Accounting is essentially the process of keeping records of all financial transactions of an entity, and generating various reports or statements out of those records.
Financial reporting, on the other hand, is a subset of the accounting process that uses financial statements to disclose a company’s financial information and performance over a particular period to outside parties such as investors, lending institutions, regulators, tax authorities and players in the capital markets.
The manner of accounting for each item in the financial reports affect the information presented, from which other information may be derived, such as, among others: (a) tax due on the reported income, (b) expected dividends, (c) earnings per share of stock, (d) value of each stock share, and (e) debt servicing capacity.
- Significant financing component in CTS
- Contract asset vs. receivables
- Treatment of materials delivered onsite but not yet installed
- Accounting for CUSA charges
- Accounting for sales cancellation/repossession
- Use of standard cost vs. actual cost
- Treatment of land cost in measuring completion progress
- Capitalization of borrowing cost
Faulty information in the reports could result in faulty decisions by stakeholders, which in turn could lead to either considerable losses or fictional gain.
For instance, in simple terms, if the amount of revenue recognized and reported is distorted, this could create a chain of distortion affecting, among others, the net income, taxes due, retained earnings and dividends to be declared. This could affect the value of stocks of existing investors, as well as debt instruments held by creditors. And since accounting is linear overtime, any distortion for a certain period would carry over to succeeding periods – unless adjustments are made in the latter period.
Accounting and financial reporting standards have been established on an international level to ensure that financial reports present reliable, consistent, understandable, relevant and comparable information about the financial position of an enterprise at a given time, such as to enable a wide range of users to make wise economic decisions.
Each standard sets forth, among others, the principles, criteria and procedures to be applied in identifying and quantifying items that will be recorded as either asset, liability, equity, revenue or expense, and the point in time when they will be recognized as such.
Uniformity in applying these standards across various transactions, industries, capital markets and nations is deemed particularly crucial in this age of globalization when economic activities and financial transactions transcend territorial borders.
In the Philippines, accounting and financial reporting standards conform fully to the international standards developed by the International Financial Reporting Interpretations Committee (IFRIC) under the auspices of the governing International Accounting Standards Board (IASB).
In most cases, a prescribed standard leaves little room for judgment; in some, it allows a certain amount of flexibility, given the nature or peculiarities of particular businesses in the context of the legal and economic environments within which they operate.
The process of adopting the international standards for implementation in the Philippines is as follows:
- The Financial Reporting Standards Council (FRSC) of the Professional Regulatory Commission (PRC) reviews draft standards and interpretations as these are issued by the IASB, invites comments thereon, and recommends adoption;
- The Board of Accountancy of the PRC approves the FRSC recommendations. Once approved, these are designated as either Philippine Accounting Standards (PAS), Philippine Financial Reporting Standards (PFRS) or Philippine Interpretations–IFRIC;
- The Philippine Interpretations Committee (PIC) under the FRSC formulates and issues the implementation guidance (or guidelines) designated as PIC Q&A.
The Securities and Exchange Commission (SEC) requires registered firms – especially those that offer their stocks or debt instruments to the public – to comply with these standards once adopted.
PHILIPPINE REAL ESTATE – DEVELOPMENT, SELLING & REVENUE RECOGNITION
Real property development – starting from the evaluation of land to be acquired for the purpose up to the final transfer of title – is one of the businesses that has the longest gestation period. It also entails the highest production cost, considering the sheer number and value of inputs required, and is thus the highest priced among all commodities.
Furthermore, the real estate business in the Philippines is considered to be one of the most highly regulated, as evident from the many restrictive laws, policies and regulations in existence; so much so that once a development plan is submitted for approval, the developer practically loses effective control over the property.
These factors combined compel Philippine developers and sellers to employ the most innovative development and selling approaches.
For decades, sales of real property by developers revolved around the following paradigms, mainly using Contract To Sell (CTS) as the sales instrument:
- The pre-completion model, otherwise known as pre-selling, where a property is offered for sale once a License to Sell is issued and before completion of development activities; and
- The post-completion model, where a property is sold after full completion.
