Balancing an accounting problem
By GOH KEAN HOE
LATELY, IFRIC 15 has become a hot topic among accountants and leading property developers in Malaysia. Developers here have been using the percentage method for decades to report revenue from projects sold under the sell-and-build system. Naturally, they were shocked when ‘told’ to change to the completed method.
(IFRIC 15 is an interpretation issued in July 2008 by the International Financial Reporting Interpretations Committee to cover agreements for the construction of real estate. The document is meant to standardise accounting practice across jurisdictions for the recognition of revenue among real estate developers for sales of units before construction is complete.)
The message to the marketplace from the Malaysian Accounting Standards Board (MASB) and Malaysian Institute of Accountants (MIA) is that under IFRIC 15, property developers can only recognise the revenue when the construction is completed and the completed units are handed over to the purchasers. The top audit firms have also indicated to their clients to prepare for this fundamental change.
The developers are perplexed. Some ask: “Does that mean we were wrong to use the percentage method all this while?”
A general explanation is that property developers are selling goods and not providing construction services.
Hence, revenue can only be recognised when the goods are delivered to the purchasers.
Which paragraph?
That may be true, but to be exact, IFRIC 15 lists three categories of agreements:
(a) The agreement is a construction contract;
(b) The agreement is for rendering of services (only); and
(c) The agreement is for sale of goods (services plus materials)
For types (a) and (b), IFRIC 15 says the appropriate method is the percentage method. For type (c), the applicable method depends on whether the agreement meets the criterion set out in paragraph 17 or paragraph 18 of IFRIC 15.
Paragraph 17 says: “The entity may transfer to the buyer control and significant risks and rewards of ownership of the work in progress in its current state as construction progresses. In this case, ....”
Paragraph 18 says: “The entity may transfer to the buyer control and significant risks and rewards of ownership of the real estate in its entirety at a single point of time (e.g. at completion, upon or after delivery). In this case, ...”
So which paragraph should apply to the Malaysian property development industry? Whose WIP (work in progress) is it?
But the answer is more than just about the legal ownership of the properties or WIP.
In accounting, substance is more important than form. In fact, the concept of “continuous transfer of control, risk and reward” introduced in IFRIC 15 is rather new and obviously, not well or easily understood even by accountants. IFRIC 15 acknowledges that circumstances that meet the criterion of paragraph 17 may not exist frequently.
In addition, IFRIC 15 requires an entity to disclose how it determines which agreements meet that criterion. It seems that the International Accounting Standards Board (IASB) is biased towards the completed method by making it tougher to apply paragraph 17.
Noting that the draft of IFRIC 15 (issued in 2007) might not have addressed the industry practice in Malaysia, I included a suggestion in my letter for IASB/IFRIC “to examine various typical sales agreements on uncompleted real estate and categorise them as much as possible (or by way of examples)”.
IASB did take into consideration many of the comments and concerns raised, and yet, did it fall short of addressing adequately our unique circumstances?
Percentage vs completed
Can the circumstances in Malaysia be differentiated from those in other countries to justify the use of the percentage method?
Based on my observation, the general view is that there are either equally strong arguments for both methods and any difference could be just a fine line, or there is no a clear answer due to lack of specific guidance in IFRIC 15 for our unique circumstances.
Since the MASB and MIA have taken the view that the completed method is the way to go under IFRIC 15, it will be useful if they issue a formal document putting forward their views, with the basis and arguments, so as to convince the property developers and the doubters that this is the correct way.
To conclude that we do not meet paragraph 17 and hence, the completed method shall apply, is an easier task, but the important consideration is if the financial statements will still provide a true and fair view of the financial position and performance of the developers.
It is understood that the Real Estate and Housing Developers’ Association (Rehda) recently submitted a memorandum to the MIA and other relevant bodies about their view, which is biased towards the percentage method.
The objective of IFRIC 15 is to clarify existing standards and to standardise the accounting practice worldwide. Singapore converged to IFRS (international financial reporting standards) in 2005.
However, it has yet to adopted IFRIC 15 and is still trying to find ways and means to interpret it correctly and in such a way that it can be accepted by all stakeholders. Meanwhile, the percentage method continues to be used there.
