The past weeks have been abuzz with news about the plans of our incoming Philippine President, from his economic agenda to his choices of Cabinet members, down to his plan of imposing on cab drivers the practice of giving exact change to passengers. Certainly, everyone is eager to see what changes the new administration will bring to the country and whether it can really deliver, not only the economic growth that we expect, but also initiatives to address poverty, crime, drugs, graft and corruption, among other problems.
One sector that is, perhaps, very much interested in these changes is the construction and real estate industry, which makes up about 20 percent of the Philippine economy.
However, this sector should not only focus on the economic and political changes, but on accounting developments that will have a significant impact on the industry in the years to come.
Current state of affairs
In 2005, the Philippines adopted its version of the International Financial Reporting Standards (IFRS)—the Philippine Financial Reporting Standards or PFRS. Such adoption made the financial statements of local reporting under PFRS substantially comparable to and aligned with the financial statements of companies in countries adopting the same accounting framework. This is due to certain provisions in the IFRS that are still different from the PFRS, such as the accounting for sale of real estate properties in the Philippines, particularly those being offered for sale while the project is still under construction.
Under PFRS, companies account for the sale of real estate using the percentage of completion (POC) method, whereby profit is recognized based on the percentage of completion of the project (70 percent completed means 70 percent recognition of profit).
Based on IFRS rules, the completed contract method of accounting would be the more appropriate accounting for the sale of the property. This would mean that the recognition of the entire amount of consideration is made only when there is already a transfer of significant risks and rewards to the buyers—normally at the date of the completion and turnover of the project to the buyer.
To illustrate the disparity between the two, let us take the case of ABC Company, which expects a profit of P100 million from the sale of condominium units. Using PFRS, if the project is completed at a rate of 25 percent every year for the next four years, ABC Company should report profit of P25 million for each year from years one to four.
Under IFRS, however, ABC Company will have to report no profit until the completion and turnover of the units. If such completion and transfer was made in year four, all of the P100 million profit will be recognized only in year four. The difference between the standards does not only result in differences in the amounts and timing of profit recognized but will also have significant impact on other aspects of the business. Early recognition of the profit under the POC method in PFRS may translate to earlier distribution of dividends to shareholders compared to the possible dividend payout only after year four under the full profit recognition on year four under IFRS.
Other critical and sometimes complex matters specific to POC under PFRS are management’s judgment, estimates and assumptions related to the determination of the appropriate POC to use as basis for project progress to date, since these have impact on profit reported by developers. This topic on management’s judgment, given its impact on the balances in the financial statements, would warrant another discussion, which we could cover in future articles.
On the horizon
IFRS 15, “Revenue from contracts with customers,” was recently issued and will become effective for annual periods beginning on or after Jan. 1, 2018. Relative to this, real estate companies in the Philippines will again have to prepare for its implementation even before its actual effective date. In articles written on this revenue standard, it has been consistently highlighted that real estate is one of the industries that will be significantly affected.
For most urban dwellers tired of the traffic in the city, buying a condominium unit has become an attractive option over the past few years because of the convenience of having a house closer to work. Construction and real estate companies, and even those considering buying, or those who have actually bought their units might find the analysis of the accounting of the sale of a condominium unit below quite interesting and informative if you will consider the provisions of the contract of sale and the relevant laws in the Philippines.
IFRS 15 (or PFRS 15 when this is adopted in the Philippines) provides that an entity recognizes revenue when it satisfies a performance obligation by transferring promised goods or a service to a customer (which is when the customer obtains control of the goods or service).
A performance obligation may be satisfied at a point in time or over time. For performance obligations to be satisfied over time, an entity recognizes revenue over time by selecting an appropriate method for measuring the entity’s progress toward complete satisfaction of that performance obligation.
Most relevant to real estate companies will be IFRS 15, paragraph 35, where it provides that an entity transfers control of goods (in this case, the real estate property) over time and therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met:
A) The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;
B) The entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced; or
C) The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
Let us analyze each of the above criteria and check whether real estate companies can continue on recognizing revenue over time (substantially similar to the percentage of completion).
For criterion A, we should ask the question whether the customer receives or consumes the benefit as the entity performs its services. The answer would be clearly NO as the buyer is not able to benefit as the developer performs its services. This is more applicable when service is the subject of the contract. The customer benefits from a performance (like in a maintenance contract or cleaning services contract) as the entity renders the service.
On the other hand, for criterion B, while the developer creates and enhances an asset, the more relevant question is again, whether the buyer controls the asset as it is created or enhanced. Again, it is difficult to establish that a buyer of a real estate property being constructed has control over that asset in progress.
Finally for criterion C, which has twin requirements that may provide a chance for real estate companies to continue on recognizing their revenues from sales of real estate properties over time. The first requirement is that the entity’s performance does not create an asset with an alternative use to the entity. This can generally be complied with as the contract of sale is specific to a unit, which the entity cannot use or sell to another buyer.
The second requirement is that the entity should have an enforceable right to payment for performance completed to date.
For the second requirement, consideration has to be made on whether the entity can enforce payment from the buyer for performance completed to date. Such right to payment should be sustained even when the buyer defaults. In this case, the provisions of the contract and laws are being considered. Some contracts will support this right to payment such that the contract will provide that “In the event of default in payment by the buyer, the seller may enforce full payment of the buyer’s obligation under the contract.” But do our local laws support this right to payment of the developer?
Republic Act (RA) 6552—The Realty Installment Buyer Act, more commonly known as the Maceda Law, provides remedies should the buyer default from payment based on the payment schedule initially agreed with the developer. Under this law, in the event of buyer’s default, the buyer should be given a grace period and a refund of 50 percent to 90 percent of what has been paid (provided that the buyer has paid installments for at least two years). Also, under the Act, notice of cancellation, and then the refund (twin requirements), should be completed before cancellation of the contract to sell can be carried out. Some legal opinions will say that without such cancellation, the contract between buyer and developer remains valid.
With these provisions on cancellation (cancellation right of the developer), there is a chance that the real estate companies can sustain their legal right to payment. The discussion in the new revenue standard explains that, notwithstanding that an entity may choose to waive its right to payment in similar contracts, an entity would continue to have a right to payment to date, if in the contract with the customer, its right to payment for performance to date remains enforceable. This legal position on enforceability of the right to payment to support the recognition of revenue on the sale of real estate is currently being reviewed by the real estate industry.
Before reality bites
Accounting for the sale of real estate can be complicated and such might become even more so with the adoption of the new standard, coupled with the consideration of legal requirements. As various stakeholders continue to focus and rely on the fair presentation of the balances reported in the financial statements, it is therefore very important for companies, especially those in the construction and real estate sector, to prepare and engage in discussions regarding the possible impact of the new revenue standard.
The change is real and it becomes even more relevant and critical as companies also deal with possible changes and impact on the political and economic environment.
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Gina S. Detera is a Partner from Assurance, Corporate Responsibility Leader and Accounting Consulting Services Co-Leader of Isla Lipana & Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.