Under either model, payment can be in either cash, or installment under various schemes depending on buyer preference. Transfer of possession to the buyer is effected upon completion of the unit. Transfer of ownership or title is effected when full payment has been made, either by the buyer himself or by a third-party mortgagor under a home mortgage-financing scheme.
In the case of longer-term projects, buyer payments are not immediately reported as revenue at the time they are received. Rather, sales revenue to be reported for a given accounting period is calculated using the Percentage-of-Completion (POC) accounting method. Under this method, revenue, expenses, and profit related to the project are apportioned based on the percentage of work completed or costs incurred during the period.
It is thus crucial to determine exactly what cost inputs are included in calculating the POC, as inclusion of a cost component that should have been excluded, or vice versa, will distort the percentage and, consequently, the revenue to be reported. Such distortion will impact on the other items reported in the financial statements for the given period.
NEW STANDARDS FOR REVENUE RECOGNITION
On July 2008, the IASB released IFRIC 15 – “Agreements for the Construction of Real Estate”, which was supposed to take effect on 01 January 2009. IFRIC 15 dealt with the timing of revenue recognition by real estate developers for sales of units, such as apartments or houses.
IFRIC 15 intended to provide guidance for distinguishing between whether the developer is selling a product – the completed apartment or house, or is selling a service – a construction service as a contractor engaged by the buyer. The distinction is deemed essential as revenue from selling products is normally recognized at delivery, while revenue from selling construction services is normally recognized proportionally as construction progresses.
IFRIC 15 concluded that a developer is selling a product because the buyer has only limited ability to influence design or development; and therefore the principle that revenue should be reported and recognized only when “control, risks and rewards” (CRR) are transferred to the buyer – that is, only upon completion and delivery – must be applied.
IFRIC 15 also required retroactive application – which meant that in the case of projects that have been presold but were still uncompleted, all revenue and related costs that have already been recognized and reported will have to be reversed, and succeeding periodic collections will have to be treated as liabilities until completion and delivery.
The Real Estate Industry groups (CREBA, SHDA, OSHDP, NREA, APREA) presented a strong case detailing the disastrous macroeconomic impact of IFRIC 15, given the adverse implications on financial statements and reporting, investor and creditor relations, capital markets, corporate finance, management reporting systems, tax planning and payments, employee and executive compensation, and even availment of BOI incentives.
Consequently, on August 2011, the SEC issued a Notice of its Resolution to “defer the implementation of IFRIC 15 until the final Revenue Standard is issued by the IASB and after an evaluation of the requirements and guidance in the said Standard vis-a-vis the practices and regulations in the Philippine real estate industry is completed.”
On May 2014, IFRIC 15 was superseded by IFRS 15 – “Revenue from Contracts with Customers” issued by the IASB, which was to be effective 01 January 2018. The FSRC adopted this for implementation in the Philippines as PFRS 15.
In response to the Industry Position, the PIC issued PIC Q&A 2016-04 clarifying that developers may continue to recognize revenue overtime under the POC method – rather than upon completion and delivery – since sales of residential properties under the pre-completion model meet the criteria under PFRS 15.
On November 2017 when the PIC Task Force for PFRS 15 implementation released its final draft of the implementation guidance, the Industry groups submitted their position. However, in the final version (PIC Q&A 2018-12) approved by the FRSC, none of the points they raised were taken into account. Due to protests lodged by the Industry, the SEC deferred the implementation of the contentious provisions to 01 January 2021, and again up to 2023.
PFRS 15 - THE ISSUES
The Industry raised the following issues relative to the implementation of PFRS 15 and other related accounting standards:
PFRS 15 requires a developer to determine the “transaction price”, portions of which will be periodically recognized as revenue overtime based on percentage of completion of the development work. The transaction price is to be derived by adjusting the contract price for effects of certain factors identified in the PFRS, one of which is “significant financing component.”
In the implementation guidance (PIC Q&A 2018-12), the PIC concluded that contracts for the sale of real property include a significant financing component when there is a mismatch between the percentage of the consideration already paid by the buyer and the percentage of completion of the development work so far. In which case, the seller is required to include in the transaction price either an interest expense or an interest income.