Hong Kong, on the other hand, has switched to the completed method since its convergence to IFRS in 2005. In my view, for Malaysia to solve this issue and to make sure we get it right, we must go through a due process as follows:
● To understand thoroughly IFRIC 15 and also related accounting standards – IAS 18 and IAS 11 as well as the upcoming new standard on revenue recognition. This may necessitate consulting the IASB on unclear areas.
● To understand exactly the property development business and to critically review the industry practices, laws and the terms of the typical sale and purchase agreements in order to understand completely the relationship between the developers and their customers. The relevant substance must be identified and given due consideration.
● To compare with other countries such as Singapore, Hong Kong, Australia, Britain and the United States on the industry practices and laws and the accounting treatments.
Remember the objective of financial statements
We must consider two more factors. First, we cannot totally ignore the unique characteristics of this industry – that real estate is an immovable asset and that the construction element can be undertaken by another engineering firm so long as the design and specifications are available.
Second, the ultimate objective of financial statements is to provide useful and relevant information for users to make economic decisions.
Hence, it must be true and fair, and reflect the economic and business activities and events that happened during the reporting period, including any value added or destroyed.
Another point is that many may not be aware that our Companies Act and the FRS 101 (on presentation of financial statements) actually provide that if applying an accounting standard or interpretation will not result in true and fair financial statements, the directors should not apply it.
I suspect many companies may consider making use of this provision.
Finding a good solution to this issue is by no means an easy task. It is important that the MASB, MIA and Rehda pool their resources to resolve this. Since the real estate laws and practices in Singapore and Malaysia are quite similar, it may not be a bad idea for the two countries to cooperate on this matter. Will accountants in Malaysia, and perhaps in Singapore as well, have the same opinion on an accounting issue for once?
● Goh Kean Hoe is a partner of TKNP International and a trainer consultant with Globalacc Research & Training Sdn Bhd. This article is an abridged version. For feedback and requests for the full article, email him at gkh2001@tm.net.my.
(IFRIC 15 is an interpretation issued in July 2008 by the International Financial Reporting Interpretations Committee to cover agreements for the construction of real estate. The document is meant to standardise accounting practice across jurisdictions for the recognition of revenue among real estate developers for sales of units before construction is complete.)
The message to the marketplace from the Malaysian Accounting Standards Board (MASB) and Malaysian Institute of Accountants (MIA) is that under IFRIC 15, property developers can only recognise the revenue when the construction is completed and the completed units are handed over to the purchasers. The top audit firms have also indicated to their clients to prepare for this fundamental change.
The developers are perplexed. Some ask: “Does that mean we were wrong to use the percentage method all this while?”
A general explanation is that property developers are selling goods and not providing construction services.
Hence, revenue can only be recognised when the goods are delivered to the purchasers.
Which paragraph?
That may be true, but to be exact, IFRIC 15 lists three categories of agreements:
(a) The agreement is a construction contract;
(b) The agreement is for rendering of services (only); and
(c) The agreement is for sale of goods (services plus materials)
For types (a) and (b), IFRIC 15 says the appropriate method is the percentage method. For type (c), the applicable method depends on whether the agreement meets the criterion set out in paragraph 17 or paragraph 18 of IFRIC 15.
Paragraph 17 says: “The entity may transfer to the buyer control and significant risks and rewards of ownership of the work in progress in its current state as construction progresses. In this case, ....”
Paragraph 18 says: “The entity may transfer to the buyer control and significant risks and rewards of ownership of the real estate in its entirety at a single point of time (e.g. at completion, upon or after delivery). In this case, ...”
So which paragraph should apply to the Malaysian property development industry? Whose WIP (work in progress) is it?
But the answer is more than just about the legal ownership of the properties or WIP.
In accounting, substance is more important than form. In fact, the concept of “continuous transfer of control, risk and reward” introduced in IFRIC 15 is rather new and obviously, not well or easily understood even by accountants. IFRIC 15 acknowledges that circumstances that meet the criterion of paragraph 17 may not exist frequently.
