Accounting for real estate construction under Indian GAAP was covered
under the Guidance Note on Accounting for Real Estate Transactions
(Revised 2012). Under Ind AS real estate construction accounting is
specifically scoped into Ind AS 11 Construction Contracts. In this
article, Dolphy D’Souza discusses the similarities and dissimilarities
of accounting between the Guidance Note and Ind AS 11.
Scoping – Ind AS 18 or Ind AS 11?
Under
IFRS, IFRIC Interpretation 15 Agreements for the Construction of Real
Estate deals with accounting of real estate contracts. Determining
whether an agreement for the construction of real estate is within the
scope of IAS 11 (Ind AS 11) Construction Contracts or IAS 18 (Ind AS 18)
Revenue depends on the terms of the agreement and all the surrounding
facts and circumstances. Such a determination requires judgement 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 the construction
of real estate meets the definition of a construction contract when the
buyer is able to specify the 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). Thus, a customer may ask a real estate
contractor to construct a villa (a) on a land owned by the customer and
(b) as per design and specification approved by the customer. The
customer controls the work-in-progress on an ongoing basis, and can
generally sack the contractor (albeit by payment of penalty) and hire a
new contractor. In situations such as this, the contractor will have to
apply IAS 11.
In contrast, an agreement for the 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 the sale of goods within the scope
of IAS 18. The entity may transfer to the buyer control and the
significant risks and rewards of ownership of the work in progress in
its current state as construction progresses. In this case, if all the
criteria in paragraph 14 of IAS 18 are met continuously as construction
progresses, the entity shall recognise revenue by reference to the stage
of completion using the percentage of completion method. The
requirements of IAS 11 are generally applicable to the recognition of
revenue and the associated expenses for such a transaction. The entity
may transfer to the buyer control and the significant risks and rewards
of ownership of the real estate in its entirety at a single time (e.g.
at completion, upon or after delivery). In this case, the entity shall
recognise revenue only when all the criteria in paragraph 14 of IAS 18
are satisfied. Thus, consider a scenario where a real estate developer
own a piece of land in which it constructs a building with about 100
flats. In this scenario, the risk and rewards are transferred to the 100
customers, when the building construction is complete and the flats are
ultimately delivered to the customers. It is inconceivable that the
risk and rewards are transferred to the 100 customers on an ongoing
basis. If that was the case, each customer would own the work in
progress and have the ability to hire another contractor to construct
his/her individual flat. That is neither legally nor practically
possible, for example, it is not possible that 100 different contractors
representing 100 different customers could possibly complete the
construction of the building.
In the Indian situation,
considering the demand of the real estate developers the standard
setters decided to carve out IFRIC 15. Further, a real estate contract
was specifically scoped in Ind AS 11. In accordance with Ind AS 11
Construction Contracts, the standard would apply to accounting in the
financial statements of contractors including the financial statements
of real estate developers. The definition of construction contracts in
Ind AS 11 also includes agreement of real estate development to provide
services together with construction material in order to perform
contractual obligation to deliver the real estate to the buyer.
Thus,
real estate construction contracts would be accounted for in accordance
with Ind AS 11, like any other construction contract. Therefore, in the
above example, the sale of 100 flats would be treated like a
construction contract to be accounted for using the percentage of
completion method (POCM) rather than accounting for them as sale of
goods, wherein, revenue is recognised when the completed flat is
ultimately delivered to the customer.
The carve in to Ind AS 11
is somewhat nebulously drafted. As per this carve in, Ind AS 11 would
apply to accounting in the financial statements of contractors including
the financial statements of real estate developers. Does that mean Ind
AS 11 would apply to contractors other than real estate contractors
also? For example, it is not absolutely clear, whether Ind AS 11 or Ind
AS 18 would apply to construction of a standard equipment such as a ship
or aircraft or windmill. The author believes that Ind AS 18 should
apply to these items, since the buyer is unable to specify the major
structural elements of the design of the equipment before construction
begins and/ or specify major structural changes once construction is in
progress whether or not it exercises that ability. In other words, the
author believes that the above items should be treated like a sale of
goods. This can also be supported by the intention of the ICAI to allow
construction contract accounting to real estate development only.
