New Developments Summary

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1 February 4, 2015 NDS New Developments Summary Real estate the new revenue standard ASU shifts the top line Summary After dedicating many years to its development, the FASB and the IASB have issued their converged standard on revenue recognition. Accounting Standards Update (ASU) , Revenue from Contracts with Customers, and IFRS 15, with the same title, create a new, principle-based revenue recognition framework that will affect nearly every revenue-generating entity, including real estate entities. This bulletin explains the key features of the guidance in ASU and provides practical insights into its application by real estate entities and impact on the real estate industry. The new guidance will have a significant impact on entities accounting for real estate sales, as most of the prescriptive guidance in ASC , Property, Plant, and Equipment: Real Estate Sales, is superseded and replaced with a control-based revenue model that applies to all contracts with customers. This change will likely cause more transactions to qualify as real estate sales and earlier revenue recognition. The new guidance will also significantly change the accounting for fees earned by property managers, who will now be required to estimate performance-based fees at contract inception and to recognize those fees as or when they satisfy their performance obligations. In addition, the guidance in ASU includes many new interim and annual disclosure requirements that are designed to enable financial statement users to understand the nature, amount, timing, and uncertainty of revenues and cash flows from contracts with customers. The guidance in ASU is effective for public entities for annual reporting periods beginning after December 15, 2016, including interim periods therein. Nonpublic entities are required to apply the guidance for annual periods beginning after December 15, 2017 and for interim and annual reporting periods thereafter. Early application is not permitted for public entities. A nonpublic entity may apply the guidance as early as annual reporting periods, and interim periods within those years, beginning after December 15, The FASB and the IASB have formed the Joint Transition Working Group for Revenue Recognition (TRG), which meets quarterly to discuss implementation issues. The TRG cannot issue guidance. In addition, the AICPA has formed 16 industry task forces to address implementation issues. As a result of the ongoing implementation activities, the views expressed in this document are preliminary and may change as we evaluate, and entities begin to apply, the guidance and related interpretation.

2 New Developments Summary 2 Contents A. Scope... 2 Sales of nonfinancial assets... 3 Partial sales... 5 Like-kind exchanges... 5 Sale-leaseback transactions... 5 B. The five steps of the revenue recognition model... 5 Step one: Identify the contract with a customer... 6 Step two: Identify the performance obligations... 8 Step three: Determine the transaction price Variable consideration Significant financing components Step four: Allocate the transaction price to the performance obligations Step five: Recognize revenue C. Other topics Repurchase agreements Asset management Project costs D. Effective date and transition A. Scope After more than 10 years of work on the project, the FASB and the IASB have published their new converged standard on revenue recognition. The FASB issued ASU and the IASB issued IFRS 15, both titled Revenue from Contracts with Customers. ASU creates a new topic in the FASB Accounting Standards Codification (ASC or Codification), Topic 606, which replaces virtually all existing U.S. GAAP on revenue recognition, including most of the existing guidance in ASC , Property, Plant, and Equipment: Real Estate Sales. However, the new standard, which applies to contracts with customers to provide goods and services, excludes certain contracts within the scope of other ASC Topics, such as lease contracts accounted for under ASC 840, Leases, and sale-leaseback transactions for which the existing guidance in ASC is retained. The FASB and IASB are working on a separate joint project to develop a new lease accounting model. In addition, the new guidance does not apply to the following types of contracts: Insurance contracts within the scope of ASC 944, Financial Services Insurance Financial instruments and other contractual rights or obligations, including those within the scope of ASC 310, Receivables, ASC 320, Investments Debt and Equity Securities, and ASC 815, Derivatives and Hedging Guarantees, other than product or service warranties, within the scope of ASC 460, Guarantees Nonmonetary exchanges with an entity in the same line of business to facilitate sales to customers or potential customers Some contracts might be partially within the scope of the new revenue recognition guidance and partially within the scope of other guidance. For these types of contracts, entities must first apply the separation guidance in the other relevant Codification Topic, and then apply the revenue recognition guidance to the

