The process and methodology of revenue recognition for development project depend on the type of project. The revenue recognition for sale of condominium units is very different from that for the sale of an office building or apartment building after they are built, for example. It is also different from the revenue recognition of the rental of any office or apartment building.
Examples of rental properties include office space, residential apartments, retail shopping centers, warehouses, and hotels. Revenues from the rental of spaces from these types of properties are not recognized until the projects are substantially completed and held available for occupancy. A project is defined as substantially complete and held available for occupancy when the developer has completed tenant improvements but no longer than one year after major construction activity has been completed.
Profits and revenues from sale of real estate are accounted for in various ways, depending on the nature of transaction. The six most common methods of revenue and profit recognition are: (1) Full accrual method (2) Deposit method (3) Installment method (4) Reduced-profit method (5) Percentage-of-completion method (6) Cost recovery method.
This post discusses these types of projects and the revenue recognition methods.
Generally accepted accounting principles (GAAP) require that revenue should be recognized when earned. The revenue from a month-to-month rental of a space is recognized when the rent is due from the tenant. However, for long-term leases (leases for periods over one year), GAAP requires that the revenue should be recognized on a straight-line basis unless another systematic and rational basis is more representative of the beneficial usage of the leased property.
1. Full Accrual Method
The full accrual method is one of the methods of real estate profit recognition in which the full sale price and profits are recognized when the real estate is sold. For the full accrual method to be used, the transaction has to meet two main conditions:
- The profit can be reasonably determined.
- The seller’s obligation to the buyer is complete.
The profit from the sales transaction can be reasonably determined if there is reasonable assurance that the sales price of the transaction is collectible from the buyer and any portion of the sale price that is not collectible can be reasonably estimated.
If the two criteria are not met, the seller has to determine which other methods would be appropriate.
However, in addition to the two main conditions noted above, a transaction has to meet these four additional criteria:
- Criteria-1. A final sale between the buyer and the seller has been consummated such that all the obligations between the parties have been fulfilled and all conditions prior to closing have been met.
- Criteria-2. The buyer has sufficient initial and continuing investment in the transaction to demonstrate its ability and willingness to fulfill its obligation. This ensures that the buyer has enough skin in the deal to avoid backing out of the transaction. The buyer can meet this requirement by providing enough down payments, an irrevocable letter of credit from an independent financially viable lending institution, or full payment of the asset’s purchase price.
- Criteria-3. In cases where the buyer did not pay for the purchase price in full at the time of closing, the remaining amount due to the seller is not subject to any future subordination after the sale. This also means that in the event of default by the buyer, none of the buyer’s debt obligations would have preferential claim on the property higher than the seller’s claim on the property.
- Criteria-4. The sale transfers all the rights, risks, and rewards of ownership of the property to the buyer. The seller should not have any substantial remaining obligation to the buyer in relation to the sale. An example would be a development project where the completion and delivery date is still in the future. In this case, the seller still has substantial remaining obligation to deliver a completed premises to the buyer at a future date. Thus, the full accrual method would not be used in recognizing the total profit.
If it is determined that the transaction meets the criteria for full accrual method, the entry to record the transaction by the seller (e.g., the sale of a property for $20 million) would be:
[Debit]. Cash = $20,000,000
[Credit]. Sales = $20,000,000
Initial Investment Criterion 2 above requires that buyer has sufficient initial investment in the transaction, so for the buyer’s initial investments requirement to be met, GAAP provides that the initial investment shall be equal to at least a major part of the difference between usual loan limits for that type of property in that market and the sales value of the property.
GAAP also requires that for recently obtained permanent loan or firm permanent loan commitment for maximum financing of the property, the minimum initial investment by the buyer should be whichever of the following is greater:
a. The minimum percentage of the sales value . . . of the property.
b. The lesser of:
- The amount of the sales value of the property in excess of 115 percent of the amount of a newly placed permanent loan or firm permanent loan commitment from a primary lender that is an independent established lending institution.
- Twenty-five percent of the sales value. It is important to note that the initial deposit used in the analysis of minimum initial investment is the nonrefundable part of the deposit if the agreement has a refundable deposit clause.
In addition, criterion 2 for use of full accrual method requires that the buyer has sufficient continuing investment in the transaction. Continuing investment relates to the buyer’s payment of the remaining purchase price after the initial investment in the transaction.
The Statement of Financial Accounting Standards No. 66, paragraph 12, says:
The buyer’s continuing investment in a real estate transaction shall not qualify unless the buyer is contractually required to pay each year on its total debt for the purchase price of the property an amount at least equal to the level annual payment that would be needed to pay that debt and interest on the unpaid balance over no more than (a) 20 years for debt for land and (b) the customary amortization term of a first mortgage loan by an independent established lending institution for other real estate.