The PIC reasoned that when the buyer’s payment is more than the percentage of completion, it is as if the buyer is financing the seller by paying more than what the work in progress is currently worth; and therefore, the seller should recognize an interest expense. Conversely, when the buyer’s payment is less than the POC, the seller should recognize an interest income because it is as if he is financing the buyer.
The Industry objected to adoption of the concept, asserting that the mismatch between buyer payments and work completion does not arise from provision of financing to either the buyer or the seller, but rather, is attributable to such factors as, among others:
- Regulatory requirements (i.e. the HLURB requires a minimum level of works to have been already completed prior to issuance of the License to Sell);
- Force majeure which affects development time tables; and
- Payment schemes that are structured to take into account market preferences, business risks, inventory risks, tax implications and other cost concerns.
RESOLUTION STATUS: During the 17 October 2019 meeting between the Industry groups and the PIC, the latter agreed to the former’s position. Consequently, on 06 November 2020, PIC Q&A 2020-04 was issued, which states:
“There is no significant financing component, if the difference between the promised consideration and the cash selling price of the good or service (as described in paragraph 61) arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. The support should be documented in writing by the real estate entity, considering both qualitative and quantitative factors.”
The implementation guidance (PIC Q&A 2018-12) required that in cases where the percentage of completion is higher than the payment of the buyer, the uncollected payments should be recorded as Contract Asset rather than Receivables, since the developer’s right to future payments is conditioned upon delivery based on the completion milestones. (PFRS 15 defines Contract Asset as “an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance.”)
The distinction between a contract asset and a receivable is important because it provides stakeholders relevant information about the risks related to a reporting entity’s rights in a contract – for instance, whether there is only a credit risk, or whether the contract has other associated risks, such as performance risk.
The Industry asserted that uncollected revenues do not fall under the definition of Contract Asset, since payment terms have already been agreed upon at the execution of Contract to Sell, and the developer’s right to the buyer’s payments is conditioned only on the passage of time.
RESOLUTION STATUS: During the 17 October 2019 meeting between the Industry groups and the PIC, the latter agreed to allow policy choice by the firm in determining whether to recognize uncollected revenue as contract asset (in accordance with PFRS 15) or as unbilled receivable (in accordance with PFRS 9).
Consequently, on 30 September 2020,PIC Q&A 2020-03 was issued, which states that both choices are acceptable as long as consistently applied in transactions of the same nature, and the disclosures required under PFRS 15 are complied with.
In long-term projects, revenue to be reported for a given period is computed based on the percentage of completion of the works required, which in turn is computed based on costs incurred. Essentially, this means that revenues recognized will be less if certain costs are excluded from POC computation.
Under PFRS 15, inclusion or exclusion of cost components in the POC is predicated on the transfer of control of the component to the buyer. PFRS 15 defines “control” as the ability to direct the use of and obtain substantially all of the remaining benefits from the asset, including the ability to prevent other entities from directing the use of and obtaining the benefits from the asset.
Consequently, the implementation guidance (PIC Q&A 2018-12) excluded the cost of the land from POC computation, on the rationale that “the customer does not obtain control of the land upfront, but rather, when the construction has been completed, and thus the entity cannot recognize revenue relating to the cost of the land element.”
As the PIC contended:
- The customer has no ability to direct the use of the land component other than for its current use;
- Although the customer has the ability to obtain substantially all of the remaining benefits from the unit, it still does not give him control of the unit since he does not have the ability to direct the use of the unit (including any land attributed to it); and
- Although the customer has the right to resell or pledge his right to the real estate unit including the land, the right to sell or pledge this right is not evidence of control of the property itself.
The PIC decided that the cost of the land will be accounted for as “fulfillment cost”, which would be amortized over the period of performance.
Asserting that land cost should be included in POC computation, the Industry contended that transfer of control should be viewed not just from the perspective of the buyer, but also from the seller’s perspective.
In particular, the Industry invoked Par. 35 of PFRS 15, which constitutes the basis for real estate companies to use the POC accounting method, and which provides that:
“An entity transfers control of a good or service over time, and therefore satisfies a performance obligation and recognizes revenue over time, if …xxx…(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.”
Among the Industry’s contentions were:
- There can be no real estate development or construction when there is no land on which to develop. The cost of land is significant and indispensable to the developer’s progress in satisfying the performance obligation, and it is included in the selling price of the property.