Ind AS 11 vs Guidance Note on Accounting for Real Estate Transactions (Revised 2012)
On
account of the diverse practices under Indian GAAP, the ICAI felt it
necessary to issue a revised Guidance Note titled Guidance Note on
Accounting for Real Estate Transactions (Revised 2012) to harmonise the
accounting practices followed by real estate companies in India. Under
Ind AS 11, accounting for real estate development would be accounted for
as a construction contract in accordance with Ind AS 11. An interesting
point to note is that the requirements of Ind AS 11, may or may not be
the same as those contained in the Guidance Note. This section deals
with some critical areas of similarities and differences that exist
between Ind AS 11 and the Guidance Note. Under both Ind AS 11 and the
Guidance Note, completed contract method would be prohibited. However,
there are significant dissimilarities in the way POC method is applied.
Question 1: Is the scope of the Guidance Note and Ind AS 11 the same?
The
revised Guidance Note would apply to any enterprise dealing in real
estate as sellers or developers. The term ‘real estate’ refers to land
as well as buildings and rights in relation thereto. The Guidance Note
provides an illustrative list of transactions which are in scope. The
Guidance Note applies not only to development and sale of residential
and commercial units, row houses, independent houses, with or without an
undivided share in land, but to many other real estate transactions.
These are sale of plots of land with or without any development. The
development may be in the form of common facilities like laying of
roads, drainage lines, water pipelines, electrical lines, sewage tanks,
water storage tanks, club house, landscaping etc. The sale of plots of
land, include long term sale type leases. What is a long term sale type
lease is not defined. Typically a 99 year lease would generally fulfill
the definition of a sale type lease. However, whether a 50 year lease
would be a sale type lease is a matter of conjecture and judgment will
have to be applied. However, the principles that would be used to apply
the judgment are not contained in the Guidance Note. In the author’s
view, conditions that establish whether a lease is a finance lease or
operating lease may serve as a good basis for making that decision. For
example, in the case of a 99 year lease, if the present value of the
minimum lease payments is atleast 90% or higher of the fair value of the
land, it could be construed, subject to other requirements that the
lease in substance is a sale type lease. Another example, which may be
construed as a sale type lease is a 50 year lease of land, where the
ownership is transferred to the lessee at the end of the lease period.
Whether a lease is a sale type lease or not, will have a significant
impact on the accounting. In the case of a lease, the revenue is
recognised over the lease period; whereas in a sale type lease the
revenue is accounted for when the sale type lease is executed.
The
revised Guidance Note also scopes in the acquisition, utilisation and
transfer of development rights, redevelopment of existing buildings and
structures and joint development agreements for real estate activities.
Other
than scoping in joint development agreements, the revised Guidance Note
does not provide any guidance on how to account for such agreements.
Real estate transactions of the nature covered by Accounting Standard
(AS) 10, Accounting for Fixed Assets, Accounting Standard (AS) 12,
Accounting for Government Grants, Accounting Standard (AS) 19, Leases,
and Accounting Standard (AS) 26, Intangible Assets, are outside the
scope of the Guidance Note. For example if a real estate contract was
being constructed for own administrative use, AS-10 principles rather
than this Guidance Note would apply. Similarly short-term leasing of
real estate would be covered by AS-19; however, a long term sale type
lease would be covered under the Guidance Note.
Ind AS 11 would
apply to accounting in the financial statements of contractors including
the financial statements of real estate developers. Under Ind AS 11,
there is no definition of what constitutes a real estate developer or
real estate development. Generally, the guidance in the Guidance Note
with respect to scoping may be used for Ind AS 11 purposes.
Question 2: How are transactions which are in substance delivery of goods accounted for under Ind AS and the Guidance Note?
