Revenue from Contracts with Customers (FASB ASC 606)
ASC 606 is a principles-based framework for recognizing revenue and replaces Generally Accepted Accounting Principles (GAAP) revenue recognition requirements and accounting guidance that homeowner associations have followed for many years. The intent of ASC 606 is to create consistency in and comparability of financial statements and improve the usefulness of financial statements.
For homeowner associations, adoption is required for annual reporting periods beginning after December 15, 2018 and for interim periods within annual reporting periods beginning after December 15, 2019. This means the standard will apply to all annual GAAP financial statements for the year ended December 31, 2019 and for all monthly financial statements beginning January 2020.
This paper is meant to assist homeowner associations in applying ASC 606 to their accrual based financial statements with the following 5 steps:
- Identifying an association’s customer and contract with the customer;
- Recognizing the rights and obligations of contracts;
- Recognizing and valuing revenue from contracts;
- Determining how the presentation of revenue from contracts and other financial information will be different than the current presentation;
- Implementing steps to take in transitioning and reporting as required by ASC 606.
Step 1: Identifying an Association’s Customer and Contract with the Customer
The new standards refer to contracts between the Association and its members as “performance obligations”. The customers of an association are its members, including the declarant, and the contract between an association and its members is what the Association is obligated to provide its members based on its governing documents. Operating budgets, provisions in governing documents to assess initial working capital and budget for major repairs and replacements, and special assessment resolutions are contracts with association members.
The new standards make it clear that the accounting treatment for performance obligations take into consideration the understanding between the Association and members in determining the nature of the performance obligation as opposed to the theoretical application of accounting standards.
Step 2: Recognizing the Rights and Obligations of Contracts
A contract between an association and its members obligates the Association to provide goods and services defined in the contract, and members have the right to those goods and services for which they are assessed. Contracts promise services to members, such as management of day-to-day operations, maintenance, repairs, and replacements, and the facilitation of ancillary services. In return, members pay for those services through assessments.
The operating budget is a contract that gives an estimated cost of goods and services the Association plans to provide its members during the budget period (usually one year) and the amount of assessments the members will be billed for their right to the goods and services during the budget period. Such services are generally billed monthly for operating expenses.
The reserve study is a contract that gives the estimated costs of repairs and maintenance an association plans to provide to its members, but not necessarily in the same period as members are assessed. Members are also generally billed monthly for estimated future reserve expenditures.
Special assessment resolutions are contracts that obligate an association to provide goods or services to its members or other purposes such as funding shortfalls or repaying loans.
Step 3: Recognizing and Valuing Revenue from Contracts
Contract revenue is recognized when the obligation for which revenue is assessed is performed and ASC 606 requires revenue to be recognized in the amount estimated to be collectable. All expense items in the operating budget are defined as a single performance obligation. Major repair and replacement components are separate performance obligations.
Budgeted operating fund assessments are recognized in the same period as they are assessed. This may be a monthly, quarterly, semi-annual or annual assessment as required by the governing documents. ASC 606 has not changed the current practice of revenue recognition for operating assessments except for the manner in which bad debts are reported as enumerated below.
ASC 606 has not changed the current budget practice of including known bad debts in the budget as an expense line item. This practice in essence grosses up the total budgeted assessments to compensate for the bad debt. The current practice is to recognize all operating assessments billed and to record the bad debt as an expense when billed or when the account is analyzed for collectability. ASC 606 requires budgeted assessments to be reported net of budgeted uncollectible amounts. This does not mean assessments will not be assessed as budgeted, but it does mean that each time assessments are billed, an entry is posted to a contra-revenue account, in effect decreasing the amount of operating assessments recognized on the accrual method of accounting.
ASC 606 has changed the manner that budgeted reserve assessments are recognized. Budgeted replacement reserve assessments will now be recognized when the obligation for which they were assessed is fulfilled, that is, when major repairs and replacements included in an association’s reserve study occur. This is a significant change from current practice.
The recognition of special assessment revenue will depend on the nature and purpose of the special assessment and should agree with the expectation of the members. For example, a special assessment to fund a shortfall will be recognized when it is assessed, but a special assessment to repay a loan will be recognized when loan payments are made. In the case of a serial assessment, there are typically two performance obligations; the first is repairs and replacements and the second is loan servicing. When members elect to pay a lump sum amount up front, this revenue is recognized when the repairs and replacements are completed and expensed. When members elect to be assessed the monthly serial assessments that are tied to a loan repayment, this revenue is recognized as the loan and loan interest is paid. This is not a change from current practice, it merely reinforces the current practice.
