Revenue recognition: Complex complexities
Complex living has become very popular due to the perceived safety and affordability. Complexes range from apartments to estates to retirement villages; we all know someone who is in, was in, or is moving into, one, if not ourselves.
Industry data provided by the Association of Residential Communities indicates that over 5 million people live in organised communities1. According to Lightstone2, just over 17% of all homes sold in South Africa during the first half of 2022 were in estates.
While we’re all aware of the benefits (and some of the difficulties) of complex living, are you aware of complexities faced by property developers in identifying the performance obligations, and the timing of revenue recognition?
Units in a residential estate are usually bought in the form of plot-and-plan contracts or turnkey contracts. ‘Plot-and-plan’ means buying a plot of land and funding the construction of a property on that plot, while turnkey is buying a product that is ready for immediate use. In plot-and-plan, the customer usually has input into the structural design or specification of the building. In turnkey, the customer may choose from the designs that are already specified by the developer.
The identification of performance obligations for these contracts will be different, given the divergence in the nature of the contracts themselves, not to mention all the other promises that could exist in each contract.
To qualify as a performance obligation in terms of IFRS 15 Revenue from Contracts with Customers, a promise to a customer must be distinct. In terms of paragraph 27 of IFRS 15, “A good or service that is promised to a customer is distinct if both the following criteria are met: (a) the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer (i.e., the good or service is capable of being distinct); and (b) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (i.e., the promise to transfer the good or service is distinct within the context of the contract).”
Plot-and-plan contracts
In a plot-and-plan contract, the promise to transfer the land can be separately identified from the promise to construct the building. The buyer can benefit from the land separately from construction services that are readily available, either from the residential complex developer or from another constructor.
The timing of the revenue recognition requires the property developer to consider these three questions: Does the customer receive and consume the benefits from the asset at the same time as the development happens? Does performance create or enhance an asset that the customer controls? Does performance create an asset with an alternative use for the developer?
For the transfer of land, the answer to these questions is a resounding “no.” The land, itself, is neither created by the developer nor enhanced. The developer would therefore recognise revenue at the point that control is transferred to the customer, usually when title transfers.
Applying the same questions to the construction of the building, the answer would, however, be “yes.” Construction creates an asset that the customer controls as the land already belongs to the customer. Construction revenue would, therefore, be recognised over time, as the developer performs. The Standard does not prescribe how to measure the satisfaction of the performance obligation, i.e., cost completed to the total cost or percentage completion, or input- compared to output-method.
Management is allowed to determine the best method; however, it is essential that the method elected is disclosed, along with the reason why this is considered the best method.
Turnkey contracts
Turnkey contracts work a little differently. The customer buys an off-plan unit that is ready for immediate use when the customer takes it over. The promise to transfer the land can usually not be separated from the promise to construct the building. The two promises, in this case, are considered to be a single performance obligation. As the name suggests, control of the unit is transferred when the key is turned over to the customer. This is the point that the developer can recognise the revenue.
Other promises
Complex complexities, however, do not end there. Estate houses are also a big player in the ‘complex living’ arena where developers compete to sell a ‘lifestyle.’ In fact, in a Private Property article dated 10 January 2023 Increasing demand for homes in estates3: “estates account for a growing percentage of home sales in the over R3 million bracket, increasing from around 20% in early 2010 to 37.9% in the second quarter of 2022." These estates promise residents much more than just the house or apartment. These promises can range from shopping centres to schools, and gyms to swimming pools and clubhouses in the complex. How should the developer recognise the revenue for these other goods and services promised in the contract?
One would need to consider the nature of each performance obligation. Usually, each promise is a separate performance obligation as each is distinct from the other. A swimming pool is distinct from a shopping centre or school. Depending on the nature thereof, each promise would be recognised on completion. For example, the swimming pool once it can be used to swim. Shopping centres are often completed in phases and can be recognised at the point each phase is made available.
Revenue recognition requires the transaction price to be allocated to each of the performance obligations in a contract. The performance obligations will not always be limited to just the land and building (plot-and-plan), or just the unit (turnkey), they might often include other promises too.
The key to resolving complex complexities lies in understanding the nature of the promises that the developers make to the customers, and the relationships between those promises. What is the customer really buying into?
2Lightstone provides information, valuations, and market intelligence on properties in South Africa.
3Increasing demand for homes in estates
Authors:
Refilwe Mahoko, Manager
Justine Combrink, Partner
26 May 2023
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