The IFRS Interpretations Committee tentatively decided not to add this matter to its standard-setting agenda at its meeting in September 2017. The Committee will reconsider the following tentative agenda decision, including the reasons for not adding the matter to the standard-setting agenda, at a future meeting. The Committee encourages interested parties to submit their responses using the link below.
Tentative Agenda Decision
The Committee received a request about revenue recognition in a contract for the sale of a unit in a residential multi-unit complex (real estate unit). The real estate developer (entity) and the customer enter into a contract for the sale of the real estate unit before the entity constructs it. Specifically, the request asked about the application of paragraph 35 of IFRS 15, which specifies when an entity recognises revenue over time.
In considering this request, the Committee first considered the requirements in IFRS 15 and then discussed the application of those requirements to the fact pattern described in the request.
Identifying performance obligations in the contract
Before applying paragraph 35 of IFRS 15, an entity applies paragraphs 22–30 in identifying as a performance obligation each promise to transfer to the customer a good or service that is distinct.
Applying paragraph 35 of IFRS 15
Paragraph 35 of IFRS 15 specifies that an entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognises revenue over time, if any one (or more) of the three criteria in paragraph 35 is met. Paragraph 32 of IFRS 15 states that if an entity does not satisfy a performance obligation over time, it satisfies the performance obligation at a point in time. Accordingly, the Committee observed that, at contract inception, an entity assesses each of the three criteria in paragraph 35 to determine whether it recognises revenue over time.
Applying paragraph 35(a), an entity recognises revenue over time if the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. In a contract for the sale of a real estate unit that the entity constructs, the Committee observed that paragraph 35(a) is not applicable because the entity’s performance creates an asset, ie the real estate unit, that is not consumed immediately.
Applying paragraph 35(b), an entity recognises revenue over time if the customer controls the asset that an entity’s performance creates or enhances as the asset is created or enhanced. Control refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.
Paragraph BC129 of IFRS 15 explains that the Board included the criterion in paragraph 35(b) to ‘address situations in which an entity’s performance creates or enhances an asset that a customer clearly controls as the asset is created or enhanced’. Accordingly, the Committee observed that, in applying paragraph 35(b), an entity assesses whether there is evidence that the customer clearly controls the asset that is being created or enhanced (for example, the part-constructed real estate unit) as it is created or enhanced. An entity considers all relevant factors in making this assessment—no one factor is determinative.
In applying paragraph 35(b), it is important to apply the requirements for control to the asset that the entity’s performance creates or enhances. In a contract for the sale of a real estate unit that the entity constructs, the asset created is the real estate unit itself. It is not, for example, the right to obtain the real estate unit in the future. The right to sell or pledge this right is not evidence of control of the real estate unit itself.
Paragraph BC131 of IFRS 15 explains that the Board developed a third criterion in paragraph 35(c) for recognising revenue over time because it observed, in some cases, it may be unclear whether the asset that is created or enhanced is controlled by the customer.
Applying paragraph 35(c), an entity recognises revenue over time if (a) the asset created by an entity’s performance does not have an alternative use to the entity; and (b) the entity has an enforceable right to payment for performance completed to date.
Paragraph 36 of IFRS 15 specifies that the asset created does not have an alternative use to an entity if the entity is restricted contractually from readily directing the asset for another use during the creation of that asset or limited practically from readily directing the asset in its completed state for another use.
Paragraph 37 of IFRS 15 states that, to have an enforceable right to payment, at all times throughout the duration of the contract the entity must be entitled to an amount that at least compensates the entity for performance completed to date if the contract is terminated by the customer for reasons other than the entity’s failure to perform as promised. In assessing whether it has an enforceable right to payment, an entity considers the contractual terms as well as any legislation or legal precedent that could supplement or override those contractual terms.
The Committee observed that the assessment of enforceable rights as described in paragraph 35(c) is focussed on the existence of the right and its enforceability. The likelihood that the entity would exercise the right is not relevant to this assessment. Similarly, if a customer has the right to terminate the contract, the likelihood that the customer would terminate the contract is not relevant to this assessment.
The Committee concluded that the principles and requirements in IFRS 15 provide an adequate basis for an entity to determine whether to recognise revenue over time or at a point in time for a contract for the sale of a real estate unit. Consequently, the Committee [decided] not to add this matter to its standard-setting agenda.
