Conversion to international financial reporting standards: The RP experience

Second of three parts) Concerns on revenue recognition for sale of property units under pre-completion contracts

( A number of real estate developers expressed concern on the revenue recognition for the sale of property units under pre-completion contracts. A strict interpretation of PAS 18, Revenue, will result in recognizing revenue only when the project is completed. The present practice of income recognition is based on percentage of completion. The change will negatively affect the reporting of some listed real property developers. The Philippine Interpretations Committee recently issued an interpretation, in a question and answer format, to address this matter and decided that recognizing revenues based on the percentage of completion of the projects under construction will still be allowed when all of the following conditions are met:

(a) equitable interest is transferred to the buyer;

(b) the seller is obliged to perform significant acts;

(c) the amount of revenue can be measured reliably;

(d) the costs incurred or to be incurred can be measured reliably; and

(e) it is probable that the economic benefits will flow to the entity.

Regulatory arbitrage

The Securities and Exchange Commission (SEC) also had to be mindful of how other regulators have ruled for financial products which are competing with the products of companies under SEC supervision. The SEC did this for the mutual fund industry which offers products similar to the common trust funds (CTFs, now called UITFs). Since the BSP had earlier allowed CTFs to use amortized cost or accrual valuation up to September 30, 2006, the SEC allowed the mutual fund industry to do the same in order to level the playing field. As you are aware PAS 39, Financial Instruments: Recognition and Measurement, which requires marked-to-market valuation for these types of products was effective as of January 1, 2005 so these rulings, in effect, delayed the effective date for this industry.

Tainting rule

Due to national interest, the SEC liberalized the tainting rule applicable to Held-to-Maturity (HTM) financial instruments under PAS 39 for the Exchange Bond program of the Philippine Government. Under that standard, if more than an insignificant portion of instruments classified under HTM is sold or disposed of, the whole HTM instruments will be tainted and therefore will be reclassified to "available for sale". Accordingly, these instruments will be marked-to-market, hence, subject to the volatility of the market. Companies generally prefer the HTM category due to the resulting predictability of earnings. To apply this tainting rule to the letter would have discouraged a lot of investors from participating in the Exchange Bond program which had the laudable objective of grouping the government bonds into bigger lots to increase their liquidity and therefore, their market value. The SEC exempted the Exchange Bond program from the tainting rule and we now know it was successful.

Hedging and derivative transactions of mining companies

Prior to IFRS, there was no single framework on accounting for hedging and derivative transactions. Companies had different treatments for these financial instruments. Some would treat these financial instruments on off-balance sheet basis with limited disclosures in the notes to the financial statements. Some would recognize these transactions on the basis of prevailing market spot rates/prices, and still others would follow rules similar to US accounting standards which require marking to fair value. On the other extreme are the companies that only recognize these derivatives on settlement date, without any accounting or disclosures during the periods when these were outstanding. This divergence in accounting practices rendered the financial statements of these companies less comparable and transparent to the end-users, and prone to surprises because of off-balance sheet gains and losses that were sometimes very significant.

PAS 39 became effective on January 1, 2005 and required that all derivative contracts (whether used for hedging or trading) to be accounted for at fair value with any fair value changes taken directly to profit and loss unless special hedge accounting rules are complied with. This fair value treatment introduced unanticipated volatility and caught certain mining companies off guard, especially for those with long-term hedging contracts entered into prior to January 1, 2005. (To be continued)

(Roberto G. Manabat is the chairman and CEO of Manabat Sanagustin & Co., CPAs, a member firm of KPMG International, a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG international or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. For comments and inquiries, please email [email protected] or [email protected])