Accounting standard requires lessees to recognise nearly all leases

Accounting in the real estate, property and construction industries involves many unique challenges – from dealing with complex bundles of interrelated goods and services, to vendor guarantees and financing. In May 2014, the International Accounting Standards Board (IASB) published IFRS 15: Revenue from Contracts with Customers. IFRS 15 contains comprehensive guidance for accounting for revenue, some of which will have a notable impact within the global real estate sector. The publication of IFRS 15  was shortly followed by IFRS 9, which outlined the new accounting requirements for financial instruments. IFRS 16: Leases was also released. This new standard requires lessees to recognise nearly all leases on the balance sheet that will reflect their right to use an asset for a period of time; and the associated liability for payments. The most significant anticipated change as a result of IFRS 9 is the new impairment rules. This will require evaluating available qualitative data, data processes used by risk teams, changes in the macro economic environment and the like. Accounting for financial instruments, including accounting for impairment will also become more complex.  This will require the alignment of key controls within the new processes.IFRS 16 will mean that substantially all leases will need to be included on a balance sheet, meaning that one of the end results will see operating leases no longer existing once they are all moved to a balance sheet. There are two cases where this reporting can be classed as exempt. These considerations are first, whether it’s a short-term lease agreement of under 12 months and secondly, whether it’s a low-value ticket asset – estimated around just under a $5,000 list price. For construction companies, this standard will likely cause a lot of disruption, given how much of their equipment is acquired via a lease. Similarly, the property industry will face a number of changes with regard to the ambiguity surrounding practices such as contingent rent or rent expense. The effects on the balance sheet are expected to be significant for companies with material off balance sheet leases.The revenue standard will replace substantially all revenue guidance under  IFRS, including the industry-specific guidance for construction-type and production-type contracts. IFRS 15 does not change the primary unit of measure which is still a contract or specific obligation within a contract and the percentage-of-completion revenue recognition methodology is still intact. However, this does not mean that this standard does not come without some impact. What did result from the implementation of this standard is a five-step process that will, to varying degrees, impact all participants in the construction industry. Whether it will add to comparability between participants in the construction industry and participants in other industries remains to be seen. In this article, we will highlight the impact that the new standard will place on the construction industry by process step.Step 1: Identify the ContractThe model in IFRS 15 applies to contract with a customer when certain criteria are met. Contracts may be written, oral or implied by an entity’s customary business practices, but must be legally enforceable and meet specified criteria. IFRS 15 requires an entity to conclude that it is probable that it will collect the consideration to determine whether a contract with a customer exists. The transaction price may differ from the stated contract price e.g., when an entity intends to offer a concession. Therefore, significant judgement is required to determine whether a contract is within the scope of IFRS 15.  If an entity believes that it will receive partial payment for performance it must determine whether the amount of consideration that it does not expect to receive is a price concession or an amount that the customer does not have the ability and intention to pay. In making this determination, an entity will have to consider its customary business practices, published policies or specific statements provide the customer with a valid expectation that the entity will accept an amount of consideration that is less than the price stated in the contract.Step 2: Identify the Performance ObligationsA performance obligation (PO) is defined as a promise in a contract. Under the new standard, the performance obligation, rather than the contract, is the new basis of measurement for revenue recognition. Properly identifying performance obligations is critical to the revenue model since revenue is allocated to each performance obligation is recognised as the obligation is satisfied.Construction entities, particularly those with long-term construction contracts, should carefully assess whether applying the new requirements results in the identification of performance obligations that are different from the separately identifiable components assessed under IAS 11 or IAS 18. These differences may result in a change in the pattern of revenue recognition and associated profit.Companies will likely find that evaluating whether a good or service is distinct within the context of the contract will be a significant aspect of implementing the new standard.Step 3: Determine the Transaction PriceThe determination of the transaction price has the potential for requiring the biggest change from previous revenue recognition methodology. In determining the transaction price, the new standard requires the contractor to assess the original contract price plus adjustments for variable consideration. The contract price is typically stated in the contract as a fixed price or as a calculated value from agreed upon time and materials billing rates, plus fully executed change orders. When including variable consideration