For the past three years, the Philippine stock market has been among the fastest-growing capital markets in the world. It grew by 9 percent in the year to date and by 20 percent in the past 12 months. Among the fastest-growing sectors is property, in which practically all of the country’s large conglomerates are heavily invested. While this sector looks quite bright, there is a looming shadow that may have a significant impact on it. This is with respect to the application to the real estate industry of International Financial Reporting Standard (IFRS) 15, Revenue from Contracts with Customers.
At present, revenues from the industry’s sales of condominium units are recognized under the percentage-of-completion method. Under this method, provided certain criteria are met, the gross income from the presale of condominium units is recognized based on the stage of completion. To illustrate, if a condominium project takes, say, four years to complete and the developer has been authorized to presell the units, the gross income (selling price less estimated cost of the project) from units presold is recognized on the basis of the percentage of completion of the project. Thus, if the project is 60 percent complete and there is no uncertainty as to the ability of the buyer to pay the amortization payments, the developer is allowed to recognize 60 percent of the estimated gross profit from the sale.
This has always been the practice in the industry and seems to have served the developers well. But this will change once IFRS 15 as currently interpreted is fully adopted in the Philippines.
Philippine Interpretation IFRIC 15, “Agreements for the Construction of Real Estate,” covers accounting for revenue and associated expenses by entities that undertake the construction of real estate directly or through subcontractors. Under the interpretation, and consistent with IFRS 15, revenue on construction of real estate as currently practiced in the Philippines should be recognized only upon completion. The interpretation also provides that contracts involving provision of services with the construction materials and where the risks and reward of ownership are transferred to the buyer on a continuous basis will also be accounted for based on stage of completion.
This, however, is quite uncommon, if nonexistent, in the Philippines. The Philippine Securities and Exchange Commission and the Financial Reporting Standards Council (FRSC) have deferred the effectivity of this interpretation until the final IFRS 15 is issued by the International Accounting Standards Board (IASB) and an evaluation of the requirements of the final revenue standard against the practices of the Philippine real estate industry is completed.
In May 2014, the IASB adopted IFRS 15 and it will apply to annual periods beginning on or after Jan. 1, 2017, with early adoption permitted. (Last April 28, the IASB voted to issue an exposure draft to defer the effectivity date to Jan. 1, 2018.) The transition to the new standard may either be on a full retrospective approach or a modified retrospective approach. The full retrospective approach will require the restatement of all prior periods presented with revenues recognized under the new standard. The modified approach will allow the standard to be applied only to existing contracts beginning with the current period. No restatement of the comparative periods will be required under this approach, provided, however, that comparative disclosures about the current period’s revenues under the existing IFRS are presented.
As currently interpreted by the Philippine Interpretations Committee of the FRSC, the percentage-of-completion method currently followed by the real estate sector will no longer be acceptable, and the developers will thus have to recognize revenues from the presale of condominium units only upon completion of the project. In the year of adoption of IFRS 15 under the full retrospective approach, earnings already recognized in the previous years with respect to uncompleted projects will have to be reversed and will thus result in the reduction of beginning retained earnings. For real estate companies that have a high dividend payout rate, this may conceivably even result in retained earnings becoming a deficit! It is imperative, therefore, that these developers, the Philippine Stock Exchange and the SEC should now start to assess the implications of adopting the standard and not wait for 2017 or 2018.
However, this situation may easily be avoided simply by following the allowed modified retrospective approach described. Under this approach, the unrealized gross profit from existing contracts as of the initial date of adoption will be recorded as earned only upon completion of the project and delivery of the condominium units. But this modified approach will result in substantial drops in the revenues of the developers in the year of adoption and the next three to four years (the average construction period for condominium projects). Since the stock prices of listed companies are very sensitive to reported earnings, the drop in earnings of these developers will likely have significant implications on their stock prices.
It should be noted that although there may not be any significant change in the fundamentals of these property-sector companies, their stock prices may be adversely affected by the accounting change brought about by IFRS 15.
David L. Balangue (davidlbalangue@yahoo.com.ph) chairs the Philippine Financial Reporting Standards Council.