This narrative considers key implications IFRS 15 Revenue from Contracts with Customers for real estate entities. It provides an overview of the revenue recognition model in IFRS 15 with a focus on entities that: Allocate the transaction price to the performance obligation
- Own, operate and sell real estate
- Provide property management services
- Construct and sell residential property
IFRS 15 introduced a five step process for recognising revenue, as follows:
- Identify the contract with the customer
- Identify the performance obligations in the contract
- Determine the transaction price for the contract
- Allocate the transaction price to each specific performance obligation
- Recognise the revenue when the entity satisfies each performance obligation
Once the performance obligations have been identified and the transaction price has been determined, an entity is required to allocate the transaction price to the performance obligations, generally in proportion to their stand-alone selling prices (i.e., on a relative stand-alone selling price basis), with two exceptions (see Exceptions…… below). The transaction price is not reallocated to reflect changes in stand-alone selling prices after contract inception.
To allocate the transaction price on a relative selling price basis, an entity must first determine the stand-alone selling price (i.e., the price at which an entity would sell a good or service on a stand-alone basis at contract inception) for each performance obligation. Generally, the observable price of a good or service sold separately provides the best evidence of stand-alone selling price. However, in many situations, stand-alone selling prices will not be readily observable. In those cases, the entity has to estimate the stand-alone selling price based on information that is reasonably available.
When determining stand-alone selling prices, an entity is required to use observable information, if available. If stand-alone selling prices are not directly observable, an entity will need to make estimates based on information that is reasonably available. Possible estimation approaches include an adjusted market assessment approach, an expected cost plus a margin approach or a residual approach. An entity is required to apply estimation methods consistently in similar circumstances.
As such, IFRS 15 will require a real estate seller to separately estimate the stand-alone selling prices of the real estate asset and associated services, if any, and allocate total consideration received in the contract on a relative stand-alone selling price basis.
Under the relative stand-alone selling price method, once an entity determines the stand-alone selling price for the performance obligations in an arrangement, the entity allocates the transaction price to those performance obligations based on the proportion of the stand-alone selling price of each performance obligation to the sum of the stand-alone selling prices of all of the performance obligations in the arrangement.
Exceptions to the relative stand-alone selling price method Allocate the transaction price to the performance obligation
The standard provides two exceptions to the relative selling price method of allocating the transaction price. The first requires an entity to only allocate a discount in a contract to the specific goods or services to which it relates, rather than proportionately to all of the separate performance obligations. To apply this exception, the entity must meet certain criteria (IFRS 15 82) that are unlikely to be satisfied in most types of real estate contracts.
The second exception requires variable consideration to be allocated entirely to a specific part of a contract, such as one or more (but not all) performance obligations or one or more (but not all) distinct goods or services promised in a series of distinct goods or services that forms part of a single performance obligation, if both of the following criteria (IFRS 15 85) are met:
- The terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service).
- Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the standard’s overall objective of allocating revenue in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.
In the Basis for Conclusions (IFRS 15 BC285), IASB discussed an example of a contract to provide hotel management services for one year (i.e., a single performance obligation that is a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer) for which the consideration is variable and based on the operating results of the hotel. In this example, the variable consideration that relates specifically to an entity’s efforts to transfer the services for a certain period within a contract (e.g., a month, a quarter), which are distinct from the services provided in other periods within the contract, are allocated to those distinct periods instead of being spread over the entire performance obligation.
The following illustration depicts the application of this exception by a property manager that determines that the services it is providing represent a single performance obligation:
Example – Property management fees Allocate the transaction price to the performance obligation
On 1 January 2018, Operator E enters into a one-year contract with a shopping centre owner to provide property management services. Operator E receives a 5% management fee, based on the shopping centre’s quarterly lease revenues, as defined in the agreement. This is a form of variable consideration.
How to handle this for IFRS 15 Allocate the transaction price to the performance obligation
Operator E concludes that the management services represent a single performance obligation recognised over time. This is on the basis that it is providing a series of distinct services that are substantially the same and have the same pattern of transfer (i.e., the services transfer to the customer over time and Operator E uses time elapsed to measure progress).
Operator E determines that the transaction price is allocated to each individual quarter because the quarterly management fee relates specifically to the entity’s efforts to satisfy the performance obligation during each quarter. In addition, the allocation is consistent with the objective of allocating an amount that depicts the consideration to which the entity expects to be entitled in exchange for transferring the promised services.
For example, if the lease revenue generated by the property was CU2.0 million in the first quarter of 2018, Operator E would recognise revenue of CU100,000 (CU2.0 million x 5%) for the period ending 31 March 2018.
Some property management contracts contain incentive fees that are based on the performance of the underlying property over a different period rather than the base management fees (e.g., annually versus quarterly). The following illustration depicts the complexity that entities may face and the significant judgement that may be required when recognising revenues from these arrangements:
Example – Incentive-based fees Allocate the transaction price to the performance obligation
Assume the same facts as in the above example Property management fees, except that Operator E also receives a fee of 2% of the property’s annual net operating income (NOI). The shopping centre has stabilised occupancy and no significant tenant vacancies are expected during the term of the agreement. The shopping centre is located in a region that periodically receives significant snowfall during the period from December to May, which results in extensive snow removal costs in certain years.
How to handle this for IFRS 15 Allocate the transaction price to the performance obligation
Operator E evaluates variable consideration in the form of the incentive fee. While most of the property’s operating costs are predictable, Operator E determines that the variability of snow removal costs can significantly affect NOI of the property. Because of the potential variability in NOI, Operator E uses the ’expected value‘ method and concludes that there is an equal (33.3%) likelihood of the property generating NOI of CU1.2 million, CU1.5 million and CU1.8 million. Based on this approach, Operator E initially estimates that it will earn CU30,000 [0.02 x ((CU1.2 million x 33.3%) + (CU1.5 million x 33.3%) + (CU1.8 million x 33.3%))] from the incentive fee.
In this scenario, the incentive fee is based on the annual NOI of the property.
However, Operator E must determine whether any of the variable consideration needs to be recognised in the specific period (i.e., quarter) when the underlying services were performed. Operator E considers whether it is highly probable that a significant reversal in the incentive fees will not occur prior to the end of the annual period. This assessment requires consideration of the unique facts and circumstances of the arrangement.
Assume Operator E cannot conclude at contract inception that it is highly probable a significant reversal of revenue (from the incentive fees) will not occur because NOI could be significantly affected by snow removal costs.
Snow removal costs result from factors that are beyond its influence (e.g., future weather patterns). Therefore, Operator E applies the constraint to the annual incentive fee.It only includes in the allocable transaction price the fees that would be earned from the estimated outcome of NOI for which it is highly probable that a significant reversal in incentive fees will not occur. In making this assessment Operator E concludes that the 66.6% chance of earning at least CU30,000 (CU1,5 million x 0.02) does not make that outcome ‘highly probable’. As such, Operator E constrains the amount included in the transaction price to CU24,000 (CU1,200,000 x 0.02) given it considers there is a 100% probability it will receive, at least, that amount.
Operator E would subsequently update its estimate of the transaction price (and its evaluation of the constraint on variable consideration) at the end of each reporting period.
Allocate the transaction price to the performance obligation
o the performance obligation