In other words, after the buyer makes the initial investment in a real estate purchase, the remaining amount due to the seller, which in most cases is financed through an independent lender, should at a minimum have financing terms as mentioned. This criterion is viewed as an indication of the buyer’s ability to acquire the assets and also fulfills the borrower’s obligations on the transaction.
A condominium unit purchased as the buyer’s secondary residence is sold for $1 million, and the buyer provided an initial deposit of $150,000. Assume in this example that the loan for the remaining balance of $850,000 was from an independent established lending institution.
To determine if the $150,000 initial deposit is sufficient to establish the buyer’s commitment using the minimum initial investment criteria, this analysis should be performed.
(a) Minimum percentage of the sales value per-
Minimum Initial Investment Table (10%) = $100,000
(b)(1) Sales value in excess 115% of –
loan ($1,000,000 – ($850,000 x 115%) = $ 22,500
(2) 25% of the sales value ($1,000,000 x25%) = $250,000
In this analysis, the required minimum initial investment should be $100,000. This amount is determined by first calculating (a), then obtaining the lesser of (b)(1) ($22,500) or (b)(2) ($250,000). The minimum initial investment is the greater of (a) ($100,000) and (b) ($22,500).
2. Deposit Method
The deposit method is one of the methods that can be used when a real estate transaction does not meet the conditions and criteria required for the full accrual of profits. Under this method, no profit, receivables, or sales are recognized; however, the seller can disclose in its financial statements that the asset is subject to a sales contract.
This method is used to record the initial and continuing investments in a real estate transaction made by the buyer prior to consummation of sales. The deposit method is also the appropriate method of accounting for a transaction where the recovery of the project’s cost, in the event of the buyer’s default, is not assured.
Examples of real estate transactions where the deposit method may be used are:
1. The sale has not yet been consummated; thus the deal has not yet closed, or there are remaining obligations between the parties required before consummation that have not been fulfilled.
2. The buyer meets all the criteria for the full accrual method except that the initial investment and the recovery of the project’s cost cannot be assured if the buyer defaults.
3. Condominium projects where one or more of the four criteria required for the percentage-of-completion method (PCM) has not been met. (See the discussion on the ‘‘Percentage-of-Completion Method.’’)
4. A real estate transaction where the seller guarantees a return on the investment for a limited period of time. The agreed-upon costs and expenses incurred prior to the operation of the property should be accounted for using the deposit method. However, if the guarantee is for an extended period, the transaction should be accounted for as a financing, leasing, or profit-sharing arrangement, depending on other specific terms of the transaction.
At closing, when all the conditions required for consummation of sale and full accrual are met, the seller would then recognize the sale with this journal entry:
[Debit]. Deposit liability = $1,700,000
[Credit]. Sales = $1,700,000
This entry reduces to zero the liability that has been recognized from the prior deposits received by the seller and also recognizes the sale as a result of the transfer of the risks and rewards of the asset from the seller to the buyer.
In this exercise we focus on the revenue-related journal entries. Note, however, that other journal entries would have to be recorded to recognize the related cost of sales, which prior to now were being capitalized as work in progress (WIP).
Assume that the total cost of the unit sold to the plastics company was $1 million. This amount, which was recorded when incurred as WIP, will be recognized in the income statement as cost of sales with this entry:
[Debit]. Cost of sales = $1,000,000
[Credit]. Work in progress = $1,000,000
This entry should be recorded at the same time as the total sales is recognized. In essence, it matches the cost of sales with the related sales recognized.
Lie Dharma Construction Corp., a developer of industrial warehouse and manufacturing facilities, is developing an industrial park built-to-suit. A start-up plastics manufacturer signs a contract to purchase one of the 20 warehouse units at the park at a purchase price of $1.7 million. Prior to the signing of the sale agreement, the buyer provided the seller deposit money representing 10 percent of purchase price. Assume that the sale has not been consummated and the seller has determined that in an event of default by the buyer, the cost of the property would not be recovered due to reasons such as property location or design uniqueness. In this type of situation, when the seller collects the 10 percent deposit, the amount should be recorded by the developer as a deposit with this journal entry:
[Debit]. Cash = $170,000
[Credit]. Buyer deposit liability = $170,000
Any subsequent continuing investments by the buyer would be recorded with similar entries as above until sale is consummated and the ownership rights, rewards, and obligations pass to the buyer.
3. Installment Method
The installment method is the appropriate method where both:
- A transaction would have qualified under the full accrual method except that the buyer’s initial minimum criteria were not met; and
- The cost of the property could be recovered by reselling the property in the event the buyer is not able to fulfill its obligation under the terms of the agreement.