In addition, IFRIC 15 requires an entity to disclose how it determines which agreements meet that criterion. It seems that the International Accounting Standards Board (IASB) is biased towards the completed method by making it tougher to apply paragraph 17.
Noting that the draft of IFRIC 15 (issued in 2007) might not have addressed the industry practice in Malaysia, I included a suggestion in my letter for IASB/IFRIC “to examine various typical sales agreements on uncompleted real estate and categorise them as much as possible (or by way of examples)”.
IASB did take into consideration many of the comments and concerns raised, and yet, did it fall short of addressing adequately our unique circumstances?
Percentage vs completed
Can the circumstances in Malaysia be differentiated from those in other countries to justify the use of the percentage method?
Based on my observation, the general view is that there are either equally strong arguments for both methods and any difference could be just a fine line, or there is no a clear answer due to lack of specific guidance in IFRIC 15 for our unique circumstances.
Since the MASB and MIA have taken the view that the completed method is the way to go under IFRIC 15, it will be useful if they issue a formal document putting forward their views, with the basis and arguments, so as to convince the property developers and the doubters that this is the correct way.
To conclude that we do not meet paragraph 17 and hence, the completed method shall apply, is an easier task, but the important consideration is if the financial statements will still provide a true and fair view of the financial position and performance of the developers.
It is understood that the Real Estate and Housing Developers’ Association (Rehda) recently submitted a memorandum to the MIA and other relevant bodies about their view, which is biased towards the percentage method.
The objective of IFRIC 15 is to clarify existing standards and to standardise the accounting practice worldwide. Singapore converged to IFRS (international financial reporting standards) in 2005.
However, it has yet to adopted IFRIC 15 and is still trying to find ways and means to interpret it correctly and in such a way that it can be accepted by all stakeholders. Meanwhile, the percentage method continues to be used there.
Hong Kong, on the other hand, has switched to the completed method since its convergence to IFRS in 2005. In my view, for Malaysia to solve this issue and to make sure we get it right, we must go through a due process as follows:
● To understand thoroughly IFRIC 15 and also related accounting standards – IAS 18 and IAS 11 as well as the upcoming new standard on revenue recognition. This may necessitate consulting the IASB on unclear areas.
● To understand exactly the property development business and to critically review the industry practices, laws and the terms of the typical sale and purchase agreements in order to understand completely the relationship between the developers and their customers. The relevant substance must be identified and given due consideration.
● To compare with other countries such as Singapore, Hong Kong, Australia, Britain and the United States on the industry practices and laws and the accounting treatments.
Remember the objective of financial statements
We must consider two more factors. First, we cannot totally ignore the unique characteristics of this industry – that real estate is an immovable asset and that the construction element can be undertaken by another engineering firm so long as the design and specifications are available.
Second, the ultimate objective of financial statements is to provide useful and relevant information for users to make economic decisions.
Hence, it must be true and fair, and reflect the economic and business activities and events that happened during the reporting period, including any value added or destroyed.
Another point is that many may not be aware that our Companies Act and the FRS 101 (on presentation of financial statements) actually provide that if applying an accounting standard or interpretation will not result in true and fair financial statements, the directors should not apply it.
I suspect many companies may consider making use of this provision.
Finding a good solution to this issue is by no means an easy task. It is important that the MASB, MIA and Rehda pool their resources to resolve this. Since the real estate laws and practices in Singapore and Malaysia are quite similar, it may not be a bad idea for the two countries to cooperate on this matter. Will accountants in Malaysia, and perhaps in Singapore as well, have the same opinion on an accounting issue for once?
● Goh Kean Hoe is a partner of TKNP International and a trainer consultant with Globalacc Research & Training Sdn Bhd. This article is an abridged version. For feedback and requests for the full article, email him at gkh2001@tm.net.my.
Get set for new accounting rules
By Adrian Lee
THE International Accounting Standards Board’s (IASB) new thinking on financial instruments accounting represents a big departure from the current FRS139/IAS39. Many entities may need to undertake another round of changes in systems and reporting to comply with the new IFRS9 requirements.
