Revenue Recognition by Real Estate Developers — An Important carve-out in Ind-AS

The GN should be applied to all transactions in real estate commencing or entered into on or after 1st April 2012. The GN also gives an early adoption option, provided that it is applied to all transactions commencing on or were entered into on or after the earlier adoption date.

This GN mandates the application of POC method [as defined in Accounting Standard (AS) 7, Construction Contracts] in respect of real estate transactions where the economic substance is similar to construction-type contracts. It gives the following indicators for determining if the economic substance of the transactions is similar to construction type contracts:

(a) The period of such projects is in excess of 12 months and the project commencement date and project completion date fall into different accounting periods.

(b) Most features of the project are common to construction-type contracts, viz., land development, structural engineering, architectural design, construction, etc.

(c) While individual units of the project are contracted to be delivered to different buyers these are interdependent upon or interrelated to completion of a number of common activities and/or provision of common amenities.

(d) The construction or development activities form a significant proportion of the project activity.

The GN also specifies that the POC method is applied only when all the following conditions are fulfilled:

(a) All critical approvals necessary for commencement of the project have been obtained;

(b) When the stage of completion reaches a reasonable level of development. Rebuttable presumption — reasonable level is not achieved if the expenditure incurred on project costs is less than 25% of the construction and development costs;

(c) At least 25% of the estimated project revenues are secured by contracts or agreements with buyers; and

(d) At least 10% of the total revenue as per the agreements of sale or any other legally enforceable documents are realised at the reporting date.

Therefore, companies need to assess the eligibility of individual project based on the above parameters at each reporting period before any revenue can be recognised from them. Unless and until all the above conditions are met, revenue cannot be recognised from a project. In the calculation of stage of completion of 25% for point (b) above, only actual construction costs can be included and other costs (i.e., cost of land and development rights and borrowing costs) are excluded. Hence, the GN focusses on actual physical construction activities rather than costs. However, this calculation of stage of completion is only for determining if the project is an eligible project for revenue recognition. Once it is determined that a particular project is an eligible project, revenue can be recognised based on a POC calculation that is different from the calculation done for deciding eligibility. Put differently, revenue recognition can be based on a higher POC, calculated by taking total actual costs including cost of land and development rights. While this is not explicitly mentioned in the GN it is coming out from the illustration appended to the GN.

The GN also puts an additional overall restriction on recognition of revenue when there are outstanding defaults in payment by customers. It says that the recognition of revenue by reference to POC should not at any point exceed the estimated total revenue from eligible contracts. Eligible contracts for this purpose are those meeting the above four POC criteria plus where there are no outstanding defaults of the payment terms. The GN does not define ‘outstanding default’ and hence, a question arises if the ‘outstanding default’ to be determined as at the period ends only or post balance sheet payments should also be considered? For example, there was a default in payment by a customer before the period end, but the customer has paid and regularised the account post the period end before the financial statements approved. It is not clear from the GN whether this will be considered as an ‘outstanding default’ as at the period end.

Example
ABC Limited is in the business of real estate development and sale. On 1st April 2010, ABC started a project to construct and sell 100 flats of 1,000 sq.ft. each. Cost of construction, including directly attributable costs is Rs.3,000 per sq.ft. Cost of land and development right is Rs.30 crore. Actual figures for the year ended 31st March 2011 are given in Table 1:

In case there were defaults in payment by 10 flat holders out of the total 30, the additional computation shown in Table 3 is to be done to determine if the revenue recognition of Rs.15.24 crore is appropriate.

Since the revenue as per the POC workings of Rs.15.24 crore is higher than the estimated total revenue from eligible contracts of Rs.14 crore, revenue recognition should be restricted to Rs.14 crore and correspondingly cost of projects to be recognised in the profit and loss should also be adjusted.

This guidance note will enhance consistency in the accounting practices of real estate developers and in particular the application of the percentage completion method. This however remains a very important ‘carve-out’ and will have a significant impact on companies who wish to prepare and report their financial statements under IFRS.

Editor’s Note: It is understood that the Guidance Note on Recognition of Revenue by Real Estate Developers has been finalised and is expected to be issued shortly.