|By Sidharth Mehta, partner and head of building, construction and real estate at KPMG Lower Gulf|
In May 2014, the International Accounting Standards Board published the International Financial Reporting Standard (IFRS) 15, which significantly impacted real estate companies as they could now recognise revenue over the construction period if certain conditions were met. This meant greater transparency for real estate entities, but also certain challenges such as volatile contract margins and data requirements.
It has been more than three years since major real estate players in the UAE adopted IFRS 15 accounting standards. IFRS 15 rules require developers to recognise revenue based on the percentage of completed units, as opposed to earlier regulations that mandated revenue to be calculated based on the number of completed units handed over to customers. This standard is particularly beneficial for off-plan sales, as it allows developers to recognise revenues and profits partially from the sale of off-plan properties during different stages of their completion.
The move was lauded by experts, with ratings agency Moody’s saying the adoption of IFRS 15 will aid in accurately reflecting companies’ financial performance, thereby supporting transparency in the sector. According to Moody’s, this will also help better align earnings and cash flows, leading to financial results that better reflect the underlying activities of UAE property developers.
In a country where real estate and construction is a major contributor to the national economy, efforts to increase transparency may create more confidence in purchasing off-plan property, as well as attracting foreign direct investment in the property market in the country.
Three years on, listed and regulated entities in the UAE have applied IFRS 15 standards as they publish quarterly results. However, small and medium-sized enterprises (SMEs) may have some catching up to do—it would seem they are yet to appreciate the impact of the new standards and the information needed to comply with the fresh approach to revenue recognition, as mandated by the IFRS 15 standard. By implementing the standards, SMEs may benefit from overall revenue recognition and reduce earnings volatility.
Given current market conditions, construction companies’ revenues, profits and margins are under immense pressure. Revenues may change under the new standard if construction contracts do not qualify for revenue recognition over time. For instance, issues may arise when deciding if leasing, development activities and other such services are simultaneously received and consumed by real estate owners.
In my experience, some companies may find that applying the new revenue standard will result in a revenue accounting outcome similar to the current percentage-of-completion (POC) method.
However, cost accounting may result in a volatile contract margin over the lifecycle of a typical contract—there is no automatic link between revenue and cost or the old matching concept. Therefore, construction contracts that use a balance sheet true-up to create a consistent margin over the life of the contract may change under the new standard.
The biggest challenge accompanying the transition to revenue recognition continues to be data requirements. For instance, the main costs for construction contracts are related to staff, materials and depreciation. Sophisticated systems may be required to determine how to segregate costs between those relating to “future performance” and those that need to be “expensed off directly to the income statement”. In addition, it is not uncommon for costs to be incurred for variation orders before they are approved. Whether these costs should be expensed off or not depends on how performance obligations are designed in a contract.
Overall, it is possible that we will see many changes with respect to accounting for revenue and costs in the construction sector. While the impact may or may not be significant, companies need to do a thorough analysis of their contracts. Only then are they in a position to assess what type of counsel they require. Companies can also turn to the professional services of accountancy firms that are capable of helping in the implementation process—from issue diagnosis to solution development to deployment.
This article is extracted from a report produced by MEED and Mashreq titled Regulating Construction: Adapting to New Standards. Click here to download the report
To know more about the MEED Mashreq Partnership, get in touch with us at MEEDMashreqPartnership@meed.com or find more info on www.meedmashreqconstructionhub.com