As Indian companies get poised to converge with IFRS in April
2011, some of the sectors may witness significant changes in the financial
statements used for reporting their performance to various stakeholders. The
foremost amongst them is the real estate industry. This article seeks to discuss
these changes and their related impact in greater detail.
Revenue recognition :
Generally, developers start marketing the project before
construction is complete or perhaps, even before construction has started.
Buyers enter into agreements to acquire a spe+cific unit within the building on
completion of the construction. The contracts may require the buyer to pay a
deposit and progress payments, which are refundable only if the developer fails
to complete and deliver the unit.
Under IFRS, IFRIC 15 Agreements for the Construction of
Real Estate provides detailed guidance on recognition of revenue from real
estate contracts. Under the Indian GAAP, the matter is currently dealt through
the Guidance Note on Accounting for Real Estate Developers issued by the
Institute of Chartered Accountants of India (‘ICAI’).
There are significant differences between the accounting
recommended under the two pronouncements.
Under the Indian GAAP, the ICAI Guidance Note permits the
real estate development contracts to be accounted on percentage of completion
method.
Accounting for real estate construction arrangements under IFRS
An agreement for construction of real estate can be accounted
as :
(a) Construction contract, which is within the scope of
IAS 11 on construction contracts; or
(b) Sale of goods and service, which is within the scope
of IAS 18 on revenue recognition.
An agreement for construction of real estate meets the
definition of a construction contract when the buyer is able to specify major
structural elements of the design of the real estate before construction begins
and/or specify major structural changes once construction is in progress
(whether or not it exercises that ability). In such cases, IAS 11 on
construction contracts applies.
In contrast, an agreement for construction of real estate in
which buyers have only limited ability to influence the design of the real
estate, e.g., to select a design from a range of options specified by the
entity, or to specify only minor variations to the basic design, is an agreement
for sale of goods within the scope of IAS 18. IAS 18 prescribes the following
criteria for revenue recognition — Revenue from the sale of goods shall be
recognised when all the following conditions have been satisfied :
(a) the entity has transferred to the buyer the
significant risks and rewards of ownership of the goods;
(b) the entity retains neither continuing managerial
involvement to the degree usually associated with ownership, nor effective
control over the goods sold;
(c) the amount of revenue can be measured reliably;
(d) it is probable that the economic benefits
associated with the transaction will flow to the entity; and
(e) the costs incurred or to be incurred in respect of
the transaction can be measured reliably.
An analysis of general agreements for sale of real estate in
India shows that the buyers have only limited ability to influence the design of
the real estate, in fact they have no influence over the basic design/layout of
the building/apartment. Hence the sale would generally fall under IAS 18
principles as an agreement for sale of goods.
There could be two scenarios under sale of goods :
Determining continuing managerial involvement :
At the time of signing the provisional letter of allotment or
the agreement for sale, generally the seller has significant pending acts to
perform for completion of its obligations to deliver the apartment. All
decisions related to construction are with the seller and also, the construction
risk is to the account of the seller. This indicates continuing managerial
involvement in the property.
Determining transfer of risks and rewards :
The following indicators in real estate sale agreements
demonstrate that the risk and rewards of ownership are not continuously
transferred to the buyer :
— If the agreement is terminated before completion of the
construction by the buyer, the buyer does not retain the work-in-progress
and the developer does not have the right to be paid for the work performed.
The developer has to refund the money received from the buyer.
— The agreement does not give the buyer the right to take
over the incomplete property in case of default by the developer or
otherwise.
These indicate that the seller effectively retains control
and has continuing managerial involvement over the flats until possession is
transferred.
Hence the completed contract method will have to be applied
and revenue shall be recorded in its entirety on transfer of possession.
Construction costs incurred will be carried in the books of the developer as
work-in-progress under ‘Inventory’.
Difference from accounting for construction contracts :
As discussed above, determining whether an agreement for the
construction of real estate is within the scope of IAS 11 or IAS 18 depends on
the terms of the agreement and all the surrounding facts and circumstances. Such
a determination requires judgment with respect to each agreement.