Requirement under the Guidance Note
In
respect of transactions of real estate which are in substance similar
to delivery of goods, principles enunciated in Accounting Standard (AS)
9, Revenue Recognition, are applied. For example, sale of plots of land
without any development would be covered by the principles of AS-9.
These transactions are treated similar to delivery of goods where the
revenues, costs and profits are recognised when the revenue process is
completed. For recognition of revenue in case of real estate sales, it
is necessary that the conditions specified in paragraph 10 and 11 of
AS-9 are satisfied. Those conditions are enumerated below.
10.
Revenue from sales or service transactions should be recognised when the
requirements as to performance set out in paragraphs 11 ……. are
satisfied, provided that at the time of performance it is not
unreasonable to expect ultimate collection. If at the time of raising of
any claim it is unreasonable to expect ultimate collection, revenue
recognition should be postponed.
11. In a transaction involving
the sale of goods, performance should be regarded as being achieved when
the following conditions have been fulfilled:
i. the seller of
goods has transferred to the buyer the property in the goods for a price
or all significant risks and rewards of ownership have been transferred
to the buyer and the seller retains no effective control of the goods
transferred to a degree usually associated with ownership; and
ii.
no significant uncertainty exists regarding the amount of the
consideration that will be derived from the sale of the goods.
In
accordance with the above, the point of time at which all significant
risks and rewards of ownership can be considered as transferred, is
required to be determined on the basis of the terms and conditions of
the agreement for sale. The completion of the revenue recognition
process is usually identified when the following conditions are
satisfied:
(a) The seller has transferred to the buyer all
significant risks and rewards of ownership and the seller retains no
effective control of the real estate to a degree usually associated with
ownership;
(b) The seller has effectively handed over possession of the real estate unit to the buyer forming part of the transaction;
(c) No significant uncertainty exists regarding the amount of consideration that will be derived from the real estate sales; and
(d) It is not unreasonable to expect ultimate collection of revenue from buyers.
Revenue
from sale of lands or plots without any development is recognised when
the above conditions are satisfied. In the case of sale of developed
plots, where the development activity is significant, these would be
treated as transactions which are in substance construction type
contracts and accounted for accordingly. The Guidance Note does not
elaborate further as to when development activity would be treated as
significant or insignificant. This may have a material impact on revenue
recognition in some cases. Consider an example, where at the end of
reporting period a company sells plots of land, which will entail start
and completion of development activity subsequent to the reporting
period. If the development activity is considered significant, entire
revenue will be recognised in the subsequent reporting period, because
the 25% threshold criterion in the Guidance Note for revenue recognition
under POCM will be met only in the subsequent reporting period. If the
development activity is considered insignificant, revenue on the plot
will be recognised in the current reporting period, and revenue on the
development (to be allocated on market value basis) will be recognised
in the following reporting period. Requirement under Ind AS 18/Ind AS 11
Revenue from sale of lands or plots without any development is
recognised like a sale of goods under Ind AS 18. This is similar to the
requirement in the Guidance Note. In the case of sale of developed
plots, where the development activity is significant, these may be
treated in accordance with the Guidance Note which is to treat them as
construction type contracts. However it is questionable whether the 25%
revenue recognition threshold criterion in the Guidance Note would apply
under Ind AS. The author believes that the 25% threshold in the
Guidance Note is not relevant under Ind AS and entities will have to
apply judgement to assess whether the general revenue recognition
criteria are fulfilled.
Question 3: What are in substance
construction type contracts and how are they accounted for under the
Guidance Note and Ind AS?
Requirement in the Guidance Note
In
the case of real estate transaction which has the same economic
substance as construction contracts, the Guidance Note draws upon the
principles enunciated in Accounting Standard (AS) 7, Construction
Contracts and Accounting Standard (AS) 9, Revenue Recognition. Some
indicators of construction type contracts are:
(a) The duration
of such projects is beyond 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 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.