3 New Developments Summary 3 revenue component. For example, if an entity determines that a contract with a customer contains a lease, it should refer to the guidance in ASC 840 to determine how to separate the lease components from the nonlease components. In this case, ASC 840 refers to ASC 606 for guidance on how to allocate consideration between lease and nonlease components. In some real estate transactions, the seller guarantees the buyer s return on investment for a certain period of time. Under current guidance, this type of guarantee is generally outside the scope of ASC 460 because the guidance in ASC requires entities to account for transactions involving certain seller guarantees as financing, leasing, or profit-sharing arrangements, and ASC 460 excludes from its scope guarantees that prevent the guarantor from accounting for a transaction as a sale or recognizing in earnings the profit from a sale transaction. Since most of the guidance in ASC has been superseded, many seller guarantees would fall within the scope of ASC 460 under the amended guidance in ASU Therefore, the seller in this type of arrangement should first apply the guidance in ASC 460 to allocate consideration to the guarantee component, and then apply the guidance in ASC 606 to measure and recognize the revenue component. Under ASC 606, a customer is defined as a party that has contracted with an entity to obtain goods or services that are an output of the entity s ordinary activities in exchange for consideration. Therefore, an entity that is primarily engaged in developing and selling condominiums might deem a condominium buyer a customer, while an entity primarily engaged in leasing condominiums might not. A counterparty to the contract might not be a customer if, rather than the counterparty obtaining an output of the entity s ordinary activities, the contract calls for an entity to participate with the counterparty in an activity or process, such as developing an asset, and the parties share in the risks and benefits resulting from that activity or process. Therefore, an entity that enters into such arrangements as real estate ventures involving the contribution of real estate must evaluate the particular facts and circumstances of each contract, including its purpose, to determine if the counterparty is a customer. Sales of nonfinancial assets ASU adds Subtopic , Other Income Gains and Losses from the Derecognition of Nonfinancial Assets, to the Codification, which requires an entity to apply the guidance on contract existence, control, and measurement in ASC 606 to transfers of nonfinancial assets to noncustomers. Currently, entities apply the real estate sales guidance in ASC , rather than the deconsolidation guidance in ASC , Consolidation, to account for sales of in-substance real estate and disposals of integral equipment. This practice is the result of past EITF decisions that gave precedence to the real estate sales guidance over the deconsolidation guidance for derecognizing in-substance real estate. Under the guidance in ASU , an entity must now evaluate all transfers of in-substance nonfinancial assets not just in-substance real estate to determine whether they meet the criteria for sale accounting under ASC 606 via ASC Contrary to previous EITF decisions, the new guidance requires an entity to apply the derecognition guidance in ASC to the sale of a subsidiary or group of assets that is either a business or nonprofit activity only if the subsidiary or group of assets is not an insubstance nonfinancial asset. If the subsidiary or group of assets is an in-substance nonfinancial asset, then an entity should apply the guidance in ASC The following decision tree depicts how an entity should determine the appropriate guidance to apply to a real estate transaction in light of the new standard.

4 New Developments Summary 4

5 New Developments Summary 5 Partial sales The guidance in ASU does not carry forward the guidance in ASC on partial sales of real estate. Under the current guidance, an entity recognizes a gain or loss on a partial sale of real estate if (a) it is independent from the buyer, (b) collectibility is reasonably assured, and (c) it is not required to support property operations and does not have related obligations to an extent greater than its proportionate interest in the real estate. Under the new revenue recognition model, if the transfer is an in-substance sale of real estate, the transferor should apply the new guidance in ASC 360 to determine whether the transfer is subject to the guidance for (a) a sale in a contract with a customer, (b) derecognition of a subsidiary or group of assets that is either a business or nonprofit activity, or (c) derecognition of a nonfinancial asset. If the transfer is not an in-substance sale, an entity should consider the existing guidance in ASC , Real Estate General: Investments Equity Method and Joint Ventures, which requires an entity to record an investor s contribution of real estate to a real estate venture at its cost basis, as well as the guidance in ASC 845, Nonmonetary Transactions. Like-kind exchanges Under the guidance in ASU , an entity should account for the exchange of real estate in a transaction with a customer as a sale of real estate for noncash consideration. If the transaction meets the criteria for a sale under the new revenue recognition model, the entity should measure the real estate received at fair value and recognize a gain or loss on the sale. However, the entity should apply the guidance in ASC 845 if it either (a) receives a noncontrolling ownership interest in an entity, or (b) transacts with an entity in the same line of business to facilitate sales to potential customers. Sale-leaseback transactions The new revenue recognition guidance does not amend the existing guidance in ASC , Sale- Leaseback Transactions. The guidance in ASC was not superseded, although its scope has been significantly narrowed to apply only to sale-leaseback transactions accounted for under ASC Entities should not analogize to the guidance in ASC and ASC to account for any transaction that is not a sale-leaseback. B. The five steps of the revenue recognition model The new revenue recognition model is based on the core principle that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which it expects to be entitled in exchange for those goods or services. Applying the core principle involves the following five steps: 1. Identify the contract with a customer. 2. Identify the performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations. 5. Recognize revenue. Identify the contract with the customer Identify the performance obligations Determine the transaction price Allocate the transaction price Recognize revenue

