As the new revenue recognition guidelines get ever closer to becoming the way of life for just about every industry, we continue our occasional deep dives into specific industries to shed light on what is coming, and much sooner than people may realize. Today, we take a look at how the guidelines could shuffle up the real estate industry.
As recently reported in an article in the Daily Business Review, the overall affect as a result of this shift in guidelines in both real estate and associated construction industries could be quite substantial.
Let’s look at this in terms of the new five-step model of which we’re all quite aware – and if not, you really should be by now – since all businesses, regardless of industry, will need to recognize revenue from customers using this model going forward. Different businesses will account for revenue at a particular point in time or over time using a percentage-of-completion method of performance measurement by applying this new model.
With regard to Step 1 – identifying the contract – not much unique for the real estate industry, as everyone works to determine when an agreement has commercial substance, identifies rights to goods, services and related payment terms and when approval and commitment to contractual obligations are made to confirm the existence of a contract.
In considering Step 2 – identifying the performance obligations of a contract – the new model of revenue recognition offers extra help for businesses to determine when goods and services aren’t distinct, or more specifically, bundled or not. In the case of a real estate developer, a contract to develop a multi-family apartment project with a clubhouse, park and retail facilities might have previously been accounted as one contract, or a single performance obligation. Under the new rules, the homes, clubhouse, park and retail facilities might be considered separate performance obligations. How a businesses various goods and services sold and how they relate to one another will need to be considered very carefully.
For Step 3 – determining the transaction price – the amount that real estate developers expect as payment – their transaction prices – in return for goods or services to a customer, will need to factor in the following going forward: variable consideration and constraining estimates, consideration payable to the customer, a significant financing component and non-cash consideration. A developer or other real estate business will need to consider all those factors in determining the eventual transaction price, as well as the how and the when on recognizing resulting revenue.
With Step 4 – allocating transaction price to performance obligations in the contract – a real estate business will need to determine at the earliest stage of a contract a standalone selling price for each distinct product and service offered. Going back to that same example of the multi-family apartment project, the developer would need to allocate the total contract price to each individual performance obligation, which in that case equates to the homes themselves, the clubhouse, park and retail facilities.
And, finally, with Step 5 – recognizing revenue when a performance obligation is satisfied – we’ll restate that companies will either recognize revenue at a point in time or over a period during which a performance obligation is met. For a real estate transfer which occurs over time, this could include a product the business builds on a customer’s site or an asset created for use only be the customer. In such cases, a real estate developer will recognize revenue over time using performance measurements which could include units produced or hours of labor or costs incurred.
In 2016, businesses in this industry and all others need to identify gaps between existing practices and those required in the future, prepare to comply with enhanced disclosure requirements and make the changes needed to their existing policies, processes and IT systems.
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