For
example, construction and sale of units in a residential complex would
be covered by the principles of AS-7 and AS-9. The
construction/development of commercial and residential units has all
features of a construction contract – land development, structural
engineering, architectural design and construction are all present. The
natures of these activities are such that often the date when the
activity is commenced and the date when the activity is completed
usually fall into different accounting periods.
In case of real
estate sales, which are in substance construction type contracts, a two
step approach is followed for accounting purposes. Firstly, it is
assessed whether significant risks and rewards are transferred to the
buyer. The seller usually enters into an agreement for sale with the
buyer at initial stages of construction. This agreement for sale is also
considered to have the effect of transferring all significant risks and
rewards of ownership to the buyer provided the agreement is legally
enforceable and subject to the satisfaction of conditions which signify
transferring of significant risks and rewards even though the legal
title is not transferred or the possession of the real estate is not
given to the buyer. After satisfaction of step one, the second step is
applied, which involves the application of the POCM method. Once the
seller has transferred all the significant risks and rewards to the
buyer, any acts on the real estate performed by the seller are, in
substance, performed on behalf of the buyer in the manner similar to a
contractor. Accordingly, revenue in such cases is recognized by applying
the POCM method on the basis of the broad methodology explained in AS
7, Construction Contracts and detailed in the Guidance Note.
Paragraph
3.3 of the 2012 Guidance Note states as follows: “The point of time at
which all significant risks and rewards of ownership can be considered
as transferred, is required to be determined on the basis of the terms
and conditions of the agreement for sale. In the case of real estate
sales, the seller usually enters into an agreement for sale with the
buyer at initial stages of construction. This agreement for sale is also
considered to have the effect of transferring all significant risks and
rewards of ownership to the buyer provided the agreement is legally
enforceable and subject to the satisfaction of conditions which signify
transferring of significant risks and rewards even though the legal
title is not transferred or the possession of the real estate is not
given to the buyer.”
The 2012 Guidance note contains an
anti-abuse clause to prevent companies from recognising revenue in
certain circumstances. Paragraph 3.4 of the Guidance Note states that
“The application of the methods described above requires a careful
analysis of the elements of the transaction, agreement, understanding
and conduct of the parties to the transaction to determine the economic
substance of the transaction. The economic substance of the transaction
is not influenced or affected by the structure and/or legal form of the
transaction or agreement.” Though this appears to be an anti-abuse
clause the full meaning of this paragraph is not clear and hence,
judgement would be required in many situations.
The anti-abuse
clause was more clearly spelt out in paragraph 9 of the 2006 Guidance
Note which required the nature and extent of continuing involvement of
the seller to be assessed to determine whether the seller retains
effective control. In some cases, real estate may be sold with a degree
of continuing involvement by the seller such that the risks and rewards
of ownership are not transferred; for example, this may happen in the
case of a sale and repurchase agreements which include put and call
options, and agreements whereby the seller guarantees occupancy of the
property for a specified period. The anti-abuse clause in the 2012
Guidance Note is more broadly drafted and some may argue that it
encompasses many other situations. For example, a real estate company
may be precluded from considering real estate sales made to related
parties that are not genuine for the purposes of determining whether it
has satisfied the various threshold limits prescribed in the Guidance
Note for recognising revenue.
Paragraph 4.3 of the 2012 Guidance
Note sets out a very interesting perspective on the linkage between the
transfer of a legal title and the transfer of risks and rewards of
ownership. Paragraph 4.3 states “Where transfer of legal title is a
condition precedent to the buyer taking on the significant risks and
rewards of ownership and accepting significant completion of the
seller’s obligation, revenue should not be recognised till such time
legal title is validly transferred to the buyer”. For example, a real
estate company may have entered into a sale contract with a customer, of
a flat in a building that would take two years to complete. The
customer prefers to register the contract and pay stamp duty after two
years at the time of receiving possession of the flat to postpone the
cash outflow and thereby save on interest. On the other hand, another
customer that is availing a bank loan may have to register the sale
deed, pay stamp duty and obtain legal title immediately on entering into
the contract. In the former case, just because the customer is
obtaining legal title only at the time of possession, should not
preclude revenue recognition in the books of the real estate company. In
many cases, legal title would be deemed to be transferred to the
customer on entering into an agreement for sale, and registration with
the local authority may be seen as a formality that could be completed
at a later date. What is important is the agreement for sale, has to be
legally enforceable. In addition to selling to end users, real estate
companies often sell units to investors. In such cases, real estate
companies should be able to recognise revenue as long as there is a
legally enforceable contract between the real estate company and the
investor and the real estate company has no obligation to buy back the
unit or provide any other form of guarantee.
