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:
- 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
The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. The entitled amount is meant to reflect the amount to which the entity has rights under the present contract and this amount may differ from the contractual price (e.g., if the entity expects or intends to offer a price concession).
The transaction price may be less than the stated contract price if an entity concludes that it has offered, or is willing to accept, a price concession or other discount. Such concessions or discounts are forms of variable consideration that an entity would estimate at contract inception and reduce from the contract price to derive the transaction price. The estimated transaction price would then be evaluated for collectability. The following example illustrates these concepts:
Stated contract price Determine the transaction price – property construction
Price concession – amount entity estimates it will offer or accept as a reduction to the contractual price
Transaction price Determine the transaction price – property construction
The consideration promised in a contract may include fixed and/or variable amounts. When determining the transaction price, entities must estimate the variable consideration, which is subject to a constraint. The requirement to estimate variable consideration at contract inception in property management contracts and certain real estate sales agreements may represent a significant change for real estate entities. The transaction price also will include the fair value of any non-cash consideration, the effect of a significant financing component (ie the time value of money) and the effect of any consideration paid or payable to a customer.
Variable consideration Determine the transaction price – property construction
The transaction price may vary in amount and timing as a result of discounts, credits, price concessions, incentives or bonuses. In addition, consideration may be contingent on the occurrence or non-occurrence of a future event or earned as a percentage of an underlying measure (e.g., sales, profits, operating performance).
An entity is required to estimate variable consideration using either the ’expected value‘ method (i.e., the sum of probability-weighted amounts) or the ’most likely amount‘ method (i.e., the single-most likely outcome), whichever better predicts the amount of consideration to which it will be entitled. That is, the method selected is not meant to be a ’free choice’. The entity is required to apply the selected method consistently throughout the contract and update the estimated transaction price at the end of each reporting period.
Example – Estimating variable consideration Determine the transaction price – property construction
Developer D sells a newly constructed commercial property with a cost basis of CU1.9 million for CU2 million, plus a right to receive 5% of future operating profit from the property for the first year. Developer D has no additional ongoing performance obligations. Developer D determines there are a number of possible outcomes for consideration to be received based on the performance of the property (i.e., the buyer’s ability to secure tenants for the entire property at favorable rental rates). The buyer currently has executed leases or letters of intent from prospective tenants for 50% of the property.
Analysis: Developer D has to determine whether the ’expected value‘ or ’most likely amount‘ method better predicts the variable consideration to be received. Developer D determines that the ’expected value‘ method is the better predictor of the variable consideration since multiple outcomes are possible.
Based on the buyer’s current pre-leasing, Developer D estimates the following future profit participation:
Assume for purposes of this illustration that the constraint, discussed further below, does not limit the amount that can be included in the transaction price at contract inception (i.e., assume it is highly probable that a significant revenue reversal will not occur). Using a probability-weighted estimate, Developer D would include CU225,000 [(CU500,000 x 10%) + (CU250,000 x 70%) + (CU0 x 20%)] in the transaction price associated with this variable consideration. That is, the transaction price would be CU2,225,000.
Developer D updates its estimate of the transaction price at the end of the next reporting period. After considering that the buyer now has letters of intent or executed leases for 75% of the property, Developer D determines it is now 75% likely to receive future profit participation of CU500,000 and 25% likely to receive CU250,000. As a result, Developer D’s estimate of variable consideration is updated to CU437,500 [(CU500,000 x 75%) + (CU250,000 x 25%)] and additional revenue of CU212,500 (CU2,437,500 — CU2,225,000) is recognised.
Constraining estimates of variable consideration
The constraint needs to be considered when accounting for variable consideration resulting from the sale of real estate or property management arrangements.
To include variable consideration in the estimated transaction price, the entity has to first conclude that it is ’highly probable‘ that a significant revenue reversal will not occur when the uncertainties related to the variability are resolved. IASB provided factors that may indicate that revenue is subject to a significant reversal:
- The amount of consideration is highly susceptible to factors outside the entity’s influence (e.g., market volatility, judgement or actions of third parties, weather conditions).
- The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
The entity’s experience (or other evidence) of similar types of contracts is limited or that experience (or other evidence) has limited predictive value.
- The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.
