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The implementation date of ASC 606: Revenue from Contracts with Customers is quickly approaching, which may have some real estate operators feeling a bit apprehensive. For private companies, ASC 606 is effective for years beginning after December 15, 2018. So, if your company has a calendar year-end, ASC 606 will be effective for fiscal years beginning January 1, 2019. In response to these concerns, we took a closer look at how this new standard may impact operating real estate companies.
Given the name of the standard, it is important to understand what is considered a contract, who is considered a customer, and what is considered revenue. The first consideration is whether or not you have a contract. A contract must have five elements: (1) the contract is approved and the parties are committed to perform; (2) each party’s rights regarding the goods/services to be transferred can be identified; (3) payment terms regarding the goods/services to be transferred can be identified; (4) the contract has commercial substance; and (5) it is probable that the consideration will be collected. If you do not have a contract by the standards above, then ASC 606 does not apply.
Who a customer is and what revenue means is generally considered straightforward, but in terms of ASC 606, we must remember that only revenue from an entity’s ordinary activities falls under this standard. If you sell a division of your business, or dispose of some assets, those types of transactions will likely be excluded from ASC 606.
The 5-Step Model – A Case Study
The crux of the new standard is a 5-step model. As an example of how it works, let’s apply the 5-step model to a common revenue stream in the real estate industry; management fee revenue.
Step 1 – Identify the contract(s) with a customer.
If your organization does not always use an executed management fee agreement, we recommend you obtain one for all future projects. In this case study, the management fee contract has the following terms:
Manager enters into a one-year contract with Owner to provide property management services for an apartment building. The contract stipulates that Manager will manage day-to-day operations of Owner’s apartment building for a fee of 5% of the property’s operating revenue. There is also an incentive fee of 3% of annual Net Operating Income, with a threshold of $5 million.
Step 2 – Identify the performance obligations in the contract.
How do you identify performance obligations? Think about the following questions:
What are the promised services? In this case, the promised service is to provide daily management services.
What is/are the performance obligation(s)? The performance obligation is daily property management. This series of services forms a single property management performance obligation. The various aspects of property management services (janitorial and maintenance, rent collection, purchase of operating supplies and equipment, etc.) are inputs to produce a combined output (the property management services).
Should any distinct services be combined and accounted for as a single performance obligation? Although the underlying activities will vary within a single day and day-to-day, the manager is providing a daily management service that is distinct and substantially the same. Therefore, the property management service is a single performance obligation composed of a series of distinct services.
Step 3 – Determine the transaction price.
In our case study, this is fairly straightforward. The base management fee is equal to 5% of operating revenues and the incentive management fee is equal to 3% of annual net operating income. The incentive management fee falls under a category of revenue known as variable consideration, which is discussed in further detail below.
Step 4 – Allocate the transaction price to the performance obligations in the contract.
When a contract has a single performance obligation, the transaction price is attributed to that performance obligation. When a contract has more than one performance obligation, you must allocate consideration to each performance obligation based on the relative standalone selling prices of the goods or services at the inception of the contract. If such prices are not known, they must be estimated. In this case we have one performance obligation, so this step is rather simple.
Step 5 – Recognize revenue when (or as) the entity satisfies a performance obligation.
Revenue should be recognized when (or as) performance obligations are satisfied by transferring a promised good or service (i.e., an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. Performance obligations may be satisfied at a single point in time or over a period of time.
Steps 4 and 5 – Application to the Base Management Fee
In this case study, we determined that management services represent a single performance obligation recognized over time because the manager is providing a series of distinct services. Since each day is a distinct service, the operator would recognize revenue daily; however, for practical purposes, revenue recognition on a monthly basis is more likely. As such, at the end of Month 1, if operating revenues were $500,000, the manager would recognize management fee revenue of $25,000 ($500,000 x 5%).
Steps 4 and 5 – Application to the Incentive Management Fee
The concept of variable consideration is important under ASC 606. The incentive fee is an example of variable consideration, as the actual amount of revenue to be received is unknown at contract inception. In this case study, the incentive fee is equal to 3% of annual net operating income (NOI). However, the fee is only earned if NOI is at least $5 million.
To determine how much revenue to recognize after one month, two methods can be used: the “Expected Value” approach or the “Most Likely Amount” approach. Under the Expected Value approach, the amount of revenue recognized is equal to the sum of probability-weighted amounts in a range of possible amounts. Under the Most Likely Amount approach, the single most likely amount in a range of possible amounts is recognized as revenue. The Expected Value approach would fit this situation. Based on the below assumptions, after 1 month, $13,000 of incentive fee revenue would be recognized by the manager.
It is important to remember that you cannot recognize future variable fees, and you must consider if it is probable that a significant reversal of revenue will occur. If you anticipate a significant reversal, no variable revenue would be recognized.
Analysis and review of variable consideration recognized to date must be done at each reporting period, with recognized revenue adjusted as needed.
How to Prepare for ASC 606
First, examine your revenue streams (management fee, developer fee, incentive fee, etc.). Remember that leases within the scope of ASC 840: Leases, do not fall under ASC 606. Next, perform and document the 5-step process for each of these revenue streams. Remember that this should be an ongoing process. Each time there is a significant new customer contract or revenue steam, an analysis should be performed.
If revenue sources include variable consideration (i.e., an incentive management fee), ensure your company has the processes and procedures in place to regularly review the revenue estimates as the fee (and revenue recognized) may need to be adjusted to account for revised estimates.
Clark Nuber can assist with the implementation process. We hold live trainings (register here for our November 14, 2018, event), have developed a template to guide you through the 5-step process, can help draft footnotes, and are available for consulting and implementation projects. Please contact your Clark Nuber professional for more information.
This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.