Requirement under Ind AS 11
The
above guidance may be applied under Ind AS 11, as it may not be
inconsistent with the intention of the ICAI. The Guidance Note applies
to projects where the duration of such projects is beyond 12 months and
the project commencement date and project completion date fall into
different accounting periods. There is no such restriction under Ind AS
11, and even projects below 12 months duration may qualify for
“construction type contracts”.
Question 4: For applying POCM how is “project” defined under Ind AS 11 and the Guidance Note?
Requirement under the Guidance Note
Project
is the smallest group of units/plots/saleable spaces which are linked
with a common set of amenities in such a manner that unless the common
amenities are made available and functional, these units/plots /
saleable spaces cannot be put to their intended effective use. The
definition of a project is very critical under the Guidance Note,
because that determines when the threshold for recognising revenue is
achieved and also the manner in which the POCM is applied. In other
words, the manner in which the project is defined by a company may have a
significant impact on the revenue, cost and profit that is recognised.
If the entire township is considered as a project then it is likely that
the threshold limit for recognising revenue is achieved much later as
compared to when each building in the township is identified as a
project.
Consider an example where two buildings are being
constructed adjacent to each other. Both these buildings would have a
common underground water tank that will supply water to the two
buildings. As either of the building cannot be put to effective use
without the water tank, the project would be the two buildings together
(including the water tank). Consider another example, where each of
those two buildings have their own underground water tank and other
facilities and are not dependant on any common facilities. In this
example, the two buildings would be treated as two different projects.
Consider a third variation to the example, where each of those two
buildings has their own facilities, and the only common facility is a
swimming pool. In this example, judgment would be required, as to how
critical the swimming pool is, to make the buildings ready for their
intended use. If it is concluded that the swimming pool is not critical
to the occupancy of either of those two buildings, then each of those
two buildings would be separate projects. Where it is concluded that the
swimming pool is critical to put the two buildings to its intended
effective use, the two buildings together would constitute a project.
The
definition of the term ‘project’ in the Guidance Note is somewhat
nebulous. Firstly, it is defined as a smallest group of dependant units.
This is followed by the following sentence in the Guidance Note “A
larger venture can be split into smaller projects if the basic
conditions as set out above are fulfilled. For example, a project may
comprise a cluster of towers or each tower can also be designated as a
project. Similarly a complete township can be a project or it can be
broken down into smaller projects.” Once the term ‘project’ is defined
as the smallest group of dependant units, it is not clear why the word
‘can’ is used instead of ‘should’. Does it mean that there is a
limitation on how small a project can be, but no limitation on how big a
project could be? In the example, where two buildings are being
constructed adjacently, and each have their own independent facilities
and are not dependant on common facilities, there is a choice to cut
this as either a project comprising two buildings or two projects
comprising one building each. If this is indeed the case, the manner in
which this choice is exercised is not a matter of an accounting policy
choice but rather a choice that is exercised on a project by project
basis.
Requirement under Ind AS 11
The requirement under
Ind AS 11 with respect to combining or separating contracts for
accounting purposes is irrelevant in the context of accounting for real
estate. For example, under Ind AS 11, two contracts need to be combined
together for accounting purposes if they are negotiated as a single
package; the contracts are so closely interrelated that they are, in
effect, part of a single project with an overall profit margin; and the
contracts are performed concurrently or in a continuous sequence. This
guidance is inapplicable to real estate development as they involve
multiple customers. Therefore the definition of the term “project” under
the Guidance Note may well be applied under Ind AS 11.