- The contract has a large number and broad range of possible consideration amounts. [IFRS 15 57]
The indicators provided by the Boards are not meant to be an all-inclusive list. Therefore, additional factors may be relevant when making an evaluation. In addition, the presence of any one of these indicators does not necessarily mean that it is highly probable that a change in the estimate of variable consideration will result in a significant revenue reversal.
For example, when determining how the constraint affects the estimate of variable consideration, sellers of real estate and property managers will need to consider a variety of factors, including their experiences with similar arrangements, uncertainties that may exist in the latter years of a long-term contract, and market and other factors that may be outside of their control. All entities will want to make sure they sufficiently and contemporaneously document the reasons (including supporting and non-supporting evidence considered) for their conclusions reached. Determine the transaction price – property construction
When an entity is unable to conclude that it is highly probable that a change in the estimate of variable consideration that would result in a significant revenue reversal will not occur, the amount of variable consideration included in the transaction price is limited. In addition, when an arrangement includes variable consideration, an entity is required to update both its estimate of the transaction price and its evaluation of the constraint throughout the term of the contract to depict conditions that exist at the end of each reporting period.
The following provides an illustration of the application of the constraint to the estimation of variable consideration:
Example – Evaluating the constraint
Assume the same facts as in the example – Estimating variable consideration above except that the buyer of the property has just begun negotiations with prospective tenants. The buyer has not signed lease agreements for a significant amount of space and negotiations are proving problematic. Profits are highly dependent on whether a lease can be signed with a key anchor tenant. Determine the transaction price – property construction
What is going on?
Developer D uses the ’expected value‘ method and estimates it is 25% likely to receive future profit participation of CU1,500,000, 50% likely to receive CU250,000 and 25% likely to receive none. Using a probability-weighted estimate (prior to considering the constraint), Developer D would include variable consideration within the transaction price of CU500,000 [(CU1,500,000 x 25%) + (CU250,000 x 50%) + (CU0 x 25%)]. However, the amount of variable consideration within the transaction price is constrained to CU250,000 because the entity estimates there is a 75% probability of receiving at least that amount (i.e., the amount for which it is highly probable that a significant reversal will not occur).
Before determining that a contract is in the scope of IFRS 15, an entity has to assess whether it is probable that it will collect the consideration to which it expects to be entitled in exchange for transferring goods or services (i.e., the transaction price). When determining the transaction price, an entity must evaluate its intention or willingness at the outset of the contract to accept less than the stated contract price (i.e., offer or accept a price concession). A price concession is a form of variable consideration and, as such, must be considered when estimating the amount to which an entity expects to be entitled under the contract. Determine the transaction price – property construction
Entities are required to evaluate the magnitude of a potential revenue reversal relative to total consideration (i.e., fixed and variable), but IASB did not include any quantitative requirements for evaluating the significance of the amount. As a result, entities will need to use significant judgement when making this assessment.
The new standard specifies that when an entity receives, or expects to receive, non-cash consideration (e.g., in the form of goods or services), the fair value of the non-cash consideration (measured in accordance with IFRS 13 Fair Value Measurement) is included in the transaction price. If an entity cannot reasonably estimate the fair value of the non-cash consideration, it is required to measure the non-cash consideration indirectly, by reference to the estimated stand-alone selling price of the goods or services promised to the customer.
Significant financing component
A significant financing component may exist when the receipt of consideration does not match the timing of the transfer of goods or services to the customer (i.e., the consideration is prepaid or is paid after the services are provided).
Entities will not be required to adjust the transaction price for this component if the financing is not significant to the contract. Furthermore, an entity is not required to assess whether the arrangement contains a significant financing component unless the period between the customer’s payment and the entity’s transfer of the goods or services is greater than one year.
When an entity concludes that a financing component is significant to a contract, it determines the transaction price by discounting the amount of promised consideration. The entity uses the same discount rate that it would use if it were to enter into a separate financing transaction with the customer. The discount rate has to reflect the credit characteristics of the borrower in the arrangement; using a rate explicitly stated in the contract that does not correspond with market terms in a separate financing arrangement would not be acceptable. Subject to certain limitations, the transaction price will need to be adjusted when there is a prepayment that is determined to be a significant financing component.
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