Most entities in Malaysia would have already adopted FRS139 Financial Instruments: Recognition & Measurement, which became effective on Jan 1, 2010. FRS139 is a standard dealing with financial instruments accounting and represents a major change from how financial instruments were accounted for in Malaysia before.
Derivatives (e.g. foreign exchange contracts, options) and many financial assets such as investments in shares and debt securities are now required to be stated at fair value. The standard also introduces complex hedge accounting and impairment rules.
Whilst entities in Malaysia are familiarising themselves with the new FRS139 requirements, they need to also be mindful that another major revamp to financial instruments accounting is currently ongoing at the international level.
FRS139 is largely based on IAS39, first issued in 1999 by the International Accounting Standards Committee (IASC), the predecessor to the IASB.
The IASB is, however, currently undertaking a comprehensive review of financial instruments accounting and aims to replace IAS39 with a new financial instruments standard referred to as IFRS9 Financial Instruments.
The IFRS9 project is partly driven by requests for reform from the Group of 20 and other constituents. The IFRS9 project is divided into three main phases: classification and measurement, impairment, and hedge accounting.
The IASB aims to complete all phases by the second quarter of 2011. To date, the classification and measurement phase has been completed and draft proposals arising from the impairment phase have been issued.
Under the classification and measurement phase, the four categories for financial assets under IAS39 (namely held to maturity, loans and receivables, fair value through profit or loss, and available for sale) are replaced by just two categories i.e. amortised cost and fair value.
An entity’s “business model” condition is introduced to determine the appropriate classification for financial assets. If an entity’s business model’s objective is to hold assets to collect the contractual cashflows, then the financial assets are measured at amortised cost.
This change is intended to make it easier for entities to measure their financial assets (particularly quoted debt securities) at amortised cost rather than fair value. Hence, unlike previously, an entity does not have to hold all debt securities to maturity to qualify for amortised cost measurement.
Other key changes
There are also key changes in the accounting for investments in equity investments (shares).
Equity investments are generally measured at fair value and gains/losses on fair value changes are recognised in profit or loss. However, an entity may elect to present the fair value changes to other comprehensive income (OCI) instead. The election is irrevocable and can be made on an individual share-by-share basis.
The OCI route is somewhat similar to the “available for sale” category in the current IAS39.
However, there is no longer the need to test these equity investments for impairment. Hence, any fair value losses can remain in OCI without considering the need to recognise the losses in the profit or loss.
The “drawback” is that the amounts in OCI (gains or losses) are not recycled to profit or loss, even when they are realised, i.e. when investments are sold.
Under the impairment phase, the IASB is proposing some fundamental changes in respect of the recognition and measurement of losses associated with loans and other receivables.
One of the key criticisms of the current “incurred loss” model for loan loss provisioning is that it is “too little, too late”. The current model only allows loan-loss provisions to be made when there is objective evidence of impairment. A loss event – for example, default by borrower – must happen.
The problem with this approach is that there is no build up loan-loss provisions prior to the loss event, even though it is expected that some loans will default over the life of the loan portfolio.
‘Expected cashflow’ model
The IASB attempts to address this by proposing the “expected cashflow” model for loan-loss provisioning.
An entity would now estimate the expected credit losses from a loan portfolio. The loan-loss provision will then be built up, via an adjustment to the interest income recognised, over the life of the loan portfolio. This has an effect of smoothing out the expected loan-loss provisions over the life of the loan portfolio.
However, any subsequent changes to expectations in the credit loss or cashflows will be immediately recognised in the profit or loss. This could potentially introduce some level of volatility to the profit or loss arising from changes in expectations.
The proposed impairment changes also impact the measurement of revenue and trade receivables of non-banks.
Similar to banks, corporates are also required to estimate the expected credit losses arising from their trade receivables. However, these losses are then immediately deducted from the revenue. Revenue would now be stated at net of expected credit losses.
Though the MASB has indicated that it is unlikely to adopt IFRS9 until the IASB has completed all three phases of the project, corporates should familiarise themselves with the standard and take cognisance of the potential impact of the requirements of IFRS9 on their operations.
·Adrian Lee is an audit partner at KPMG.