Question 5: For applying POCM how is “project cost” defined under Ind AS 11 and the Guidance Note?
Requirement
under the Guidance Note Project cost includes cost of land,
construction costs and borrowing costs. Cost of land may include cost of
land itself or development rights and other related costs such as stamp
duty, registration and brokerage. It also includes rehabilitation
costs. For example, when land is acquired, companies have an obligation
towards rehabilitating the displaced people by providing alternative
property and/or incurring various other social obligations.
Construction
and development costs include costs that are related directly to a
specific project such as cost of designing, labour, material, equipment
hiring or depreciation costs, but would exclude depreciation of idle
plant and equipment. It would include site supervision and site
administration costs and cost of obtaining municipal sanction or
building permissions, but would exclude head office general
administration costs. Construction costs would include expected warranty
costs/provisions, that may be incurred during or post the completion of
the construction. It may be noted that real estate companies were
accounting for warranties in numerous ways. By treating warranties as
any other input cost, this Guidance Note will bring consistency in the
treatment of warranty costs. Costs that may be attributable to a project
activity in general and can be allocated are also included as
construction and development costs; for example, insurance, cost of the
technical, architecture or supervision department, construction or
development overheads, etc. Such costs are allocated using methods that
are systematic and rational and are applied consistently to all costs
having similar characteristics. Construction overheads include costs
such as the preparation and processing of construction personnel
payroll. The allocation is based on the normal level of project
activity, similar to overhead absorption in the case of inventories.
Therefore in periods of low activity, not all of the general
construction overheads would be absorbed on the fewer projects that may
be in progress.
Borrowing costs are capitalized in accordance
with AS-16 Borrowing Costs. The borrowing costs incurred towards
purchase of land forming part of construction of a commercial or
residential project are eligible for capitalisation since it does not
represent an asset in itself, but forms part of the project, which
requires substantial period of time to get ready for its intended use or
sale. However, borrowing costs incurred while land acquired for
building purposes is held without any associated development activity do
not qualify for capitalisation [Para 16 of AS 16]. Interest
capitalisation will be based on utilisation of funds, i.e., on the basis
of actual cash flow, and not on the accrual of liability. Thus,
warranty expenses that are included as project cost would be excluded
for the purposes of borrowing cost capitalisation, unless it involved an
actual cash flow. Sometimes real estate companies have to place
security deposits for the purposes of securing land or development
rights. EAC has opined that borrowing cost on the cash outflow on
security deposit cannot be capitalised, as the security deposit is not
part of the project cost.
Certain costs should not be considered
as part of the project cost, such as selling costs, costs of unconsumed
or uninstalled material delivered at site; and payment made to
sub-contractors in advance of work performed. Payment made to
sub-contractors for work performed will be considered as part of the
project cost. Further, accrual made for work done by sub-contractor will
also be considered as part of the project cost, but will be excluded
for the purposes of borrowing cost capitalisation, unless it results in
actual cash flows.
Requirement under Ind AS 11
The
above requirements of the Guidance Note would generally apply to Ind AS
11 as well. However, there is a significant difference. Under the
Guidance Note, the EAC had opined that borrowing cost on security
deposit paid for securing land cannot be capitalised. Under Ind AS,
security amount paid for land by the contractor is an advance
consideration for land. If the security amount was paid out of borrowed
funds, then borrowing cost should be capitalised provided the
construction on that land is taking place.
Question 6: How is Percentage of completion method (POCM) applied under Ind AS 11 and the Guidance Note?
