Initial consideration — Agenda Paper 2A

Background

This is a new issue.

The IC received a request about the application of IFRS 15 to a construction of real estate contract that involves the transfer of land. Specifically, the submitter asked whether:

1. The transfer of land on which the building will be constructed is a separate performance obligation from the construction of the building; and
2. Revenue should be recognised over time or at a point in time for the performance obligation(s) identified.

It should be noted that for question 1, the submitter is not asking whether each of the activities that go into constructing a building is distinct from one another (e.g. site clearance, engineering, procurement etc.) – the construction services as a whole is presumed to be a single performance obligation for the purpose of the Staff analysis. Instead, the question is whether the transfer of land is separately identifiable from the promise to construct the building.

Fact pattern

The pertinent facts are as follows:

1. The entity enters into a non-cancellable contract with a customer (a housing association) for the construction of a building that will comprise multiple residential units. The contract is for the delivery of the entire building and not for the sale of the individual units.
2. On signing the contract, the entity transfers legal title to the plot of land on which the building will be constructed to the customer. The price of the land is specified in the contract and the customer pays this amount on entering into the contract. Legal transfer of the land to the customer cannot be revoked regardless of what happens during construction of the building.
3. The entity and the customer agree on the design and specification of the building before the contract is signed. As the building is being constructed:
   1. if the customer requests changes to the design and specification, the entity prices the proposed changes based on the methodology specified in the contract; the customer then decides whether to proceed with the changes. The entity can reject the customer’s request for change only in limited circumstances, e.g. when the change would breach planning permission.
   2. the entity can request changes to the design or specification only if not doing so would lead to an unreasonable increase in costs or delay to construction. The customer must approve these changes.
4. The customer is required to make milestone payments throughout the construction period. However, these do not necessarily correspond to the amount of work completed to date.

Staff analysis

Is the transfer of land distinct from the construction of the building?

Capable of being distinct (IFRS 15.27(a))

It is arguably clear that the land is capable of being distinct from the construction services because the customer can benefit from each of the land and the construction services on its own or together with other resources that are readily available to it. The Staff highlight that in making this assessment, the entity should ignore any contractual restrictions that might preclude the customer from acquiring readily available goods or services from other suppliers (IFRS 15.BC 100).

Distinct within the context of the contract (IFRS 15.27(b))

The fundamental objective of such an assessment is to determine whether the nature of the promise is to transfer each of those goods or services individually (i.e. to transfer the land separately from the construction services) or, instead, to transfer a combined item to which the promised goods or services are inputs.

In this case, there is clearly a functional relationship between the building and the land – no building can exist without land. However, IFRS 15.BC116K explains that in considering the level of integration, interrelation or interdependence between the different promised goods and services, rather than considering whether one item, by its nature, depends on the other (i.e. whether two items have a functional relationship), an entity evaluates whether there is a transformative relationship between the two items in the process of fulfilling the contract. In other words, does the entity’s promise to transfer goods or services result in a combined item that is more than (or substantively different from) the sum of those individual promised goods and services (IFRS 15.BC116J)?

In light of the above guidance, the Staff believe the entity should consider the following:

• Does the transfer of land have any transformative effect on the construction of the building, and vice versa? and
• Does the transfer of the land and building result in a combined item that is more than, or substantively different from, the customer obtaining the land from one entity and the construction services from another?

If the answer is no, the Staff would view the transfer of land as being separately identifiable from the construction services.

Recognition of revenue over time or at a point in time

Assuming the transfer of land is a separate performance obligation from the construction services, the Staff believe that the land would be transferred to the customer at a point in time.

With regard to the construction services, the Staff believe that the condition in IFRS 15.35(b) is met, i.e. customer controls the partly constructed building as it is constructed. The following facts are relevant in reaching this conclusion:

1. the entity constructs a building on land owned by the customer,
2. the entity constructs the entire building for the customer as opposed to selling only certain units of the building to the customer, and
3. the customer has the right to make changes to the design and specification of the building during its construction (subject to restrictions that are arguably protective in nature).

The Staff are of the view that the customer has the right to direct the use of the construction in progress through its right to change the design and specification of the building while it is being constructed. Furthermore, the customer can obtain substantially all of the remaining benefits from the construction in progress because the entity cannot redirect the building for another use or to another entity.

Staff recommendation

The Staff recommend that the IC not add this issue to its agenda on grounds that the requirements in IFRS 15 provide an adequate basis for an entity to identify the performance obligations in the contract and to determine whether revenue should be recognised over time or at a point in time for the fact pattern described in the submission.

Discussion

The IC agreed with the Staff’s technical analysis and agreed not to add the issue onto its agenda. No significant concerns were raised on the technical aspect of the paper.
 
Most of the time was spent debating what the most appropriate approach would be to address this type of very fact-specific submission. The Chair explained that they have taken a different approach to addressing IFRS 15 submissions because of the imminent effective date of the Standard; nonetheless, she acknowledged there is a need to strike a balance between being helpful and answering every jurisdictional specific question. Several IC members believed that it is risky for the IC to conclude on specific fact patterns and warned of its potential abusive effect on the IC’s role. The other members acknowledged these concerns and emphasised that it is critical for the TAD to note that the conclusion was reached based on the limited facts presented and that entities should apply judgement to the specific facts and circumstances of each case, and not to apply the conclusion in the TAD by analogy to similar cases.

The Chair said that they will take the feedback on the September TAD on a similar IFRS 15 issue into account when deciding whether any change in approach would be necessary. From a technical analysis perspective, they will also consider what the best way would be to communicate the thought process behind the conclusions to the three similar submissions (September 2017 AP 2, November 2017 APs 2A and 2B) holistically without duplication or contradiction.