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.
A single contract priced at a total of CU 3 million is entered into for both the sale of land and subsequent construction services. Unlike scenario A there is no potential to save tax by having two separate legal contracts. On the day the contract is signed the land title passes irrevocably to PI, and PI is unconditionally required to pay the market value of the land to PD. The contractual and /or legal environment means that title to the land cannot be transferred back to PD, and PI would have recourse to PD only in respect of any future underperformance by PD in relation to construction services.
PD concludes that the sale of land and the construction of a building are both capable of being distinct, and so then considers the factors in IFRS 15.29 to assess whether they are distinct within the context of the contract. PD notes the following, which might indicate they are not distinct within the context of the contract:
- The land is integrated with the buildings in the sense that foundations need to be laid which will ensure the building will not collapse;
- The construction of the building modifies the land in the sense that once constructed, the land can only be used to ’host’ the building that has been constructed. The building would need to be demolished for the land to be available for other uses; and;
- There is a high degree of interdependence between the land and building in the sense that the land is unique. Although it is possible for an equivalent building to be constructed on a different piece of land, that would not be what PI wants (which is a building on the specific piece of land).
However, PD notes the analysis is not limited to the above three factors specified in IFRS 15 29. PD also considers IFRS 15’s Basis for Conclusions which notes that an important consideration is whether one promise in a contract (in this case the construction services) has a transformative effect on another promise (the land).
Although the construction of a building on the land will modify the land (to the extent that foundations are required and its use will be limited), it does not result in the land being turned into something else. Consequently, although there is a relationship between the land and the building, this is a functional relationship, i.e. the building cannot exist without the land. However, instead of the land and the building being transformed into one overall item, the building is installed onto the land.
In addition, PD notes that it would be able to fulfil its promise to transfer the land to PI even if PI engaged another developer for the construction services, and PD could fulfil its promise to construct the building even if the customer had purchased the land from another party.
PD concludes that there are two performance obligations: Identify Property development obligations – Single contract
- The sale of land; Identify Property development obligations – Single contract
- The construction of the building. Identify Property development obligations – Single contract