Requirement under the Guidance Note
POCM
method is applied when the outcome of a real estate project can be
estimated reliably and when all the following conditions are satisfied:
(a) total project revenues can be estimated reliably;
(b) it is probable that the economic benefits associated with the project will flow to the enterprise;
(c)
the project costs to complete the project and the stage of project
completion at the reporting date can be measured reliably; and
(d)
the project costs attributable to the project can be clearly identified
and measured reliably so that actual project costs incurred can be
compared with prior estimates. Further to the above conditions, there is
a rebuttable presumption that the outcome of a real estate project can
be estimated reliably and that revenue should be recognized under the
POCM method only when the following events are completed:
- All
critical approvals necessary for commencement of the project have been
obtained; for example, environmental and other clearances, approval of
plans, designs, etc., title to land or other rights to development/
construction and change in land use
- When the stage
of completion of the project reaches a reasonable level of development.
A reasonable level of development is not achieved if the expenditure
incurred on construction and development costs is less than 25 % of the
construction and development costs. Such costs would exclude land cost
but include borrowing costs.
- Atleast 25% of the saleable project area is secured by contracts or agreements with buyers.
- Atleast
10 % of the total revenue as per the agreements of sale or any other
legally enforceable documents are realised at the reporting date in
respect of each of the contracts and it is reasonable to expect that the
parties to such contracts will comply with the payment terms as defined
in the contracts.
When POCM is applied, project revenue
and project costs associated with the real estate project should be
recognised as revenue and expenses by reference to the stage of
completion of the project activity at the reporting date. For
computation of revenue the stage of completion is arrived at with
reference to the entire project costs incurred including land costs,
borrowing costs and construction and development costs. Interestingly,
land cost is not included to determine whether the threshold for
recognizing revenue is reached. But once the threshold is reached land
cost is included for the purposes of determining the stage of completion
and is included in revenue and costs accordingly. As mentioned earlier,
costs incurred that relate to future activity on the project and
payments made to sub-contractors in advance of work performed under the
sub-contract are excluded and matched with revenues when the activity or
work is performed. The recognition of project revenue by reference to
the stage of completion of the project activity should not at any point
exceed the estimated total revenues from ‘eligible contracts’/other
legally enforceable agreements for sale. ‘Eligible contracts’ means
contracts/ agreements where at least 10% of the contracted amounts have
been realised and there are no outstanding defaults of the payment terms
in such contracts. To illustrate – if there are 10 Agreements of sale
and 10 % of gross amount is realised in case of 8 agreements, revenue
can be recognised with respect to these 8 agreements.
The
Guidance Note does not prohibit other methods of determination of stage
of completion, e.g., surveys of work done, technical estimation, etc.
However, computation of revenue with reference to other methods of
determination of stage of completion should not, in any case, exceed the
revenue computed with reference to the ‘project costs incurred’ method.
When it is probable that total project costs will exceed total eligible
project revenues, the expected loss should be recognised as an expense
immediately. The amount of such a loss is determined irrespective of
commencement of project work; or the stage of completion of project
activity.
The percentage of completion method is applied on a
cumulative basis in each reporting period to the current estimates of
project revenues and project costs. Therefore, the effect of a change in
the estimate of project costs, or the effect of a change in the
estimate of the outcome of a project, is accounted for as a change in
accounting estimate. The changed estimates are used in determination of
the amount of revenue and expenses recognised in the statement of profit
and loss in the period in which the change is made and in subsequent
periods. The changes to estimates include changes arising out of
cancellation of contracts and cases where the property or part thereof
is subsequently earmarked for own use or for rental purposes. In such
cases any revenues attributable to such contracts previously recognized
should be reversed and the costs in relation thereto shall be carried
forward and accounted in accordance with AS 10, Accounting for Fixed
Assets. A contract that was an eligible contract (10% of the contract
value is realised and there are no outstanding defaults) may become an
ineligible contract on subsequent default in payment by the customer.
The Guidance Note does not prescribe any requirements with respect to
the same. However, it appears logical that the guidance contained above
of treating the same as a change in accounting estimate is applied.
Thus, revenue recognized previously is reversed, and the associated
costs are transferred to inventory.