6 New Developments Summary 6 Step one: Identify the contract with a customer Because the guidance in ASC 606 applies only to contracts with customers, the first step in the model is to identify those contracts. A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied by an entity s customary business practices. In addition, the guidance in ASC 606 applies only to arrangements that meet all of the following criteria: The parties have approved the contract, which creates enforceable rights and obligations. The entity can identify each party s rights. The entity can identify the payment terms for the goods or services. The contract has commercial substance. It is probable that the entity will collect the consideration to which it will be entitled. When evaluating the probability of collectibility, an entity should assess only the customer s ability and intention to pay the amount of consideration when it is due. In addition, in determining the transaction price, an entity needs to evaluate at contract inception whether it expects to provide a price concession or other discount that will result in it receiving less than the full contract price from the customer. Practical insight: Existence of a contract Step one serves as a gate through which an entity must pass before proceeding to the later steps of the model. In other words, if an entity concludes at the inception of an arrangement that the criteria above are not met, it should not apply Steps two through five of the model until it determines that the criteria above are subsequently met. Significant judgment may be required to conclude whether a contract meets the criteria above. If an entity determines at the arrangement s inception that one or more of the specified criteria above have not been met, it should continuously reassess whether the criteria are subsequently met. An entity may receive consideration from a customer before meeting all of the above criteria. In that circumstance, the entity cannot recognize revenue until the criteria above are subsequently met or either of the following conditions occurs: The entity has completed the performance under the contract, and all, or substantially all, amounts have been received from the customer and are nonrefundable. The arrangement is canceled, and amounts received from the customer are nonrefundable. Application of the new model could result in accounting that differs from current GAAP for a contract in which the customer initially transfers a minimal amount of consideration from the customer. For example, under ASC 606, if a contract does not meet the criteria above, an entity is required to recognize a liability for nonrefundable amounts received in an arrangement when performance is not complete, whereas under existing GAAP, if the buyer does not satisfy the initial and continuing investment criteria, an entity should apply the installment, cost recovery, or deposit method.

7 New Developments Summary 7 Practical insight: Collectibility This new guidance regarding collectibility is somewhat similar to current U.S. GAAP. However, an entity currently evaluates collectibility when revenue is recognized, whereas under ASC 606, an entity evaluates collectibility in Step one when it determines whether a contract exists. Under ASC 606, an entity needs to assess whether collectibility is probable before it applies Steps two through five and recognizes any revenue. Although the new guidance removes the minimum initial investment requirements for the sale of real estate, an entity must determine that the buyer is committed to perform its obligation(s) under the contract, and that collection of the consideration is probable, to conclude that a contract exists. An entity should consider the amount of the buyer s down payment and the buyer s credit standing in determining whether the buyer is committed to perform. Although not determinative, a real estate entity might conclude that a 5 percent down payment indicates that the buyer is not committed to perform. In making this determination, however, an entity should consider all facts and circumstances, including other factors such as creditworthiness, financial resources, and use of the real estate to generate cash flows to fulfill the obligation, which might result in a different conclusion. Although the new revenue recognition model does not explicitly require a real estate seller to evaluate whether the buyer s initial and continuing investments are sufficient, the contract criteria could have the effect of deferring revenue recognition for transactions in which the seller provides a significant amount of financing to the buyer. Example: Contract criteria ASC through describes an example in which a real estate developer sells a building to a customer in exchange for a nonrefundable deposit equal to 5 percent of the purchase price and a nonrecourse note receivable with a principal amount equal to 95 percent of the purchase price. In this example, the developer determines that it is not probable it will collect the consideration to which it is entitled in exchange for the building because (a) the customer intends to repay the loan with cash generated from a business it will operate in the purchased building, (b) there is significant risk that the business might be unable to generate sufficient cash to repay the loan, (c) the customer lacks other resources to repay the loan, and (d) the customer s liability is limited because the loan is nonrecourse. Therefore, a contract does not exist in this example, and the developer should not recognize any revenue related to the transaction until the contract criteria are met. Under current guidance, the developer in this example must consider whether the buyer s initial and continuing investment is sufficient in order to utilize the full accrual method for profit recognition.

