By Elizabeth K. Lewis, CPA | Business Assurance & Advisory Services Manager | Real Estate & Construction Industry Team
The effective date of the new revenue recognition standard (ASU 2014-09) is rapidly approaching (for most private companies: calendar year end 2019 reporting). As real estate entities enter into a variety of contracts that may have multiple components, the industry is expected to be impacted. Although the total contract revenues earned will not change, the timing of the recognition is expected to be different.
Questions to consider for your real estate entity to determine the scope of impact
Within a contract, how many distinct promises have we made? Are they substantially the same?
Many management or leasing contracts include multiple obligations by the performing party. An entity may be required to provide maintenance, security, back office function, and tenant support of units to earn its monthly fee. Under current guidance, the fee is typically recognized in equal amounts on a routine basis after those services have been performed (ie: monthly). However under the new guidance, the fee may or may not need to be allocated separately to the various obligations and recognized at different times. In review of a contract which includes the 4 performance requirements listed above, an entity may determine that although they are distinct activities, the time period of performance is consistent and satisfied over time (ie: the property managers are performing all duties simultaneously and at substantially the same rate over time). In this case, the services are recognized as a single performance obligation and the total fee can be recognized over time as has been done historically. However, if the fact pattern changes and the property manager also has to identify a new tenant for the anchor unit on an annual basis every January, this may be considered a separate performance obligation. Much judgment is needed to assess this scenario! If it is considered a separate performance obligation, then the standalone price for this service is identified and recognized at a point in time, separately from the allocated remainder that is earned and recognized evenly over time.
Does our contract include variable compensation or incentive fees?
Variable compensation must be estimated based on the method that best predicts the amount of consideration an entity will earn over time. Methods include either the expected value method (probability-weighted) or the most-likely method (a single most-likely amount). An entity that earns a management or development fee based on net operating income (NOI) or percentage completion may need to estimate and recognize the variable compensation at the time of contract execution and subsequently update the estimate at each reporting date.
An exception to this requirement exists for situations where the variable compensation relates directly to the entity’s efforts to perform the services during an identical period. For instance: a property management fee that is calculated based on a percentage of NOI each month can be recognized at that rate each month (instead of evenly over the quarter or year) since the amount earned relates directly to the manager’s efforts to satisfy the obligation during that same period.
Incentive fees that are calculated on an annual basis would not qualify for this exception and must be estimated at the contract’s inception. The estimate would likely use a probability-weighted calculation of expected values. Significant amounts that may not be earned may be excluded from the final calculation of the transaction price to prevent significant reversals of revenue in future periods.
As most real estate companies earn revenue through contract agreements, it is likely that those in this industry will be impacted and the timing of revenue recognition will change from current guidance. Now is the time to begin review of contracts and a walk-through of the five step process.
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