IFRS 15 Property development obligations

IFRS 15 Property development obligations – IFRS 15 Revenue from Contracts with Customers (contents page is here) introduced a single and comprehensive framework which sets out how much revenue is to be recognised, and when. The core principle is that a vendor should recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the vendor expects to be entitled in exchange for those goods or services. See a summary of IFRS 15 here.

This is an example for illustrating the concepts in ‘What is a good or service that is distinct?’

The scenarios in the following example demonstrates how two transactions which are substantively very similar but have different legal contract structures are accounted for in the same way (illustrating how the accounting is not affected by the legal form of the arrangements and instead focuses on the promises made by a vendor to its customer), and how subtle changes in the facts and circumstances can affect the assessment of whether two promises in a contract are separately identifiable (i.e. distinct within the context of the contract).

Entity PD, a property development company, contracts with Entity PI a property investment company to:

  1. Sell a piece of land currently owned by PD; and
  2. Construct a property on the land.

Scenario A

Both (i) and (ii) are contained in separate legal contracts, with the first contract specifying the land is sold at a price of CU 1 million and the second contract specifying the construction services are sold at a price of CU 2 million.

The transfer of a piece of land results in local taxes being levied on the purchase price. It is not legally possible to transfer legal ownership of a building independently of the land on which it sits, and so the tax payable would be greater IFRS 15 Property development obligations when a transaction involves the sale of both land and buildings. The tax authority does not permit structuring of a transaction to avoid tax on the building element by artificially breaking the contract into two elements, or by negotiating a price for the land that is clearly below market value, with this reduction being offset by the selling price for construction services being above market rate.

However, tax on the price of buildings can be avoided if the contracts are not linked. Therefore the transaction is structured as follows:

  • The sale of land is completed (i.e. the customer pays PD in full for the land, and has legal ownership and physical possession) four weeks before a contract for construction services is signed;
  • Although PI and PD may have previously discussed a project for construction services for CU 2 million on the land, and PI has the intention to engage PD to provide those construction services, both are ‘on risk’ following the sale of land. PD is on risk that, subsequent to purchasing the land, PI may decide to engage another entity to provide construction services, or could change its mind about undertaking construction (i.e. it decides instead to hold the undeveloped land as investment property). PI is on risk that PD may change its mind about wanting to undertake the construction services or, for whatever reason, it might not be capable of providing the intended construction services. Experience with previous transactions indicates that in almost all cases the property construction does proceed, but in a small number of cases only the land is sold;
  • The contract for the sale of land is priced at fair value in order to comply with tax legislation, and to protect the position of both PI and PD because of the risk that the property will not be constructed;
  • The construction contact between PI and PD is signed four weeks after the sale of land was completed, as was the non-binding intention. If PD fails to construct the building in accordance with the terms of the contract PI will only have recourse against PD for its failure to perform that contract. It would have no recourse in relation to the contract for the sale of the land.

In this example, because of the separation of the contract for the sale of land and the contract for construction services, including the lack of any contractual obligation for either PI or PD to enter into the second contract for the construction of the building, PD concludes that the risks associated with the transfer of land are separable from those associated with the construction services.

Consequently, there are two performance obligations: IFRS 15 Property development obligations

  • The sale of land; and IFRS 15 Property development obligations
  • The construction of the building. IFRS 15 Property development obligations

Scenario B

A single contract priced at a total of CU 3 million is entered into for both the sale of land and subsequent construction services. Unlike scenario A there is no potential to save tax by having two separate legal contracts. On the day the contract is signed the land title passes irrevocably to PI, and PI is unconditionally required to pay the market value of the land to PD. The contractual and /or legal environment means that title to the land cannot be transferred back to PD, and PI would have recourse to PD only in respect of any future underperformance by PD in relation to construction services.

PD concludes that the sale of land and the construction of a building are both capable of being distinct, and so then considers the factors in IFRS 15.29 to assess whether they are distinct within the context of the contract. PD notes the following, which might indicate they are not distinct within the context of the contract:

  • The land is integrated with the buildings in the sense that foundations need to be laid which will ensure the building will not collapse; IFRS 15 Property development obligations
  • The construction of the building modifies the land in the sense that once constructed, the land can only be used to ’host’ the building that has been constructed. The building would need to be demolished for the land to be available for other uses; and;IFRS 15 Property development obligations
  • There is a high degree of interdependence between the land and building in the sense that the land is unique. Although it is possible for an equivalent building to be constructed on a different piece of land, that would not be what PI wants (which is a building on the specific piece of land).

However, PD notes the analysis is not limited to the above three factors specified in IFRS 15 29. PD also considers IFRS 15’s Basis for Conclusions which notes that an important consideration is whether one promise in a contract (in this case the construction services) has a transformative effect on another promise (the land). IFRS 15 Property development obligations

Although the construction of a building on the land will modify the land (to the extent that foundations are required and its use will be limited), it does not result in the land being turned into something else. Consequently, although there is a relationship between the land and the building, this is a functional relationship, i.e. the building cannot exist without the land. However, instead of the land and the building being transformed into one overall item, the building is installed onto the land.

In addition, PD notes that it would be able to fulfill its promise to transfer the land to PI even if PI engaged another developer for the construction services, and PD could fulfill its promise to construct the building even if the customer had purchased the land from another party.

PD concludes that there are two performance obligations: IFRS 15 Property development obligations

  • The sale of land; IFRS 15 Property development obligations
  • The construction of the building. IFRS 15 Property development obligations

Scenario C 

In this scenario, the fact pattern is the same as for scenario B, except that the contract contains an additional clause which states that if PD fails to perform as contractually required in respect of the building construction, PI will have the right to transfer title of the land back to PD for a full refund and also have recourse for damages.

PD concludes that in this case, the contract is for the supply of a single product – a building on the specified piece of land, and therefore there is a single performance obligation. The risks PD is assuming by transferring land are not separable from the risks assumed in constructing the building. This would also be the case even if the arrangement had been structured as two separate legal contracts as in scenario A. IFRS 15 Property development obligations

IFRS 15 Property development obligations

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