IAS 11 applies when the agreement meets the definition of a construction contract set out in paragraph 3 of IAS 11: ‘a contract specifically negotiated for the construction of an asset or a combination of assets ….’ An agreement for construction of real estate meets the definition of a construction contract when the buyer is able to specify major structural elements of the design of the real estate before construction begins and/ or specify major structural changes once construction is in progress (whether or not it exercises that ability).
One view could be that IAS 11 should apply to all agreements for the construction of real estate. In support of this view, it is argued that:
a) these agreements are in substance construction contracts. The typical features of a construction contract — land development, structural engineering, architectural design and construction — are all present
b) IAS 11 requires a percentage of completion method of revenue recognition for construction contracts. Revenue is recognised progressively as work is performed. Because many real estate development projects span more than one accounting period, the rationale for this method — that it ‘provides useful information on the extent of contract activity and performance during a period’ (IAS 11 paragraph 25) — applies to real estate development as much as it does to other construction contracts. If revenue is recognised only when the IAS 18 conditions for recognising revenue from the sale of goods are met, the financial statements do not reflect the entity’s economic value generation in the period and are susceptible to manipulation.
In reaching the consensus that IAS 11 should apply only when the agreement meets the definition of a construction contract and apply IAS 18 when the agreement does not meet the
definition of a construction contract, the IFRIC noted that:
a) the fact that the construction spans more than one accounting period and requires progress payments are not relevant features to consider when determining the applicable standard and the timing of revenue recognition;
b) determining whether an agreement for the construction of real estate is within the scope of IAS 11 or IAS 18 depends on the terms of the agreement and all the surrounding facts and circumstances. Such a determination requires judgement with respect to each agreement. It is not an accounting policy choice;
c) IAS 11 lacks specific guidance on the definition of a construction contract and further application guidance is needed to help identify construction contracts.
The IFRIC concluded that the most important distinguishing feature is whether the customer is actually specifying the main elements of the structural design. In situations involving the sale of real estate, the customer generally does not have the ability to specify or alter the basic design of the product. Rather, the customer is simply choosing elements from a range of options specified by the seller or specifying only minor variations to the basic design. The IFRIC decided to include guidance to this effect in the Interpretation to help clarify the application of the definition of a construction contract.
Currently under the Indian GAAP, guidance note on recognition of revenue by real estate developers states that revenue can be recognised once significant risks and rewards are transferred. In case of real estate sales, price risk is considered as the most significant risk; and the buyer has the right to sell or transfer his interest in the property without any conditions or with immaterial conditions attached. Thus under the current scenario, revenue from real estate sales can be recognised on the completion of an agreement for sale, even though the legal title or possession has not been delivered.
Consolidation of land acquisition companies:
Real estate companies in India are regulated under the Land Ceiling Act, 1976, which fixes a maximum limit on the area of land that may be owned by one company. To overcome these restrictions, real estate companies float various special purpose entities (SPEs) that purchase land from the market. A real estate company may have differing arrangements with SPEs. These arrangements would have to be closely evaluated and in light of SIC Interpretation 12 Consolidation — Special Purpose Entities.
In certain cases, real estate companies directly or indirectly hold 100% or majority share capital of such SPEs and/or have majority representation on their board of directors. However in other cases, the share capital of SPEs, which is generally a small amount, is held by a third party that also controls the governing body of the SPE. In such cases, the real estate companies are involved with the SPE in various other ways, such as provision of finance to carry out the activities, exclusive rights to develop land, provide guarantee against finance taken by SPEs, guarantee minimum return to the shareholders and/or enter contract, which may restrict the decision-making powers of SPE.