Under the installment method, each payment made by the buyer to the seller is allocated between cost and profit using the same ratio by which total cost of the project and total project profit is proportional to the sales price.
ABC Corp. sells a property to XYZ Corp. for $2 million. XYZ paid a cash down payment of $100,000 with the remaining balance financed by ABC Corp. For purposes of this exercise, it is assumed that the buyer’s initial investment did not meet the initial minimum criteria and therefore will be accounted for using the installment method.
Based on the above information:
Total sales price = $2,000,000
Total cost = $1,200,000
Total profit = $ 800,000
Profit % = 800,000/2,000,000 = 40%
At the time the sale was consummated, ABC will record the sales, the gross profit that was deferred, and the total cost of the sale with this entry:
[Debit]. Cash = $100,000
[Credit]. Accounts receivable = $1,100,000
[Credit]. Sales = $1,200,000
(To recognize sales, cash receipt, and receivables)
[Debit]. Cost of sales = $1,200,000
[Credit]. Real Estate Property = $1,200,000
(To recognize related cost of sales and remove assets from books)
[Debit]. Deferred sales profit = $440,000
[Credit]. Deferred assets from uncollected receivables = $440,000
(To recognize deferred receivables; amount is determined as: 40% x $1,100,000 = $440,000)
As more of the receivables are collected from the buyer, the seller will recognize the deferred profit from the sale. Assume that the next month XYZ remitted the contracted monthly payment of $50,000; the entry to recognize this receivable and the related deferred profit would be:
[Debit]. Cash = $50,000
[Credit]. Receivables = $50,000
(To record the receipt of the receivables)
[Debit]. Deferred assets from uncollected receivables = $20,000
[Credit]. Profit recognized = $20,000
(To recognized the prior deferred profit; 40% x $50,000 = $20,000)
The income statement of ABC Corp. immediately after this transaction would look like this:
Sales $ 2,000,000
Deferred profit (440,000)
Cost of sales 1,200,000
Net income $ 360,000
4. Reduced-Profit Method
In the discussion on the installment method, we mentioned situations where a transaction meets all the criteria for full profit accrual except that the initial investment criteria were not met. The reduced-profit method is similar to the installment method. The reduced-profit method of profit recognition is used where all the criteria of full profit recognition are met except that the continuing investment criteria were not met.
However, for profit to be recorded using this method, the annual payments by the buyer should at least equal:
- The interest and principal amortization on the maximum first mortgage debt that could be used to finance the property; plus
- Interest on the difference between the total actual debt on the property and the maximum first mortgage debt.
Remember, the criterion to meet ‘‘continuing investment’’ is that the buyer is contractually required under the debt agreement of the total debt on the property to pay each year an amount equal to at least principal and interest payment over the customary amortization term of a first mortgage loan by an independent reputable lending institution. For a land purchase, the appropriate payment period is determined to be 20 years.
An office property located in downtown Houston, Texas, with cost to seller of $15 million was sold for $20 million. The buyer paid a down payment of $3 million and obtained a $14 million first mortgage from an independent lending institution at a rate of 10 percent over 20 years. In addition, the seller provided a second mortgage financing to the buyer of additional $3 million with interest of 8 percent over 25 years. The interest on both loans is compounded monthly.
Assume that the down payment of $3 million is the minimum initial investment requirement and that the customary first-mortgage financing for this type of property in this market would be over 20 years with a market rate of 11 percent.
On this transaction, since the second-mortgage financing by the seller is for 25 years (which is above the term to meet the continuing investment criteria for this type of property), the total profit of $5 million that should have been recognized at the time of the sale is reduced, and the deferred profit is recognized from years 21 through 25.
The calculation is determined as:
Total sales price = $ 20,000,000
Total cost to seller = $ 15,000,000
Total Profit = $ 5,000,000
As mentioned, the total sales price is comprised of:
Buyer’s deposit = $ 3,000,000
First mortgage from independent lender = $ 14,000,000
Second mortgage from seller = $ 3,000,000
Total sales price = $ 20,000,000
The buyer’s monthly payment based on the terms of the debt agreement on the $3 million second mortgage is calculated as:
Loan amount = $3,000,000
Term in months (25 yrs x 12) = 300
Rate = 8%
Monthly payment = $23,001
Therefore, the present value of the $23,001 monthly payment for 20 years would be:
Monthly payment = $ 23,001
Market rate = 11%
Customary market term in
months (20 yrs x 12) = 240
Present value = $ 2,248,799
Deferred profit ($3,000,000 – $2,248,799) = $ 751,201
The profit recognized at the time of sale would be:
Sales price = $ 20,000,000
Cost = $ 15,000,000
Deferred profit = $ 751,201
Profit recognized at time of sale = $ 4,248,799
So, in years 21 through 25, the deferred profit of $751,201 would be recognized as the mortgage payments are recovered. The straight-line method (or another reasonable method) can be used in recognizing this deferred profit from years 21 through 25.