8 New Developments Summary 8 Combining contracts An entity should combine two or more contracts and account for them as a single contract if they are entered into with a single customer (or related parties) at or near the same time and if they meet at least one of the following criteria: The contracts are negotiated as a package with one commercial objective. The amount paid under one contract depends on the price or performance under another contract. The goods or services to be transferred under the contracts constitute a single performance obligation. Practical insight: Combining contracts The guidance in ASC 606 on combining contracts is similar to current U.S. GAAP, except for one important distinction. Current guidance includes indicators for an entity to consider in evaluating whether two or more contracts should be combined. In contrast, ASC 606 requires that an entity combine contracts that were entered into at or near the same time if they meet any of the stated criteria. As a result, an entity needs to determine what constitutes at or near the same time, as well as develop processes to evaluate whether the criteria are met. In many situations, the criteria related to whether the performance obligations or payments in multiple contracts are interdependent will be a more straightforward evaluation; however, because ASC 606 is principle-based, many entities might find that significant judgment is required in certain circumstances to determine whether multiple contracts are negotiated with a single commercial objective in mind or whether the goods and/or services under those contracts constitute a single performance obligation. For example, if one contract with a party is for the sale of land and a second contract with the same party is to develop the land, an entity might draw one of the following conclusions after careful analysis: the contracts are negotiated as a package with one commercial objective, the amount paid under one contract depends on the price under another contract, or a single performance obligation exists. In each case, the contracts should be combined. Step two: Identify the performance obligations Having identified a contract, the entity next identifies the performance obligations within that contract. A performance obligation is defined as a promise in a contract with a customer to transfer either (1) a good or service, or a bundle of goods or services, that is distinct (see below), or (2) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. Performance obligations are normally specified in a contract but may also include promises implied by an entity s customary business practices, published policies, or specific statements that create a valid customer expectation at contract inception. Performance obligations exclude activities that do not result in the transfer of a good or service to the customer (for example, some set-up activities). Evaluating whether activities performed by a real estate entity transfer a good or service to the customer might require significant judgment.

9 New Developments Summary 9 Under ASC 606, a promised good or service is considered distinct, and must be treated as a separate performance obligation, if both of the following criteria are met: The customer can benefit from the good or service either on its own or with other resources readily available to the customer. A readily available resource is a good or service that is sold separately (by the entity or by another entity) or one that the customer has already obtained (from the entity or from other events or transactions). The promise to transfer a good or service is separable from other promises in the contract. The following factors indicate that a good or service is separable from other goods or services in the contract: The entity does not provide significant integration services. Stated differently, the entity is not using the good or service as an input to produce the specific output called for in the contract. The good or service does not significantly modify or customize other promised goods or services in the contract. The good or service is not highly dependent on, or interrelated with, other promised goods or services in the contract. For example, a good or service might not be highly interrelated if a customer can decide not to purchase a particular good or service and that decision does not significantly affect other promised goods or services under the contract. If a promised good or service is not distinct, it must be combined with other promised goods or services until, as a group, the goods and services meet the criteria to be distinct. This could result in all of the goods and services in a contract being a single performance obligation. Practical insight: Performance obligations Under current guidance, an entity must consider its continuing involvement to determine whether a sale has occurred. Under the guidance in ASU , an entity must consider whether its continuing involvement represents a separate performance obligation. For example, an entity might enter into a contract with a customer to sell land, with a commitment to develop the land and construct a building. In this example, the entity should evaluate whether the sale, development, and construction represent separate performance obligations or a single performance obligation. It is important to note that the service component of a real estate contract might consist of multiple services, such as construction services and property management services, and that each service might qualify as a separate performance obligation. In the building sale and property management services example in the preceding shaded box, although the entity might conclude that the two contracts should be combined because the consideration in the building sale contract is contingent upon the property management services, the entity should evaluate whether the building sale and property management services are distinct and separable from one another. If so, they are separate performance obligations. If both distinct criteria are not met, then the promised goods and services should be combined into a single unit of accounting.