Illustration of the application of the requirements to the fact pattern in the request
The assessment of whether revenue is recognised over time requires an entity to consider the rights and obligations created by the contract, taking into account the legal environment within which the contract is enforceable. Accordingly, the Committee observed that the outcome of an entity’s assessment depends on the particular facts and circumstances pertaining to the contract.
In the fact pattern described in the request, the contract for the real estate unit includes the following features:
- the real estate developer (entity) and the customer enter into a contract for the sale of a real estate unit in a residential multi-unit complex before the entity constructs the unit.
- the entity’s obligation under the contract is to deliver the completed real estate unit as specified in the contract—it cannot change or substitute the unit agreed to in the contract. The entity retains legal title to the real estate unit (and any land attributed to it) until construction is complete.
- the customer pays a portion of the purchase price for the real estate unit as the unit is being constructed, and pays the remainder (a majority) of the purchase price to the entity after construction is complete.
- the contract gives the customer a right to the real estate unit under construction. The customer cannot cancel the contract, except as noted in b. below, nor can it change the structural design of the unit. The customer can resell or pledge the right to the real estate unit as the unit is being constructed, subject to the entity performing a credit risk analysis of the new buyer of the right (no credit check is required if the customer has already paid the entire purchase price for the unit).
The request also noted the following legal rights of the entity and the customer:
- if the entity is in breach of its obligations under the contract, the customer, and other customers who have agreed to buy real estate units in the multi-unit complex, have the right to together decide to remove the entity and hire another real estate developer to complete the construction of the complex.
- Although the contract is irrevocable under local law, the courts have accepted requests to cancel contracts in specific circumstances, mainly when it has been proven that the customer is not financially able to fulfil the terms of the contract (for example, if the customer becomes unemployed or has a major illness that affects the customer’s ability to work). In this situation, the customer can cancel the contract and is entitled to receive most, but not all, of the payments it has already made to the entity. The remainder is retained by the entity as a termination penalty. The entity may also agree to sell the real estate unit at auction if the customer defaults on its payments.
Identifying the performance obligation
The nature of the promise in the contract is to deliver a completed real estate unit to the customer. Any land attributed to the real estate unit is not distinct applying paragraphs 22–30 of IFRS 15. Accordingly, the Committee observed that there is one performance obligation in the contract.
Paragraph 35(a)
The customer does not simultaneously receive and consume the benefits provided by the entity’s construction of the real estate unit as the unit is being constructed. This is because the entity’s performance creates an asset that is not consumed immediately—the part-constructed real estate unit. Consequently, the Committee observed that the criterion in paragraph 35(a) of IFRS 15 is not met.
Paragraph 35(b)
The entity’s performance creates the real estate unit under construction. Accordingly, the entity assesses whether, as the unit is being constructed, the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the part-constructed real estate unit. The Committee observed the following:
- although the customer can resell or pledge its contractual right to the real estate unit under construction, it is unable to sell the real estate unit itself without holding legal title to it.
- the customer has no ability to direct the construction or structural design of the real estate unit as the unit is constructed, nor can it use the part-constructed real estate unit in any other way.
- the customer’s legal right (together with other customers) to replace the entity, only in the event of the entity’s failure to perform as promised, is protective in nature and is not indicative of control.
- the customer’s exposure to changes in the market value of the real estate unit may indicate that the customer has the ability to obtain substantially all of the remaining benefits from the real estate unit. However, it does not give the customer the ability to direct the use of the unit as it is constructed.
The Committee observed that, based on the fact pattern described in the request, the customer does not have the ability to direct the use of the real estate unit as it is being constructed, and thus the customer does not control the part-constructed unit.
Paragraph 35(c)
The entity cannot change or substitute the real estate unit specified in the contract with the customer, and thus the customer could enforce its rights to the unit if the entity sought to direct the asset for another use. Accordingly, the Committee observed that the contractual restriction is substantive and the real estate unit does not have an alternative use to the entity.
The entity, however, does not have an enforceable right to payment for performance completed to date. This is because the customer has the legal right to cancel the contract and, in the event of doing so, the entity is entitled only to a termination penalty that does not compensate the entity for the performance completed to date.
Based on the fact pattern described in the request, the Committee observed that none of the criteria in paragraph 35 of IFRS 15 are met. Accordingly, the entity would recognise revenue at a point in time applying paragraph 38 of IFRS 15.
Deadline for submitting comment letters: 20 November 2017