5. Percentage-Of-Completion Method
The percentage-of-completion method is a revenue recognition methodology in which revenues and profits are recognized as construction progresses if certain specific criteria are met. This method is used mostly in condominium and time-sharing projects, where the units are sold individually. For a project to be recorded using the percentage-of-completion method, five criteria must be met:
1. The construction project has passed the preliminary stage. The preliminary stage of a project has not been completed if certain elements of the project have not be completed, such as surveys, project design, execution of construction and architectural contracts, site preparation and clearance, excavation, completion of foundation work, and similar aspects of the project. These criteria are some of the basic requirements before a percentage-of-completion method can be used in accounting for a condominium or time-sharing project.
2. GAAP requires that the ‘‘buyer is committed to the extent of being unable to require a refund except for non-delivery of the unit or interest.’’ The determination of whether the buyer is committed to buy the unit or interest requires judgment; however, one way to make this determination is to utilize the minimum initial investment criteria. It is important to understand that the purpose of determining the buyer’s commitment is to ensure that the buyer has more skin in the transaction and prevent the buyer from easily walking away at any slight change in the market. The minimum initial investment requirement provides a guide that can be used to determine the buyer’s commitment in the transaction.
3. The project should have sufficient units sold to ensure that the project will not regress to rental. Obviously, the percentage-of-completion method is used to recognize revenue and profit while the project is still ongoing based on the assumption that the units will be completed and sold to buyers, not rented to tenants. This criterion ensures that the objective is achieved. To prevent the possibility that the developer, after recognizing some revenues and profits related to the units sold, then reverts the project to a rental property, the developer is required to sell sufficient units before using the percentage-of-completion method. The determination of how many units are sufficient requires significant judgment, but the decision must be made based on the nature of the project, the market for that particular type of project, and the local and regional economy where the project is located.
4. The agreed-on sales price of the units of interest should be determinable and collectible. The collection of the sales price can be assumed to be assured if the buyer meets the initial investment and continuing investment criteria discussed earlier under the ‘‘Full Accrual Method.’’ It could be difficult to establish that the sales price is collectible if the buyer is unable to meet those criteria.
5. The total aggregate sales amounts and costs for all the units can be reasonably determined.
Because the determination of the periodic profits to be recognized is based on the estimated aggregate sales proceeds and estimated total cost of the project, it is crucial that these two numbers can be reasonably estimated. If these numbers cannot be estimated, the percentage-of-completion method is not allowed.
Any condominium or time-share project that does not meet any of these criteria can record the deposits received from the buyer using the deposit method.
5. Cost Recovery Method
The cost recovery method is another method of profit recognition of real estate sale. This method can be used in either of these situations:
- Real estate transactions where the initial investment criteria were not met and the cost of the property cannot be recovered in the event the buyer defaults.
- Transaction where the unpaid balance of the sales price due to the seller from the buyer is subject to future subordination. A seller’s receivable is subject to subordination if it is being placed in a position lower than another party’s claim against the buyer.
The cost recovery method is also appropriate in transactions where the installment method is allowed; thus, either method can be used in a transaction that meets the criteria mentioned earlier under the ‘‘Installment Method.’’
Under the cost recovery method, no profit is recognized by the seller until the total payments by the buyer to the seller are sufficient to cover the seller’s cost basis on the property.
On the seller’s financial statements for the transaction period, the income statement should show the sales, the deferred gross profit, and the cost of the property sold; the balance sheet should show the receivables from the buyer net of the deferred gross profit.
A property was sold for $1 million with a cost basis to the seller of $700,000 that qualifies to be accounted for under the cost recovery method. The journal entries at the time of sale would be:
[Debit]. Receivable from Buyer = $ 1,000,000
[Debit]. Deferred Gross Profit (contra to sales) = $ 300,000
[Credit]. Sales = $1,000,000
[Credit]. Deferred Assets (contrs to receivables) = $ 300,000
[Debit]. Cost of Sales = $ 700,000
[Credit]. Property = $ 700,000
The seller’s income statement will present the transaction as:
Sales = $ 1,000,000
Deferred Gross Profit = $ (300,000)
Net Sales = $ 700,000
Cost of Sales $ = (700,000)
Net Income = $ 0
The seller’s balance sheet would show:
Receivable from Buyer = $ 1,000,000
Deferred Assets = $ (300,000)
Total Assets = $ 700,000
Therefore, future periodic payments made by the buyer will be recorded as a reduction of the receivables with a portion credited to interest income.