10 New Developments Summary 10 Step three: Determine the transaction price Under ASC 606, transaction price is defined as the amount of consideration to which an entity expects to be entitled in exchange for the goods or services promised under a contract, excluding any amounts collected on behalf of third parties (for example, sales taxes). The transaction price may include fixed amounts, variable amounts, or both. In addition, the transaction price measurement should include the effects of a significant financing component, the fair value of noncash consideration, and consideration payable to the customer. Real estate entities should pay particular attention to variable consideration and significant financing components in determining the transaction price. Variable consideration The amount of consideration received under a contract might vary due to discounts, rebates, refunds, credits, performance bonuses, penalties, and similar items. The variable consideration guidance in ASC 606 also applies if the entity expects to offer a price concession or if goods are sold with a right of return. Some arrangements allow the seller to participate in future profits associated with the transferred property. Under current guidance, a seller generally recognizes such contingent consideration only when the contingency is resolved. Under the guidance in ASU , such amounts should be evaluated as variable consideration. The requirement to estimate variable consideration at contract inception will likely be a significant change for many real estate entities, particularly those that provide property management or other performance fee based services. To estimate the variable consideration in a contract, an entity determines either the expected value (sum of probability-weighted amounts) or the most likely amount (single most likely outcome) of consideration to be received, depending on which method better predicts the amount the entity will be entitled to. The expected value method might be appropriate in situations where the variable outcome is a range of outcomes and an entity has experience with a large number of similar contracts that provide a reasonable basis to predict future outcomes. The most likely amount method might be appropriate in situations where a contract has only two possible outcomes rather than a range of possible outcomes (for example, receipt or nonreceipt of a fixed amount of cash if an internal rate of return threshold is or is not achieved, respectively). ASC 606 requires an entity to use the same method to estimate the variable consideration throughout the life of a contract. Example: Variable consideration Real estate Entity A sells a building to a customer for $15 million in cash and the right to receive 5 percent of the proceeds from a subsequent sale of the building in excess of $15 million that occurs within five years from the original sale. Under current U.S. GAAP, the entity does not recognize any revenue associated with its 5 percent participation right until a qualifying transaction occurs and the incremental profit is realized. Under the new revenue recognition model, the entity should estimate the amount it expects to receive under its 5 percent participation right and include that amount in the transaction price (subject to the constraint discussed below under Constraint on variable consideration ). Entity A should use either the expected value method or the most likely amount method to estimate the amount it expects to receive from the participation right. If Entity A uses the expected value method, it should consider various possible outcomes, including sales at various

11 New Developments Summary 11 amounts within the five-year period, as well as a sale not occurring within the five-year period. By probability-weighting these possible outcomes, Entity A could estimate the expected value associated with its participation right and include that amount in the transaction price. Constraint on variable consideration If the amount of consideration from a customer contract is variable, an entity must evaluate whether the variable consideration should be constrained. The objective of the constraint is for an entity to recognize revenue only to the extent it is probable that a significant reversal in cumulative revenue recognized on the contract will not occur when the uncertainty is resolved. The definition of probable is consistent with the definition used in current U.S. GAAP: The future event or events are likely to occur. To meet the objective of the constraint, an entity should determine if it is probable that changes in its estimate of variable consideration will not result in a significant downward adjustment of the cumulative amount of revenue recognized on the contract. In making this determination an entity should consider all of the facts and circumstances associated with both the likelihood and the magnitude of the reversal if that uncertain event were to occur or fail to occur. The following indicators in ASC 606 might signify that including an estimate of variable consideration in the transaction price could result in a significant revenue reversal: The amount of consideration is highly susceptible to factors outside the entity s influence, such as market volatility, third-party actions, weather, and obsolescence risk. The uncertainty is not expected to be resolved for a long time. The entity s experience with similar contracts is limited or its experience has limited predictive value. The entity has a practice of offering a broad range of price concessions or changing the payment terms in similar circumstances. There are a large number and wide range of possible consideration amounts in the contract. If an entity is unable to conclude that it is probable a significant revenue reversal will not occur, it should exclude variable consideration from the transaction price until it is able to reach that conclusion for all or a portion of its variable consideration. An entity should update its estimate of variable consideration, including the application of the constraint, at the end of each reporting period to reflect changes in facts and circumstances. Example: Constraint for variable consideration If an entity determines, upon entering into a contract with a customer to sell a building, that the transaction price should include $250,000 of variable consideration but subsequently revises its estimate to $500,000, this revision to the overall transaction price is subject to the constraint discussed above. Before increasing the transaction price by $250,000, the entity must conclude that it is probable that a subsequent change in the estimate of variable consideration will not result in a significant revenue reversal.