Requirement under Ind AS 11
When
the outcome of a construction contract can be estimated reliably,
contract revenue and contract costs associated with the construction
contract should be recognised as revenue and expenses respectively by
reference to the stage of completion of the contract activity at the
balance sheet date. An expected loss on the construction contract should
be recognised as an expense immediately. In the case of a fixed price
contract, the outcome of a construction contract can be estimated
reliably when all the following conditions are satisfied:
- total contract revenue can be measured reliably;
- it is probable that the economic benefits associated with the contract will flow to the enterprise;
- both
the contract costs to complete the contract and the stage of contract
completion at the balance sheet date can be measured reliably; and
- the
contract costs attributable to the contract can be clearly identified
and measured reliably so that actual contract costs incurred can be
compared with prior estimates. In making a judgment about reliability of
measurement, the following requirements under the Guidance Note may
appear consistent with the overall Ind AS framework:
- All
critical approvals necessary for commencement of the project have been
obtained; for example, environmental and other clearances, approval of
plans, designs, etc., title to land or other rights to development/
construction and change in land use. However the following requirement
in the Guidance Note appears inconsistent with the overall Ind AS
framework:
- When the stage of completion of the project
reaches a reasonable level of development. A reasonable level of
development is not achieved if the expenditure incurred on construction
and development costs is less than 25 % of the construction and
development costs. Such costs would exclude land cost but include
borrowing costs.
This requirement appears inconsistent
with Ind AS because a threshold of 25% for a real estate company that
routinely constructs real estate appears very arbitrary. Real estate
entities therefore should make their own judgment based on the
particular facts and circumstances.
In accordance with the
Guidance Note, a real estate developer will start recognising revenue
from constructiontype contracts only after it satisfies the prescribed
criteria, e.g., the project has reached a reasonable level of
development and minimum 25% of the estimated revenues are secured by
contracts. Apparently, Ind AS 11 does not allow deferral of revenue in
this manner. Rather, it requires a company to start recognising revenue
from a construction contract immediately. In cases where the outcome of
the contract cannot be estimated reliably, the recognition of revenue is
restricted to the extent of costs incurred, which are probable of
recovery.
An interesting question that is often asked is the
treatment of land in a real estate construction contract. Some may argue
that under Ind AS 11 the cost of land does not represent “contract
activity” or “work performed” and therefore is not to be considered in
determining the stage of completion. In addition, when the percentage of
completion is based on physical inspection, no activity will be
measured if land has been acquired but the actual construction has not
yet commenced. In the Guidance Note, land is included as an input cost
and in the application of the POCM method for recognizing revenue, costs
and profits. However, land cost is not included to determine if the 25%
threshold is reached to start applying the POCM method.
Question 7: How are multiple elements accounted for under the Guidance Note and Ind AS 11?
Requirement
under the Guidance Note An enterprise may contract with a buyer to
deliver goods or services in addition to the construction/development of
real estate [e.g. property management services, sale of decorative
fittings (excluding fittings which are an integral part of the unit to
be delivered), rental in lieu of unoccupied premises, etc]. In such
cases, the contract consideration should be split into separately
identifiable components including one for the construction and delivery
of real estate units. For example, a real estate company in addition to
the consideration on the flat, charges for property maintenance services
for a period of two years, after occupancy. Such revenue is accounted
for separately and over the two year period of providing the maintenance
services. The consideration received or receivable for the contract
should be allocated to each component on the basis of the fair market
value of each component. Such a split-up may or may not be available in
the agreements, and even when available may or may not be at fair value.
When the fair market value of all the components is greater than the
total consideration on the contract, the Guidance Note does not specify
how the discount is allocated to the various components. Under the
proposed revenue recognition standard Ind AS 115, the allocation is done
on a proportion of the relative market value.
Requirement under Ind AS 11
The above guidance is generally not inconsistent with the requirements of Ind AS.
Illustration : Guidance Note vs Ind AS
Example under Guidance Note Relevant Details of a project are as below:
