According to the Financial Accounting Standards Board (FASB), “Revenue should be recorded when the revenue-generating process has been completed, or when it has been earned, rather than when the payment of revenue is actually received”.
This process can be very critical for a real estate leasing business, because the rental payment can be based on the terms between the lessor and lessee, but the recognition has to be based on above rule.
Challenges in revenue accounting
- Standard functionality in most of the commercial off-the-shelf (COTS) products support only fixed type recognition, which is derived from defined lease duration. This model will effectively work when the lease starts on the first day of the month and runs for a defined period, but not for ad hoc ones.
- In the Middle East region, majority of leased contracts based on Arabic (Hijri) calendar is not supported by most of the COTS products, including Oracle. Since number of days in Hijri calendar will be 354/355, there is a risk of lease amount getting wrongly calculated.
This blog focuses on revenue recognition model for real estate business and also caters to regional requirements in Middle Eastern countries, where billing schedule of lease contracts is based on Hijri calendar.
How to Choose a Right Product?
An ideal way is to use a single product which has the ability to handle all the requirements listed above. Multiple products can also be used to manage, provided an integration is built for seamless flow of data covering the following business functions:
- New asset development/purchase and depreciation calculation
- Ability to classify the asset as a translatable unit (building, floor, and unit etc.)
- Establish a legal contract with the customer
- Billing schedule for lease rental collection from the customer on agreed intervals
- Recognize the lease revenue accounting based on financial standards
- Asset maintenance and accounting the same against the asset to ascertain the product profitability
- Capitalize major maintenance expenses made on the assets
- Generate overall financial statements
Oracle ERP is an ideal product which has the capability to map all the above functions using modules such as purchasing, accounts payables, accounts receivables, fixed assets, general ledger, property manager and enterprise asset management. It also has the provision to develop solutions to address the challenges in revenue accounting.
- Revenue recognition on a daily basis irrespective of the lease term and period will be an efficient model. Based on the selected COTS product, revenue recognition must be designed and inserted when the lease data is interfaced from the leasing to the billing system. This is the logic for deriving revenue recognition rule start date and rule end date based on the rent collection frequency (monthly, quarterly, semiannually, annually, and one time).
For instance, if lease contract starts on 25-Jan-2020 and ends on 5-Sep-2020 with lease amount of USD 10000, payable on 25th Jan, 2020. For this case the revenue needs to be realized only for seven days in Jan-2020 (25th to 31st Jan) and five days in Sep-2020 (1st to 5th Sep).
- For Hijri dates, an additional extension is executed after the billing schedule is created by the standard product. This will revise the number of schedules and the start date of each billing line based on the Hijri calendar.
For instance, the lease contract might start on 20-Jan-2019 and end on 5-Jan-2020, which is considered as one year per Hijri calendar, with an annual lease amount for USD 12000, paid every month. As a standard process the system will calculate the rent based on Gregorian dates and since the number days is less than a year, the system will prorate 12000 and recalculate the rent when the standard billing is scheduled. This need to be overwritten by the custom extension will create 12 payment schedules with USD 1000 each, based on Hijri months.
This solution has been successfully implemented for a two-billion-dollar business conglomerate based in Saudi Arabia. The selected product was Oracle EBS Suite and the extensions were built on top of that to address the following key business challenges:
- The business has a practice of creating lease contract based on both Gregorian and Hijri calendar
- Ad hoc lease dates were used in the contracts. For example, when the lease starts on 25th of a month the first invoice should be for one month considering the occupancy period as 25th of current first month to 24th of subsequent month
- Lease revenue accounting should be done at the end of each Gregorian month based on the number of days the property was occupied by the tenant, even if the contract is based on Hijri
- For Hijri contracts the billing schedule should follow the Hijri calendar and not on the schedule date in lease contract, which is static