12 New Developments Summary 12 Significant financing components In determining the transaction price, an entity must reflect the time value of money in its estimate of the transaction price if the agreed-upon timing of payments in the contract includes a significant financing component, whether explicit or implicit. The objective in adjusting the transaction price for the time value of money is to reflect an amount for the selling price as though the customer had paid cash for the goods or services when they were transferred. Either party may receive credit that is, the customer may pay before the entity performs its obligation (in essence, a customer loan to the entity) or it may pay after the entity performs its obligation (in essence, a loan by the entity to the customer). To determine whether a financing component is significant, an entity should consider all relevant facts and circumstances, including, but not limited to, the following: The difference, if any, between the promised consideration and the cash price that would be paid if the customer had paid as the goods or services were delivered The combined effect of both The expected length of time between delivery of the goods or services and receipt of payment The prevailing market interest rates A contract may not have a significant financing component if any one of the following scenarios exists: Advance payments have been made, but the timing of the transfer of the good or service is at the customer s discretion. The consideration is variable based on factors outside the vendor s or customer s control (for example, a sales-based royalty). A difference between the promised consideration and the cash price relates to something other than financing, and the difference is proportional to the reason for the difference, such as protecting one of the parties from the other party s nonperformance (for example, a customary retainage of a certain percentage of all payments made until completion of a project). As a practical expedient, an entity can ignore the impact of the time value of money on a contract if it expects, at contract inception, that the period between the delivery of goods or services and the customer payment will be one year or less. To adjust the transaction price for a significant financing component, an entity should use the discount rate that would be reflected in a separate financing transaction between the entity and the customer at contract inception. That rate should reflect the credit risk of the borrower (the party receiving credit) for example, the customer s rate if payment is deferred, and the vendor s rate if payment is made in advance. An entity should present the effects of financing separately from revenue as interest expense or interest income in the statement of comprehensive income. Step four: Allocate the transaction price to the performance obligations Under ASC 606, an entity allocates a contract s transaction price to each separate performance obligation in that contract based on a relative stand-alone selling price at contract inception. ASC 606 defines a stand-alone selling price as the price at which an entity would sell a promised good or service separately to a customer. The best evidence of the stand-alone selling price, if available, is the observable price charged by the entity to similar customers in similar circumstances. If the stand-alone selling price is not observable because, for example, the entity does not sell the good or service

13 New Developments Summary 13 separately, an entity should estimate the stand-alone selling price using all reasonably available information (including market conditions, entity-specific factors, and information about the customer or class of customer) and maximizing the use of observable inputs. ASC 606 suggests, but does not require, the following three suitable methods to estimate the stand-alone selling price: Adjusted market assessment approach Expected cost plus a margin approach Residual approach Example: Allocating the transaction price Real estate Entity A sells a building to a customer for $15 million in cash and agrees to provide property management services related to the building for one year. The property management fee is based on a fixed percentage of lease revenue from the building s tenants, and is computed based on total lease revenue earned during the one-year period following contract inception. Entity A concludes that property management services and the building sale are separate performance obligations. Under ASC 606, Entity A determines the transaction price by estimating the amount of variable consideration associated with the property management fee and adding that amount to the fixed consideration received in cash at contract inception. Entity A determines that the expected value of variable consideration for which it is probable that a significant reversal of cumulative revenue will not occur is $5 million. Further, it determines that the stand-alone values of the building and the property management services are $13 million and $8 million, respectively. Entity A should allocate the transaction price of $20 million to the building and property management services based on their relative stand-alone values. Entity A would allocate $12.4 million to the building and $7.6 million to the property management services. This methodology marks a change from the existing guidance in ASC , which requires entities that agree to provide services at below-market rates to impute compensation that is recognized over the term of the agreement, which in this example is $2 million. Step five: Recognize revenue Under ASC 606, an entity recognizes revenue when or as it transfers promised goods or services to a customer. A transfer occurs when the customer obtains control of the good or service. A customer controls an asset if it can direct its use and obtain substantially all of its remaining benefits. Control includes the ability to prevent other entities from directing the use of and obtaining the benefits from an asset. The benefits of an asset are the potential cash flows that can be obtained either directly or indirectly. A key part of the model is the concept that for some performance obligations, control is transferred over time, while for others, control transfers at a point in time. ASC 606 specifies a sequence that requires entities first to determine whether control transfers over time for each performance obligation. If transfer is not over time, then the entity should conclude that transfer is made at a point in time.