- The developer loses control – as defined by PFRS 15 – over the land once the developer obtains a development permit and License to Sell. This is because the developer is barred by law and contractual restrictions from directing the use of the land for any other purpose than to satisfy the performance obligation covered by the License to Sell. (In effect, the regulatory body exercises control over the land for and in behalf of the buyer.)
- The buyer gains a degree of control over the property – including the land – by virtue of the legal requirement for the Contract to Sell to be annotated on the title. With this requirement, the developer loses the ability to sell the land or use it for any alternative purpose unless the contract is rescinded.
- The buyer’s interest in the land is inseparable from his interest in the entire unit. If the cost of other inputs are included in the POC, more so should the cost of the land.
- By virtue of the Contract to Sell, the developer has an enforceable right to payment for the performance to date – which includes the land.
RESOLUTION STATUS: During the 17 October 2019 meeting between the Industry groups and the PIC, the latter recommended that the matter be elevated to the SEC.
PIC Q&A 2018-12 provides that control of uninstalled materials is not transferred to the customer upon delivery to the site but only when these are installed or when they become part of the constructed building; hence, the cost thereof are excluded from POC computation.
The Industry contended otherwise, asserting that materials intended for real estate development are project-specific – i.e. customized with precision and specifications based on project design and technical requirements or measurements. As such, these cannot be directed to alternative uses or transferred to another project.
RESOLUTION STATUS: On 29 October 2020, PIC Q&A 2020-02 was issued, which states that “in recognizing revenue using a cost-based input method, customized materials are to be included in the measurement of the progress of work while materials that are not customized should be excluded.”
Accounting for Common Usage Service Area (CUSA) charges is principally a concern of developers acting as lessors by leasing out commercial space to tenants. The lessor bills and charges tenants every month for their electricity usage, water usage, air-conditioning, and share in CUSA expenses incurred by the developer-lessor in its administration of the commercial building. These CUSA expenses include electricity consumption, security, maintenance, janitorial, wi-fi, and all other common area expenses.
The fundamental issue in this regard is whether the lessor is acting as a principal, or as an agent. A determination has significant impact on financial reporting because:
- A principal should report revenue based on the gross amount billed to a customer; while
- An agent should report revenue based on the net amount retained, for example, the amount billed to a customer less the amount paid to the supplier, subcontractor or service provider.
PIC Q&A 2018-12 concluded that:
- With respect to electricity and water usage by the tenants, the developer is acting as an Agent since the utility company is responsible for the provision of the utility and the developer has no discretion over pricing.
- With respect to air-conditioning and CUSA expenses, the developer is acting as Principal because he is responsible for providing the services and has the discretion over pricing.
The Industry, however, contended that with respect to Par. b) above, the developer-lessor should also be considered as an Agent acting for the tenants, since his only responsibility pursuant to the contract of lease is to procure these services on their behalf, but the
ultimate responsibility for providing the services still lie with the third-party service providers.
RESOLUTION STATUS: During the 17 October 2019 meeting between the Industry groups and the PIC, the latter agreed to the Industry position.
PIC Q&A 2018-14 provides only two acceptable approaches to account for the sales cancellation and repossession of property: (a) the repossessed property is recognized at its fair value less cost to repossess; and (b) the repossessed property is recognized at its fair value plus repossession cost.
In either approach, “fair value” of the property is related to the fair value of the receivable from the buyer.
Reference was made to the Conceptual Framework (2010) of the international standards, which states that “assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition”.
The “consideration” in this case is the receivable that the developer will give up due to the repossession.
The Industry contested the PIC Q&A 2018-14 on the following grounds, among others:
- The concept of “fair value” relied upon by the PIC was discarded when the Conceptual Framework was revised in 2018;
- Recognizing repossessed inventories at fair value does not give a faithful representation of, or relevant information on, the cost of inventories;
- Recognition of repossessed properties at fair value will accelerate recognition of income for a sale that did not yet happen, and could distort the Income Statement with a “gain from repossession” which is not really an income or is still unrealized;
- It can create fluctuations in the Income Statement as it creates an imaginary step-up sales value. Other than that, it would also create investor expectations of cash dividends for income reported but not actually collected or realized; and
- It will distort the inventory picture by creating a mix of inventories – some stated at cost, while others stated at fair value.