in a transaction price calculation, the new guidance stipulates that the contractor should use either the estimated value approach or the most likely amount approach depending on the type of consideration.While entities may already estimate the variable consideration they expect to earn, they may need to change their processes for making those estimates. This could possibly change their conclusions about when and how much variable consideration is to be included in the transaction price. Variable consideration should only be included in the transaction price to the extent of its probability that it will not be reversed.Entities will be required to adjust the transaction price for this component if the financing is significant to the contract. A significant financing component may exist in a contract even when there is no explicit purpose to finance between the parties.  Entities will need to carefully evaluate certain payment terms and the timing of billings to determine whether a significant financing component exists.  Also, the standard does not include any quantitative application guidance for evaluating ‘significance’.This will require entities to use judgement when making this assessment.The standard does not include any quantitative application guidance to determine whether a financing component is significant to the contract. Entities are therefore required to use judgement to determine whether a financing components is significant. Step 4: Allocate the Transaction PriceIf there are multiple performance obligations, then the contractor must allocate the transaction price between the POs based on the standalone selling prices of the various POs. However, in many situations, stand-alone selling prices will not be readily observable. Therefore, an entity will be required to estimate the stand-alone selling price. The standard discusses three estimation methods:u An adjusted market assessment of the various POsu Extended cost plus margin of the various POsu A residual approachIf there is variable consideration included in the contract, and you can determine that it relates specifically to one PO, then it should be allocated specifically to that PO.Step 5: Recognize RevenueEntities will either recognise revenue as the PO is satisfied over time or at a point in time. For many construction-type contracts, it is likely that entities will determine that the control of many goods or services is transferred over time. When making the determination, entities are required to understand all contract terms as well as determine whether the asset has an alternative use and whether the entity has a right to payment for performance completed to date.Entities previously using the percentage-of-completion revenue recognition methodology will still use it to recognise revenue on their various performance obligations. Contract ModificationsContract modifications impact multiple steps in the revenue recognition process above. As adjustment to the contract (Step 1), the scope of a modification may impact the identification of the performance obligations (Step 2) and the price of the modification may impact the determination of the transaction price (Step 3).Construction entities will need to carefully evaluate performance obligations at the date of a modification to determine whether the remaining goods or services to be transferred are distinct and the prices are commensurate with their stand-alone selling prices. If it does create a distinct PO and the price of the change order reflects the pricing of a stand-alone agreement, then the modification should be accounted for as a separate contract and revenue would be recognized accordingly. This assessment is important because the accounting treatment can vary significantly depending on the conclusions reached. If the goods/services are distinct, but the pricing is not reflective of a stand-alone sales price, the contractor should treat the transaction as if the original contract is terminated and a new contract is in place. The contractor should determine the revenue remaining from the original scope of work and add it to the revenue from the change order, then allocate accordingly between the remaining performance obligations using the appropriate allocation method identified in Step 4 above.If goods/services are not distinct, the contractor should use a cumulative catch-up method. The contract amount and total estimated costs would be increased for the impact of the change order, and any additional profit would be recognized to the extent that performance obligations had been previously satisfied.The new revenue recognition guidance allows for claims to be accounted as variable consideration as described in Step 3, which could allow for the earlier recognition of profit compared to previous guidance.DisclosuresIFRS 15 significantly increases the volume of disclosures required in entities’ financial statements. Even though for some entities there may be no change in the timing of revenue recognition, disclosure requirements may, nonetheless, require significant additional effort. The standard does not specify precisely how revenue is required to be disaggregated, however, the application guidance suggests categories, as follows: u Type of good or service (e.g., major product lines); u Geographical region (e.g., country or region); u Market or type of customer (e.g., government and non-government customers); u Type of contract (e.g., fixed price and time-and-materials contracts); u Contract duration (e.g., short-term and long-term contracts) u Timing of transfer of goods or services (e.g., revenue from goods or services transferred to customers at a point in time and revenue from goods or services transferred over time); and u Sales channels (e.g., goods sold directly to customers and goods sold through intermediaries).  Conclusion