ASC 606 did not change the recognition of all income received by associations. For example, contract income as defined by the new standards does not include interest earned on deposits, insurance settlements, rents, rebates, and some income from ancillary operations. These types of revenue are now termed non-contract revenue. The recognition of non-contract revenue has not changed from current practice.
Step 4: Determining how the Presentation of Revenue from Contracts and Other Financial Information will be Different than the Current Presentation
To accommodate the required changes in the presentation of revenue from contracts, associations will need to create at least two new general ledger accounts.
- Contract Liabilities will be used to account for reserve assessments and special assessments that have not been spent on the obligation for which they were assessed.
- Contra Revenue will be used to adjust the value of operating assessments revenue. The account will be a revenue account with a normal debit balance.
- Contract Assets account can be created and used if appropriate. One example of this would be amounts owners were underbilled for property taxes in a timeshare association.
Any excess or deficit in net operating revenues and expenses is retained in the operating fund, similar to the current accounting treatment. No changes in the presentation of the operating fund balance are required.
Reserve assessment revenue will be recognized when the obligation for which they were assessed is fulfilled. Unspent reserve assessment revenue will be presented as contract liabilities on the balance sheet. A reclassification of the pre-ASC 606 replacement fund balance will most likely be required. Management will need to consider what portion of the prior period’s ending replacement fund balance is contract revenue and reclassify that portion to the new contract liabilities account. As stated previously, interest earned as well as transfers from operating to reserve funds are not considered contract revenues and will most likely be retained in the replacement reserve fund unless these amounts are considered to be spent from the reserve fund in prior years.
Timing for recognition of special assessment revenue will depend on the purpose of the special assessment. Management should consider the nature and purpose of special assessments. A few examples: a) special assessments budgeted to repay an interfund balance will be recognized in the period in which they are assessed, b) special assessments budgeted to pay for a major repair will be recognized when that repair occurs, or c) special assessments budgeted to accumulate more reserve funds, will be posted to contract liabilities.
Step 5: Implementing Steps to Transitioning Accounts and Reporting as Required by ASC 606
Replacement Fund Balance/Contract Liabilities
The most significant change is the reclassification of contract liabilities from the prior period’s replacement fund. The amount reclassified will depend on the types and amounts of revenue and amount of expenses recognized in prior periods. The easiest scenario, and one that will be true for most associations is one in which the Association has had only reserve assessments and interest income posted to their financial statements in the past and total expenditures in the replacement fund exceeds total interest. In that case, the Association may assume that all non-contract revenue such as interest was spent before member assessments and the entire balance will be reclassified to contract liabilities. The following are two examples showing the reclassification of contract liabilities from the replacement fund balance.
Example 1: The fund balance as of December 31, 2018 consists of accumulated assessments of $500,000, interest income of $2,500, and expenditures of $15,000.
|Fund balance as of December 31, 2018||$ 487,500|
|Reclassified to contract liability||(487,500)|
|Restated fund balance as of December 31, 2018||$ –|
|Contract liabilities||$ 487,500|
Example 2: The fund balance as of December 31, 2018 consists of accumulated assessments of $100,000, interest income of $1,000, and expenditures of $0.
|Fund balance as of December 31, 2018||$ 101,000|
|Reclassified to contract liability||(100,000)|
|Restated fund balance as of December 31, 2018||$ 1,000|
|Contract liabilities||$ 100,000|
Journal Entries for Recording and Recognizing Assessments
Operating assessments are recognized in the period in which they are budgeted and assessed. Reserve assessments are recognized in the period in which the promised obligation occurs (management will need to decide whether it wishes to spend non-contract income on expenditures before contract revenue). Following are two examples of accounting entries for recognizing assessment revenue.
Example 1: Monthly budgeted assessments are $4,000, $3,500 for operating and $500 for reserves, and the Association does not expect to collect from one owner whose unit is going into foreclosure. That unit’s assessments are $60 per month.
|Allowance for doubtful accounts receivable||(60)|
Example 2: A major repair occurred that cost $7,000. The Association has earned and recognized interest of $80 YTD. The $7,000 will be expensed in the replacement reserve fund. The $80 is a part of the replacement reserve balance because it was not considered contract revenue and was not recorded as a contract liability. The Association wishes to spend interest income first.
For calendar years, the year ended December 31, 2019 will be the first year ASC 606 is required to be implemented for homeowner associations. As a result, we expect there may be questions from management companies, Boards and other professionals. Schwindt & Co has performed extensive research on ASC 606 and will be pleased to help with understanding the new requirements as well as implementation issues.
Schwindt & Company: (503) 227-1165