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Real Estate and ASC 606: New Rev Rec Standards

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The people have spoken and we, your friendly dispensers of financial wisdom, have listened. Yes, real estate industry, your long and painful wait is finally over as Embark is lending our sage insights to the intricacies of the new revenue recognition standards to your particular needs. After reading our page-turners on ASC 606 with respect to oil & gas and life sciences, it is finally your turn, Ms. or Mr. Real Estate, at the plate. Pop open that champagne now because here we go.

revrec-realestate 

Steps in Revenue Recognition

As is typically the case, new standards require different procedures for different industries as they veer from existing methods. Such is the case with real estate and ASC 606, where contract complexities make adoption of the new standards a bit more unique and singular than other industries. To that point, the five step recognition process – as spelled out by the new guidance – takes on a specificity when applied to real estate contracts.

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Identify the Contract, Combine When Appropriate

Before our regular programming begins, we ask you to be a bit patient as we walk you through a bit of straightforward, like-watching-paint-dry guidance. Granted, it’s not exactly a page-turner but is still immeasurably important in providing a sound foundation to case studies and our somewhat snarky commentary. We thank you for your patience.

While determining if a contract exists with each of your customers should be clear cut for the majority of transactions, there's a certain degree of haziness when financing is involved. When a contract does in fact include financing, sellers must determine the collectibility of the transaction price or, at the very least, how likely the seller will collect the consideration.

It should be noted the new guidance is vague on how collectibility thresholds are met so an ample amount of best judgment is well in order. Therefore, developers should constantly reevaluate arrangements to determine when they have become sufficiently collectible to be considered a contract.

Also, companies need to rely on specific criteria to determine if two or more contracts should be combined. According to the new standards, this criteria includes: timing of the contracts and their specific objectives, determining if revenue generated by one contract is dependent on the amount or performance of another, or if the goods or services within the contract are a single performance obligation.

In other words, FASB has redefined what it means to be in a contract and gives companies greater freedom to apply professional judgment to determine if a contract exists. Once that contract is identified, companies must then determine the performance obligations which may be under multiple contracts.

 

Identify Performance Obligations

Regarding those performance obligations, if the contract includes the transfer of multiple goods or services to a customer, the developer can only separate them as individual obligations if the good or service is distinct or, alternatively, a series of those goods or services are substantially the same.

If they are determined to be separate performance obligations, revenue would generally be recognized at closing or, with incremental revenue for development, to be recognized over time. If it is determined that the obligations are not distinct or separate, revenue is deferred until completion of development. Also, performance obligations that are sufficiently similar should be bundled with other goods and services into a single contract. This, of course, is a common occurrence in real estate contracts.

To place this within a real world context, a single real estate contract can easily have multiple obligations or multiple contracts for each obligation, as evidenced by the following examples:

  • An investment firm or developer could sell a commercial building to a buyer while still being contracted to provide asset management or property development services.
  • A contractor may be under obligation to provide design and engineering services on top of the construction itself.
  • A leasing services provider may service one or multiple rentable units within one or multiple real estate properties, providing a variety of services like finding tenants, marketing the available space, or negotiating leases.
  • A property management company manages day-to-day operations, finds tenants, performs maintenance work, and takes care of back office support and accounting.

These multiple obligations may be completed at the same time or at different times over a number of phases, which impacts the timing of when to recognize revenue. Are you still with us? Good.

 

Determining Transaction Prices

The third step requires the company to determine what it expects to receive when it delivers promise goods or services to an individual customer. Transaction pricing should be estimated with respect to any variable considerations, including bonuses based on performance and any shared-savings arrangements. It should be noted that these estimates should only be recorded when reversing any revenue recognized based on those variable considerations is considered unlikely.

Likewise, if those variables are significant enough to change the overall scope or pricing of a contract – a common occurrence in real estate – the new guidance states they should be considered entirely new contracts if any changes add distinctly new goods or services and adjusted pricing reflects the value of those additions. Determining whether or not the added goods and services are distinctly different from those previously spelled out by the contract is the primary deciding factor in determining if a new contract is in order.

 

Allocate Transaction Prices

All transaction prices are allocated according to standalone selling prices for the specific goods or services obligated to the customer. In other words, if a real estate developer is obligated to perform a variety of different services for a particular customer, pricing for each of the services should be estimated individually and allocated accordingly.

 

Recognize the Revenue

As control of the promise goods or services are transferred to the customer, performance obligations are satisfied and revenue should be recognized. The new standards specifically state that recognition is triggered by transfer of control, not by any underlying risks and rewards of ownership. Likewise, when performance obligations are satisfied over a duration of time instead of at a single point, the accompanying revenue must also be recognized over the duration of time.

Therefore, current guidance says that if a seller remains involved with a sold property, the buyer must hold the risks and rewards of ownership before the seller can recognize revenue. ASC 606 says that, under the same circumstances, the seller can recognize revenue even if it remains involved with a sold property but the revenue should be recognized as the obligations are performed. Of course, this means the seller must determine if the obligations be bundled or, instead, are distinct promises for goods and services.

A promise is generally distinct if it is separately identifiable from other promises and the customer benefits from the provided good or service on its own or with resources that the customer already has or is readily available – if, for example, it can be provided by another entity. Again, FASB allows professional judgment to be used here as long as it is reasonable and can be substantiated.

 

Case Study Fun

Using one of our previously provided examples, let’s expand on it a bit to provide some additional insight. Typically, selling a building is distinct from providing asset management services after control of the building is transferred to the buyer. That’s pretty straight forward. Now, let’s move on to real estate activity once a property is purchased and running.

For instance, take a property management company that earns a percentage of rental revenue for providing myriad services to manage day-to-day operations of a property. The nature of the activities are nearly identical on any given day to ensure the property is running like it should under a single cohesive, consistent management. In this case, the property management services, although numerous, are considered a single obligation due to their similarity.

However, let’s add a wrinkle and say the property management company is also expected to find new tenants, earning a commission for each new lease signed. This is entirely separate from the daily maintenance and administrative operations and isn’t necessary for daily operations. It is also competing against other leasing services providers to find these tenants. In this case, the leasing activity would be a separate performance obligation.

Now, let’s build from another of the previous examples to provide even more context. Contractors often promise multiple goods and services over different phases. They design, engineer, construct the building, provide finishing services, and manage the project. Technically, each of these goods and services could be provided by other entities. However, each of these promises are often integrated and work together to provide one fully-finished and operable building. When deciding whether or not these obligations can be separated, the answer requires much professional judgment and scrutiny over whether or not they are distinct in the context of the contract.

In both our property management and contractor examples, once performance obligations have been separated and bundled as appropriate, the next step is to allocate the transaction price accordingly. Revenue is then recognized as the obligations are met or, to use more specific examples:

  • When the building is sold and control is transferred to the buyer
  • When another day of managing a property has gone by
  • When a lease with a new tenant is signed and executed
  • When a new building has been constructed and the key has been delivered

Read Next: asc 606 revenue recognition timeline


We hope your real estate-oriented trip through the winding roads of ASC 606 are pleasant and free of dramatics and hiccups. However, as your friends at Embark are all too aware, there will inevitably be a bump or two in that road. With ample preparation, however, those bumps don’t have to be potholes that wreck your metaphorical suspension. Be diligent, don’t procrastinate, and embrace the new standards because they’re not going to be disappearing like you might secretly wish.

 

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