Peeling away financial reporting issues one layer at a time

IFRIC 15: Revenue Recognition Rules Hark Back to Not-So-Good Ole Days of U.S. Accounting

With the SEC's publication of their proposed roadmap for the U.S. adoption of IFRS, all of the press coverage I have been reading has focused on the big picture. (As usual, Floyd Norris's is among the best.) But in the background, the IASB has been conducting its business as usual: drawing squiggly lines in the sand, vaingloriously dubbed principles-based standards. IFRIC 15 is a perfect example, as I shall now commence to explain.

What is 2+2? Answer: Whatever You Want.

The International Financial Reporting Interpretations Committee (IFRIC) of the IASB issued IFRIC Interpretation 15, Agreements for the Construction of Real Estate, effectively to provide whatever excuse an issuer could need to accounting for a construction project under either IAS 18, Revenue, or IAS 11, Construction Contracts. Stated as simply as possible, it's an unrestricted license for condominium developers to manage earnings.

Setting aside the vinegar bottle for a moment, the Interpretation provides that an agreement for the construction of real estate is to be accounted for by the percentage of completion method (IAS 11) when the buyer is able to specify the major structural elements of the design of the real estate before construction begins and/or specify major structural changes once construction is in progress. Otherwise, earnings would normally be deferred under IAS 18 until completion of the project, when cash has normally been received or is receivable.

Now, back to the attitude. Just to make sure everybody gets the wink and nod to issuers, IFRIC 15 states that determining whether an arrangement is a construction contract or something else requires "judgment with respect to each agreement" (¶10), and "is not an accounting policy choice" (¶BC16). What is a "major structural element"? Answer: Whatever it is, it's not an accounting policy choice. Construction agreements are like snowflakes; no two are exactly alike.

In other words, an entity will evaluate each contract whenever and however it wants. Do you need to smooth your earnings? If yes, those new construction projects are going to be accounted for under IAS 11 (percentage of completion method). Or, are you going to need the earnings next year to make your bonus target? If so, those new projects you just started are going to be accounted for under IAS 18 (essentially, the completed contract method). Even if they could, no auditor would dare to risk its fee by calling your "judgment" into serious question.

The American Way

U.S. GAAP takes a different approach, borne out of lessons learned the hard way. Statement of Financial Accounting Standards (SFAS), No. 66, Accounting for Sales of Real Estate, requires use of the percentage of completion method for recognizing earnings from sales of units in condominium projects or time-sharing interests (¶37), irrespective of a buyer's ability to affect the construction. SFAS No. 66 was issued in 1982, and its provisions were clearly motivated by a desire to put a halt to premature and inappropriate revenue recognition practices taking place in the real estate industry. Broad principles of revenue recognition have a certain attraction, but managers quickly figured out how to comply with the letter of an accounting principle (making the auditor happy), while at the same time completely disregarding its spirit. All sorts of investors, be they unsophisticated individuals hoping for a quick killing or ambitious loan officers looking for a few extra basis points, were taken in by the financial shenanigans of real estate companies that rode roughshod over the principles-based accounting guidance that existed at the time.

If there is a principle in SFAS No. 66 it is that you don't get to pick and choose under U.S. GAAP. I can't speak of financial reporting elsewhere, but in the U.S. financial reporting environment, that's a good thing. It bespeaks volumes about the current leadership of the SEC that it thinks otherwise—as evidenced by its near monotonic support of an IFRS that marches ever forth toward chicken salad for issuers.

1 Comment

  1. Reply Euro September 10, 2008

    I am sorry but with all the due respect, I truly belive that you are conpletely out of track.
    Firstly you forgot to mention SoP 81-1 which recognises the continuous trasnfer method and therefore the percentage of completion method on a fairly judgemental basis.
    Secondly, simply because each transaction is unique it does not make any sense to treat all of them in the same manner. This is wath US GAAP does. It just create the illusion that accounting is always right in one way only. Ridiculous.
    Finally, IFRIC 15 requires significant disclosures and explanations about the exercise of judgement in interpretng IAS 18 or IAS 11. This add transparency.
    For sure saying: “All transactions are accounted for this way. Period”, does not add any meaningful information.
    Again, I said this earlier: Americans you need to broad your horizons. US GAAP is history. Set of rules are broken and superseded. Resist to this is silly.
    Have a nice day.

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