14 New Developments Summary 14 Control transferred over time An entity determines at contract inception whether each separate performance obligation will be satisfied (that is, control will be transferred) over time or at a specific point in time. Control is transferred over time if one of the following conditions exists: The customer controls the asset as it is created or enhanced by the entity s performance under the contract. The customer receives and consumes the benefits of the entity s performance as the entity performs its obligation (for instance, if another entity would not have to substantially reperform the work completed to date if it stepped in to complete the remaining obligation under the contract). The entity s performance creates or enhances an asset that has no alternative use to the entity, and the entity has the right to receive payment for work performed to date and expects to fulfill the contract as promised. An entity evaluates whether a promised asset has an alternative use to the entity at contract inception by considering whether it can readily redirect the partially completed asset to another customer throughout the production process. In addition, the right to payment should be enforceable, and a vendor should consider the contractual terms, as well as any legislation or legal precedent that could override those terms, in assessing the enforceability of that right. Practical insight: No alternative use assessment The no alternative use assessment is made at contract inception and is updated only if the contract parties approve a contract modification that substantively changes the performance obligation. In making the assessment, an entity should consider the characteristics of the asset ultimately transferred rather than its characteristics at a point in time during the production process. If an entity can readily direct the asset to another customer, then the customer has not obtained control of that asset. The determination of whether an alternative use exists for an asset is a matter for significant judgment based on the particular facts and circumstances of each situation. If a substantive contract provision precludes an entity from directing an asset for another use during the creation or enhancement of the asset, the entity does not have an alternative use for that asset because it is legally obliged to transfer the asset to the customer. For example, a developer of a multi-unit residential complex might enter into separate contracts with customers for each individual unit. If the entity cannot direct a specific unit under contract to another customer, even though the units might be similar, then that unit does not have an alternative use to the entity under ASC 606. However, a contractual restriction that provides a protective right to the customer is not sufficient to conclude that the restriction is substantive. For example, a provision is not substantive if the entity can transfer a different asset to the customer and still comply with the contract. Such a contract provision may serve to protect the customer in the event that the entity breaches the contract by not transferring the asset to the customer. To illustrate how an entity should evaluate the over-time revenue recognition criteria, the guidance in ASC through describes three examples in which a real estate developer enters into a contract with a customer to sell a specific unit in a multi-unit residential complex under construction.

15 New Developments Summary 15 In the first example, the customer pays a deposit upon entering into the contract, which is refundable only if the entity fails to complete construction in accordance with the contractual terms. If the customer defaults before construction on the unit is completed, then the entity s only right under the contract is to retain the deposit. Since the entity does not have an enforceable right to payment for work completed to date, it must recognize revenue at a point in time rather than over time. In the second example, the customer agrees to make progress payments as the unit is constructed, in addition to paying a nonrefundable deposit upon entering into the contract. The contract precludes the entity from transferring the unit to another customer, and the customer cannot terminate the contract unless the entity fails to perform as promised. If the customer does not make its scheduled progress payments, the entity has the right to the full amount of consideration as long as it completes construction, a practice that is supported by previous court decisions. In this example, the entity concludes that it meets the criteria for recognizing revenue over time. The third example is similar to the second example, except for one difference: If the customer fails to perform as promised, the entity can either require the customer to perform or it can cancel the contract, entitling the entity to retain the unit under construction as well as a penalty equal to a proportion of the contract price. In this example, the inclusion of an option for the entity to cancel the contract does not preclude it from meeting the criteria for over-time revenue recognition, as long as the entity s right to payment is enforceable. Practical insight: Time-sharing arrangements Currently, entities selling time-sharing arrangements refer to ASC for revenue recognition guidance. Since this guidance is superseded by the new revenue recognition model, entities selling time-sharing arrangements can no longer determine the timing of revenue recognition by assessing their continuing involvement and the adequacy of the buyer s commitment, even though entities must still consider these factors in determining whether a contract with a customer exists. Rather, to determine whether over-time recognition is appropriate under the new model, entities should focus on whether they meet one of the following criteria: (a) the customer controls the asset during construction, (b) the customer receives and consumes benefits as the entity performs, or (c) the real estate asset has an alternative use to the entity and the entity has a right to payment for work performed to date. An entity recognizes revenue associated with a performance obligation that is satisfied over time by measuring its progress toward completion of that performance obligation. The objective of this measurement is to depict the pattern by which the entity transfers control of the goods or services to the customer. The entity should update this measurement over time as circumstances change and account for these changes as a change in accounting estimate under the guidance in ASC 250, Accounting Changes and Error Corrections. Control transferred at a point in time Revenue for performance obligations that do not meet the criteria for control transferred over time is recognized at a point in time. Accordingly, an entity recognizes revenue by evaluating when the customer obtains control of the asset (goods or services).

