Introduction to the New Revenue Recognition Standard Issued by IASB

• identify the contract with the customer;

• identify separate performance obligations in the contract;

• determine and allocate the transaction price; and

• recognise revenue when or as each performance obligation is satisfied by transferring control of a good or service to the customer.

Nearly thousand comment letters were received in response to this exposure draft. Considering the representations, the IASB issued a revised exposure draft in November 2011. One of the principles that the revised draft clarifies is on distinguishing when control of a good or service is transferred over a period of time or at a point in time. This article focusses on this aspect of the revised exposure draft in relation to its implications on revenue recognition for real estate companies.

Implications of IASB’s revised revenue recognition exposure draft for real estate companies

One of the most debated matter in India’s convergence with IFRS was point of revenue recognition from sale of real estate, more commonly known as the application of IFRIC 15 principles. The assessment of IASB’s IFRIC 15 principles which deals with agreements for the construction of Real Estate would lead to most real estate companies in India accounting for sale of apartments/flats as sale of goods and recognising revenue on completion of the contract i.e., transfer of physical possession of the units to the customer as opposed to accounting for these as construction contracts using the percentage completion method. This would have a major impact on the performance measures of real estate companies. Consequently, when Ind AS were issued in February 2011, the Ind AS on construction contracts had a carve-out from the IASB principles to include development of real estate as a construction contract and accrue revenues using the percentage completion method.

IFRIC 15 principles have been debated internationally. Malaysia and Philippines had also deferred applicability of IFRIC 15 when they adopted IFRS while Singapore decided to issue a modified IFRIC 15 providing specific guidance in the context of legal situations prevailing in that country. The issue under debate was that IFRIC 15 principles were leading to a completed contract method of accounting sometimes due to the legal framework of a country for instance, continuous transfer of legal title of the work in progress was legally not allowed in many jurisdictions and hence leading to a completed contract method of accounting although that was not the substance of these transactions. In that case, the profit and loss account of the developers will not truly reflect the performance of the business, as during the years the real estate project development continues, no revenue will be recognised and all revenue will be recognised in the year when possession is given.

IFRIC 15 principles were incorporated in the original exposure draft of revenue recognition standard. However, based on the representations and comment letters received, the IASB in its revised exposure draft has changed criterion for determining whether performance obligations are being satisfied over a period of time impacting the timing of revenue recognition from the sale of real estate.

The earlier principles of IFRIC 15 allowed the percentage completion method when either the unit is based on a customer-specific design or it could be demonstrated that there is a continuous transfer of units while construction progresses which is evidenced:

— if construction activity takes place on land owned by the buyer;
— the buyer cannot put the incomplete property back to the developer;
— on premature termination the buyer retains the work in progress and the developer has the right to be paid for the work performed; or
— the agreement gives the buyer the right to take over the work in progress during construction.

These criterions have been changed significantly under the revised exposure draft. Under the revised exposure draft, performance obligations of the company can be met over a period of time if the entity:

(a) creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced. Or

(b) does not create an asset with an alternative use to the entity and at least one of the following criteria is met:

(i) the customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs or

(ii) another entity would not need to substantially re-perform the work the entity has completed to date if that other entity were to fulfil the remaining obligation to the customer, or

(iii) the entity has a right to payment for performance completed to date and it expects to fulfil the contract as promised.

Most typical Indian real estate contracts for sale of apartments are for specific unit sales to customers, require progress payments based on completion of work and are intended to be fulfilled which would fall under the above criterion of satisfying performance obligations over time.

The following example illustrates the above criterion:

Example 1: 

Company Z is developing residential real estate and starts marketing individual units (apartments). Z has entered into the minimum number of contracts that are needed to begin construction. A customer enters into a binding sales contract for a specified unit that is not yet ready for occupancy. As per the contract, the customer pays a non-refundable deposit at inception of the contract and agrees to make progress payments throughout the contract. Those payments are intended to at least compensate Z for performance completed to date and are refundable only if Z fails to deliver the completed unit.

Z receives the final payment on delivery of possession of the unit to the customer. To finance the payments, the customer borrows from a financial institution that makes the payments directly to Z on behalf of the customer. The lender has full recourse against the customer. The customer can sell his or her interest in the partially completed unit, which would require approval of the lender but not Z. The customer is able to specify minor variations to the basic design, but cannot specify or alter major structural elements of the unit’s design. The contract precludes Z from transferring the specified unit to another customer.

The apartment created by the Z’s performance does not have an alternative use to Z, because it would lead to breach of contract with the customer. Z concludes that it has a right to payment for performance completed to date, because the customer is obliged to compensate Z for its performance rather than only a loss of profit if the contract is terminated. In addition, Z expects to fulfil the contract as promised. Hence, Z has a performance obligation that it satisfies over time.

The new rules are more pragmatic and will enable percentage completion method for real estate where the criterions are met. This essentially means that Indian real estate companies need to reassess the implications of revenue recognition under the revised exposure draft to understand whether their contracts would meet the conditions of satisfying performance obligations over time. It is important to analyse in which exact cases the new principles would allow percentage completion method. This would also then eliminate the need for a carve-out under Ind AS. Comment period for this exposure draft is open until 13 March 2012. This should be regarded as an opportunity to voice out any concerns or clarifications to the IASB so that the standard achieves global acceptance.