Currently, there is no separate Accounting Standard (AS) in India for recognition of revenue from real estate sale transactions and accordingly, in practice, the accounting and reporting for such transactions has historically been based on certain principles specified in AS 9, Revenue Recognition and AS 7, Construction Contracts, as supplemented by the Guidance Note (2006 GN) on Recognition of Revenue by Real Estate Developers, which was issued by the Institute of Chartered Accountants of India (ICAI) in June 2006.
The 2006 GN of ICAI required certain principle based conditions (risk and reward of ownership and effective control being transferred, revenue being measurable and no significant uncertainty on ultimate collection) and specific conditions (price risk being transferred to the buyer, and buyer being able to transfer right in the property during construction period) to be met before any revenue is recognized from real estate transactions. These principle based conditions have resulted in diversity in practice since these principles are interpreted and applied very differently by different real estate developers in deciding and applying their accounting policies. The increase in complexity of real estate transactions have also contributed to the increased diversity. This article discusses some of the diverse practices.
Method of revenue recognition
While most listed real estate developers recognize revenue based on the Percentage of Completion (POC) method, several unlisted developers follow the completed contract method. This decision is largely driven by tax considerations. Companies following the POC method determine the stage of completion at every reporting period and recognize project revenue and costs based on that. As against that, companies that follow the completed contract method generally accumulate project costs as ‘work in progress’ in their balance sheet and recognize project revenue and profits only when the construction is complete and possession is handed over to the buyers.
Point of revenue recognition
Diversity exists even in application of the POC method. For example, most real estate companies have set minimum thresholds for recognition of revenue and costs under POC. Accordingly, no project revenue and profits get recognized in profit and loss until these thresholds are met. The percentages used as minimum threshold by companies differ considerably and may range from 20 percent to 35 percent. Thus, for a similar project, Company A may recognize revenues when 20 percent of the project is complete, while Company B may not recognize revenues until 35 percent of the project is complete.
Determination of percentage completion
This is another area of diversity. Some companies consider cost of land, development rights and borrowing costs as costs incurred to determine the POC, while others only consider actual construction costs. Further, some companies recognize administrative and general overheads as period costs and charge them to profit and loss account, while others recognize them as project costs and include them in application of the POC. Lastly, while most companies capitalize borrowing costs as part of the project costs, a few companies charge them to profit and loss as incurred.
Sale of undivided interest in land
Some companies treat the sale of undivided interest in land as a part of the overall contract for sale of the apartment unit, and hence apply the completed contract or POC method as discussed above to the total revenues from the customer. Other companies treat the undivided interest as a separate component and recognize the sale value of this component upfront even though construction of the apartment may span over a long period.
Because of the above diversity the users of financial statements, right from retail investors to institutional investors often struggle in interpreting or comparing the financial statements of companies in this sector. Lack of specific disclosures on the application of policies has also added to the uncertainty. Most companies generally disclose broad accounting policies and do not address specific application policies.
To achieve uniformity in the above areas, the ICAI issued a revised GN on Accounting for Real Estate Transactions (revised GN) in February 2012. The revised GN mandates the application of the POC method in most cases and gives certain ‘bright-lines’ for determining the eligibility of real estate transactions for revenue recognition. The revised GN applies to real estate projects where revenues have not been recognized prior to 1 April 2012.
Even though the revised GN has its own implementation challenges and is inconsistent with the IFRS converged standards announced by the Ministry of Corporate Affairs, the revised GN is expected to reduce the current diversity in accounting practices. It is now up to all stakeholders (companies, auditors, investors and regulators) to ensure and monitor that the principles of the revised GN are being correctly applied in practice. A final determination of the tax treatment in this area (through the issuance of the proposed Tax Accounting Standards) may also reduce diversity.