16 New Developments Summary 16 In performing the evaluation, an entity should consider indicators of control, including, but not limited to, the following: The entity has a present right to receive payment for the asset. The customer has legal title to the asset. The customer has physical possession of the asset. The customer has assumed the significant risks and rewards of owning the asset. The customer has accepted the asset. C. Other topics Repurchase agreements Sometimes an entity that enters into a contract to sell an asset also promises, or has the option, to repurchase the same asset, an asset that is substantially the same, or another asset in which the original asset sold is a component. Under ASC 606, an entity should evaluate the form of the promise to repurchase the asset (for example, a forward, call, or put option) in determining the appropriate accounting. If a contract includes a forward (entity s obligation to repurchase) or a call option (entity s right to repurchase), an entity should account for the contract in one of two ways: As a lease if it can or must repurchase the asset for an amount that is less than the original selling price As a financing arrangement if it can or must repurchase the asset for an amount that is equal to or more than the original selling price If a customer is granted the right to require an entity to repurchase the asset (a put option) at a price that is less than the original selling price, the entity should assess whether the customer has a significant economic incentive to exercise its right. This assessment should take into consideration various factors, including the relationship between the repurchase price and the expected market value of the asset at the date of repurchase. If the repurchase price is expected to significantly exceed market value, then a significant economic incentive exists, and the agreement should be accounted for as a lease (because the customer is effectively paying the entity for the right to use the asset for a period of time), unless the contract is a part of a sale-leaseback arrangement. A sale-leaseback transaction with a forward or call option that has an repurchase price less than the asset s original sales price should be accounted for as a financing transaction rather than as a sale-leaseback. If the customer does not have a significant economic incentive to exercise the right described above, the entity should account for the agreement as a sale with a right of return. The contract is considered a financing arrangement if (1) the contract grants the customer a put option, and (2) the repurchase price of the asset is equal to or greater than its original selling price and is more than the asset s expected market value. In such circumstances, the entity continues to recognize the asset as well as a liability initially measured at the asset s original selling price. If either a call or put option expires unexercised, any liability recorded should be derecognized and revenue recognized.

17 New Developments Summary 17 Repurchase arrangements Type of repurchase arrangement Relationship between repurchase price (RP) and original selling price (OSP) Relationship between repurchase price (RP) and expected market value (EMV) at repurchase date Accounting treatment Forward or call option* RP > OSP RP < OSP Not applicable Not applicable Financing arrangement Lease Put option RP > OSP RP > EMV Financing arrangement RP > OSP RP < EMV Sale with right of return RP < OSP RP > EMV** Lease RP < OSP RP < EMV Sale with right of return * Excluding sale-leaseback transactions. ** If significant; otherwise, account for as a sale with a right of return. For example, an entity sells a building to a customer for $10 million in cash with an option to repurchase the building in five years for $12 million. Since the repurchase price is greater than the original selling price, the entity should account for the transaction as a financing arrangement. The entity should not derecognize the building, and should recognize a financing liability for the amount of cash consideration received. If instead of a seller call option, the arrangement includes a put option that allows the buyer to require the seller to repurchase the building in five years for $12 million, the seller should estimate the building s market value five years after the transaction to determine whether it must account for the transaction as a financing arrangement. If the entity estimates that the building s market value will be $11 million in five years, then it should account for the arrangement as a financing as of the initial transaction date, because the buyer has a significant economic incentive to exercise its put option. Alternatively, if the entity estimates the building s market value at $13 million five years after the transaction date, it should account for the arrangement as a sale with a right of return. In general, an entity should account for a sale with a right of return by (1) reducing revenue by the amount of estimated returns, (2) crediting a liability for consideration expected to be refunded to the customer, and (3) debiting an asset for the amount of the goods expected to be returned. This methodology is challenging to apply to sales of real estate where the concept of a return is less familiar than in other industries, such as consumer products. Nevertheless, entities that sell real estate in transactions with these types of repurchase options must use judgment and consider all relevant facts and circumstances to determine the amounts attributable to the right of return asset and related liability.