Under the Indian GAAP, companies consolidate only those entities where they directly or indirectly hold majority share capital and/or have majority representation on the board of directors or other governing bodies. However, under IFRS a special purpose entity may have to be consolidated even in cases where a company is not holding majority share or controlling the composition of the governing board of the SPE on account of certain arrangements like provision of finance to carry out the activities, exclusive rights to develop land, etc. which may be indicative of a control. As per SIC 12, the following circumstances, for example, may indicate a relationship in which an entity controls an SPE and consequently should consolidate the SPE?:
a) In substance, the activities of the SPE are being conducted on behalf of the entity according to its specific business needs, so that the entity obtains benefits from the SPE’s operation.
b) In substance, the entity has the decision-making powers to obtain majority of the benefits of the activities of the SPE or, by setting up an ‘autopilot’ mechanism, the entity has delegated these decision-making powers.
c) In substance, the entity has rights to obtain majority of the benefits of the SPE and therefore may be exposed to risks incident to the activities of the SPE.
d) In substance, the entity retains majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities.
Upon transition to IFRS, real estate companies will need to evaluate their relationship with SPEs based on the criteria laid down in SIC 12. Further, real estate companies will also need to examine whether such consolidation may have any legal or other implications.
Structured financing arrangements:
Structured financing arrangements for entities floated by real estate companies for projects, would need to be closely evaluated to identify the substance of the transaction; and accounting will have to reflect this underlying substance. For example, instruments issued for which the entity has an obligation to pay cash would need to be classified as debt and the underlying committed returns or fluctuations in the value of such instruments would have to be recorded in the income statement. This would also increase the volatility of the reported earnings and reduce reported profits.
Impacts of change in financial reporting framework on other operational areas:
Executive compensation plans:
Some real estate companies pay commissions/ variable incentives to employees based on sales or profits. Given the impact of IFRS, there will be a high degree of volatility in the reported revenues and reported profits of companies, thereby impacting these compensation plans. Further in case of payments to directors, which in India is limited to a specified percentage of profits, companies will need to address the impact on managerial remuneration due to insufficient profits in the period when construction activity is ongoing but possession is not transferred, though companies would have positive cash flows.
Tax:
Another important area which deserves attention is the impact on the tax liability for a company due to the change in the accounting framework with special emphasis on changes in revenue recognition. It will be important to understand whether tax authorities will recognise profits under IFRS as taxable profits and thereby postpone the tax incidence till the possession of the property is transferred. Alternatively, the authorities may require the companies to recompute revenue using percentage of completion method for tax purposes. Further, interplay between the minimum alternate tax (MAT) provisions and the reported profits under IFRS would be equally important.
Debt covenants:
In preparing its first IFRS financial statements, an entity recognises all assets and liabilities in accordance with the requirements of IFRS, and derecognises assets and liabilities that do not qualify for recognition under IFRS. Further, the entity would have to reclassify items that it recognised in accordance with previous GAAP as one type of asset, liability or component of equity, but are a different type of asset, liability or component of equity in accordance with IFRS.
This may impact various business ratios like gearing, liquidity and profitability ratios of a first-time adopter. Further, a reclassification of a long-term loan as current due to, say, a default in meeting any covenant (example business ratios) may impact debt covenants of other loans. In extreme situations, it may even impact the company’s ability to continue as a going concern. It would be therefore pertinent to conduct a detailed examination of the various loan and borrowing agreements and identify the covenants which may be impacted by the transition. An early discussion with the lenders of funds around these areas would go a long way in avoiding last minute surprises.
Conclusion:
As convergence with IFRS is inevitable, the key now lies in getting this transition right. The most important factors for real estate companies would be educating their stakeholders including investors, bankers and align internal budgets and performance measurement matrices. Companies would have to closely examine various debt covenants and clearly identify the ones which may be impacted due to the transition and discuss the same with their financiers/ bankers. At the same time, it will have to sensitise the market participants with respect to the unique impact of certain standards on the industry. This in turn would help to realign the valuation matrices based on the different set of accounting policies that will be used by these companies to report their performance results. Given the aforesaid implications, an early start towards the convergence process is pertinent for both preparers and users of financial statements to understand the impact on how the financial performance will be reported going forward.
