenueHub site for major industries identified by the AICPA. Click on the following link for a list of these articles: Industry-Specific Issues.