Most entities in Malaysia would have already adopted FRS139 Financial Instruments: Recognition & Measurement, which became effective on Jan 1, 2010. FRS139 is a standard dealing with financial instruments accounting and represents a major change from how financial instruments were accounted for in Malaysia before.
Derivatives (e.g. foreign exchange contracts, options) and many financial assets such as investments in shares and debt securities are now required to be stated at fair value. The standard also introduces complex hedge accounting and impairment rules.
Whilst entities in Malaysia are familiarising themselves with the new FRS139 requirements, they need to also be mindful that another major revamp to financial instruments accounting is currently ongoing at the international level.
FRS139 is largely based on IAS39, first issued in 1999 by the International Accounting Standards Committee (IASC), the predecessor to the IASB.
The IASB is, however, currently undertaking a comprehensive review of financial instruments accounting and aims to replace IAS39 with a new financial instruments standard referred to as IFRS9 Financial Instruments.
The IFRS9 project is partly driven by requests for reform from the Group of 20 and other constituents. The IFRS9 project is divided into three main phases: classification and measurement, impairment, and hedge accounting.
The IASB aims to complete all phases by the second quarter of 2011. To date, the classification and measurement phase has been completed and draft proposals arising from the impairment phase have been issued.
Under the classification and measurement phase, the four categories for financial assets under IAS39 (namely held to maturity, loans and receivables, fair value through profit or loss, and available for sale) are replaced by just two categories i.e. amortised cost and fair value.
An entity’s “business model” condition is introduced to determine the appropriate classification for financial assets. If an entity’s business model’s objective is to hold assets to collect the contractual cashflows, then the financial assets are measured at amortised cost.
This change is intended to make it easier for entities to measure their financial assets (particularly quoted debt securities) at amortised cost rather than fair value. Hence, unlike previously, an entity does not have to hold all debt securities to maturity to qualify for amortised cost measurement.
Other key changes
There are also key changes in the accounting for investments in equity investments (shares).
Equity investments are generally measured at fair value and gains/losses on fair value changes are recognised in profit or loss. However, an entity may elect to present the fair value changes to other comprehensive income (OCI) instead. The election is irrevocable and can be made on an individual share-by-share basis.
The OCI route is somewhat similar to the “available for sale” category in the current IAS39.
However, there is no longer the need to test these equity investments for impairment. Hence, any fair value losses can remain in OCI without considering the need to recognise the losses in the profit or loss.
The “drawback” is that the amounts in OCI (gains or losses) are not recycled to profit or loss, even when they are realised, i.e. when investments are sold.
Under the impairment phase, the IASB is proposing some fundamental changes in respect of the recognition and measurement of losses associated with loans and other receivables.
One of the key criticisms of the current “incurred loss” model for loan loss provisioning is that it is “too little, too late”. The current model only allows loan-loss provisions to be made when there is objective evidence of impairment. A loss event – for example, default by borrower – must happen.
The problem with this approach is that there is no build up loan-loss provisions prior to the loss event, even though it is expected that some loans will default over the life of the loan portfolio.
‘Expected cashflow’ model
The IASB attempts to address this by proposing the “expected cashflow” model for loan-loss provisioning.
An entity would now estimate the expected credit losses from a loan portfolio. The loan-loss provision will then be built up, via an adjustment to the interest income recognised, over the life of the loan portfolio. This has an effect of smoothing out the expected loan-loss provisions over the life of the loan portfolio.
However, any subsequent changes to expectations in the credit loss or cashflows will be immediately recognised in the profit or loss. This could potentially introduce some level of volatility to the profit or loss arising from changes in expectations.
The proposed impairment changes also impact the measurement of revenue and trade receivables of non-banks.
Similar to banks, corporates are also required to estimate the expected credit losses arising from their trade receivables. However, these losses are then immediately deducted from the revenue. Revenue would now be stated at net of expected credit losses.
Though the MASB has indicated that it is unlikely to adopt IFRS9 until the IASB has completed all three phases of the project, corporates should familiarise themselves with the standard and take cognisance of the potential impact of the requirements of IFRS9 on their operations.
·Adrian Lee is an audit partner at KPMG.
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