RESOLUTION STATUS: During the 17 October 2019 meeting between the Industry groups and the PIC, the latter agreed to allow policy choice by the firm in determining whether to record repossessed inventory at either cost or fair value. The agreement is reflected in the new PIC Q&A 2020-05 superseding PIC Q&A 2018-14.
Developers calculate the percentage of completion based on input costs – i.e. cost of labor, materials and other resources consumed or expended.
However, the implementation guidance is unclear as to the method to use in determining input cost – i.e. whether standard cost or actual cost.
The difference is that standard costs are estimates which, in the case of real estate development projects, are determined at the project planning stage; whereas actual costs are costs that are actually incurred and recorded during a given period as development work progresses.
The Industry’s position was that developers should continue using standard costing.
RESOLUTION STATUS: During the 17 October 2019 meeting between the Industry groups and the PIC, the latter agreed to the Industry’s position so long as standard costs approximates actual costs.
While this issue bears relevance to PFRS 15 implementation, it arises more directly in connection with Philippine Accounting Standard (PAS) 23 – Borrowing Cost and the IFRIC Agenda Decision on the matter.
Essentially, borrowing cost is comprised of the interest and other costs incurred in obtaining financing or a loan. Capitalization means that these costs are added to the cost basis of a fixed asset on a company’s Balance Sheet, and amortized over a period of time, rather than reflected in the Income Statement in their entirety as expense in the period they were incurred.
When capitalizing costs, a company is following the matching principle of accounting, which calls for the recording of expenses in the same period that the related revenues are recognized. When high value items are capitalized, expenses are effectively smoothed out over multiple periods. This allows a company to not present large jumps in expense in any one period.
PAS 23 provides that borrowing costs that are directly attributable to the acquisition, construction or production of a “qualifying asset” form part of the cost of that asset and, therefore, should be capitalized. Other borrowing costs are recognized as an expense.
A qualifying asset is defined as an asset that takes a substantial period of time to get ready for its intended use or sale. PAS 23 further provides that where construction is completed in stages, and the completed stages can be used while construction of the other parts continues, capitalization of attributable borrowing costs should cease when substantially all of the activities necessary to prepare that stage for its intended use or sale are complete.
The IFRIC concluded that developers cannot capitalize borrowing cost because what they produce are not “qualifying assets”. The IFRIC reasoning, essentially, is that the asset – real property inventory whether completed or work-in-progress – is ready for its intended sale in its current condition, since it is sold as soon as a suitable customer is found and, on signing a contract with a customer, the developer transfers control of any work-in-progress relating to that unit to the customer.
The basis for this reasoning is apparently the fact that the developer signs sales contracts with buyers even before construction begins – i.e. pre-selling.
The Industry propounded the opposite view that real estate inventory or work in progress, both sold and unsold, should be treated as a qualifying asset, and therefore capitalization of borrowing cost should be allowed, on the following grounds:
- Immediately recognizing borrowing costs as an expense does not faithfully or accurately present the cost of the real estate asset. As the Basis for Conclusions of PAS 23 itself states, the cost of the asset should include all costs necessarily incurred to get the asset ready for its intended use or sale, including the cost incurred in financing the expenditures as a part of the asset’s acquisition cost.
- With respect to pre-sold units, signing a sales contract or completing a certain development stage does not mean that the unit is ready for its intended use – the intended use being habitation.
- Regardless of when the sales contract is signed, borrowing cost is continuously incurred by the Developer as necessary to finance the long-term construction of the asset. Capitalization should only stop when the real estate asset is ready for its intended use.
- Allowing the capitalization of borrowing cost is consistent with the standards relative to over time revenue recognition. These standards demand the matching of revenue recognized with the costs incurred at each stage of construction or development, when such costs directly contribute to an entity’s progress in satisfying the performance obligation – in this case, delivery of a fully completed, ready to use or habitable unit, under the provisions of law and regulation.
RESOLUTION STATUS: During the 17 October 2019 meeting between the Industry groups and the PIC, the latter recommended that the matter be elevated to the SEC.