IFRS 15 Revenue from Contracts with Customers (contents page is here) introduced a single and comprehensive framework which sets out how much revenue is to be recognised, and when. The core principle is that a vendor should recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the vendor expects to be entitled in exchange for those goods or services. See a summary of IFRS 15 here.
This is an example in a small series for illustrating the concepts in What is a good or service that is distinct?
The scenarios in the following example demonstrates how two transactions which are substantively very similar but have different legal contract structures are accounted for in the same way (illustrating how the accounting is not affected by the legal form of the arrangements and instead focuses on the promises made by a vendor to its customer), and how subtle changes in the facts and circumstances can affect the assessment of whether two promises in a contract are separately identifiable (i.e. distinct within the context of the contract).
Entity PD, a property development company, contracts with Entity PI a property investment company to:
- Sell a piece of land currently owned by PD; and
- Construct a property on the land.
Both (i) and (ii) are contained in separate legal contracts, with the first contract specifying the land is sold at a price of CU 1 million and the second contract specifying the construction services are sold at a price of CU 2 million.
The transfer of a piece of land results in local taxes being levied on the purchase price. It is not legally possible to transfer legal ownership of a building independently of the land on which it sits, and so the tax payable would be greater when a transaction involves the sale of both land and buildings. The tax authority does not permit structuring of a transaction to avoid tax on the building element by artificially breaking the contract into two elements, or by negotiating a price for the land that is clearly below market value, with this reduction being offset by the selling price for construction services being above market rate.
However, tax on the price of buildings can be avoided if the contracts are not linked. Therefore the transaction is structured as follows:
- The sale of land is completed (i.e. the customer pays PD in full for the land, and has legal ownership and physical possession) four weeks before a contract for construction services is signed;
- Although PI and PD may have previously discussed a project for construction services for CU 2 million on the land, and PI has the intention to engage PD to provide those construction services, both are ‘on risk’ following the sale of land. PD is on risk that, subsequent to purchasing the land, PI may decide to engage another entity to provide construction services, or could change its mind about undertaking construction (i.e. it decides instead to hold the undeveloped land as investment property). PI is on risk that PD may change its mind about wanting to undertake the construction services or, for whatever reason, it might not be capable of providing the intended construction services. Experience with previous transactions indicates that in almost all cases the property construction does proceed, but in a small number of cases only the land is sold;
- The contract for the sale of land is priced at fair value in order to comply with tax legislation, and to protect the position of both PI and PD because of the risk that the property will not be constructed;
- The construction contact between PI and PD is signed four weeks after the sale of land was completed, as was the non-binding intention. If PD fails to construct the building in accordance with the terms of the contract PI will only have recourse against PD for its failure to perform that contract. It would have no recourse in relation to the contract for the sale of the land.
In this example, because of the separation of the contract for the sale of land and the contract for construction services, including the lack of any contractual obligation for either PI or PD to enter into the second contract for the construction of the building, PD concludes that the risks associated with the transfer of land are separable from those associated with the construction services.
Consequently, there are two performance obligations: Identify Property development obligations – Separate contrac
- The sale of land; and Identify Property development obligations – Separate contrac
- The construction of the building. Identify Property development obligations – Separate contrac