GAPS in GAAP — Guidance Note on Accounting for Real Estate Transactions (Revised 2012) is in no-man’s land

Introduction

On account of the diverse practices, 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. The revised Guidance Note should be applied to all projects in real estate which are commenced on or after April 1, 2012 and also to projects which have already commenced but where revenue is being recognised for the first time on or after April 1, 2012. An enterprise may choose to apply the revised Guidance Note from an earlier date, provided it applies it to all transactions which commenced or were entered into on or after such earlier date. The revised Guidance Note (2012) supersedes the Guidance Note on Recognition of Revenue by Real Estate Developers, issued by the ICAI in 2006, when this Guidance Note is applied as above. Though apparently the Guidance Note on accounting for real estate transactions is drafted in a simple and lucid manner, but when implemented, can throw a lot of implementation issues. Particularly, there are several requirements in the Guidance Note, which some may argue conflict with the accounting standards notified under the Companies (Accounting Standards) Rules.

 Scope of the Guidance Note

One of the big challenges is with respect to scope of the Guidance Note, which is not very clear on several aspects. The Guidance Note scopes in development and sale of residential and commercial units. Would that mean that if a customer were to hire a real estate developer to construct a villa on the land owned by the customer and in accordance with the customer’s specification, that transaction would be covered under the Guidance Note? In the author’s view, this seems like a typical construction contract, to which AS-7 and not the Guidance Note would apply. The Guidance Note applies to construction-type contracts, for example, construction of a multi-unit apartment to be sold to many buyers. It is pertinent to note that though percentage of completion is applied under AS-7 and the Guidance Note, there are other significant differences which would give different accounting results. Consider another example. A real estate developer sells villas to customers. It enters into two agreements with each buyer: one for sale of land and other for construction of building. Can the company treat these two agreements separately and recognise revenue accordingly?

In a practical scenario, three possibilities may exist with regard to construction of villa. These possibilities and likely views are:

(1) Customer owns land and it hires real estate developer to do the construction according to its specifications. In this case, the arrangement seems like a typical construction contract to which AS-7 and not the Guidance Note will apply.

(2) Real estate developer sells land and constructed villa together as part of one arrangement in a manner that customer cannot get one without the other. In this case, it seems appropriate that the developer will apply Guidance Note to land and building together.

(3) Real estate developer sells land. The buyer has an option of getting construction done either from the developer or any other third party. Both the land sale and construction element are quoted/ sold at their independent fair values.

The Guidance Note does not specifically deal with this scenario. However, the author believes that the more appropriate view will be to treat the sale of land and construction of building as two separate contracts and apply revenue recognition principles accordingly. The Guidance Note applies to redevelopment of existing buildings and structures. This scope is very confusing. For example, very often existing housing societies may ask a developer to reconstruct a property, with detailed specification on structure and design and the right to change that specification before or during the construction. The developer (who is hired like any other contractor) in return is remunerated by a fixed amount or a part of the constructed property or land. The author’s view is that in these circumstances, AS-7 should apply, rather than the Guidance Note. This is because the said contract is a construction contract which is covered under AS-7 and not a construction-type contract which is covered under the Guidance Note. But consider another example of a SRA project in Mumbai. The real estate developer evacuates existing tenants, constructs a huge property to be sold to customers, and adjacently constructs a small building that will house the existing tenants. All through the builder acts as a principal. In such a scenario the Guidance Note will apply.

Can the Guidance Note be applied by analogy to construction and sale of elevators or windmills, etc.? Therefore, applying the guidance note by analogy, can entities manufacturing elevators or windmills, which are of a standardised nature, use the percentage of completion method? The scope of the Guidance Note is very narrow.

The Guidance Note should not be applied by analogy to any other activity other than real estate development. Depending on the facts and circumstances, either AS-7 or AS-9 should apply to construction and sale of elevators, aircraft, windmills or huge engineering equipments. The Guidance Note scopes in joint development agreements, but provides no further guidance on how joint development agreements are accounted for. Joint development agreements may take various forms. The accounting for joint development agreement will be driven by facts and circumstances. They could be joint venture agreements or they could represent the typical scenario where land development rights are transferred to the real estate developer by the land owner, and the legal transfers take place much later, for reasons of stamp duty or indirect taxes. Transfer of development rights on land is like effectively transferring the land itself. Where development rights are transferred, the author has seen mixed accounting practices. Some developers treat the transaction as a barter transaction and record the development rights acquired as land purchased with the corresponding obligation to pay the landowner at a future date. The payment to the landowner could either be in a fixed amount or a fixed percentage of revenue or a portion of the constructed property. Many developers do not account for the barter transaction.

A third option is to record the acquisition of the development rights at the cost of constructed property to be provided to the land owner. This option can be justified on the basis that the Guidance Note requires TDRs to be recorded at lower of net book value or fair value. Though there is no impact on the net profit on the overall contract, whichever method is followed, it would impact the grossing up of revenue and costs. It will also result in the grossing up of the balance sheet. Further though the overall profit is the same over the project construction period, due to the manner of computing POCM, year-to-year profit may vary under the three options. For better clarity the three options are enumerated below. (Figures in all tables are in CU=Currency Unit, unless otherwise stated)

Balance sheet

Is the Guidance Note in conformity with the Companies (Accounting Standards) Rules?

AS-9, Revenue Recognition, applies to sale of goods and services. AS-7, Construction Contracts applies to construction contracts which are defined as “contracts specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose of use”. 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 and the revenues, costs and profits are recognised when the goods are delivered. 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. After satisfaction of step one, the second step is applied, which involves the application of the POCM. 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 recognised by applying the POCM. Once the revenue recognition conditions as per the Guidance Note are fulfilled, the POCM is to be applied mandatorily. In circumstances where the revenue recognition conditions are fulfilled, completed contract method is not permissible.

Accounting standards are notified under the Companies Accounting Standard Rules. The standards that deal with revenue recognition contract are AS-7 & AS-9. Accordingly the entire population of revenue contracts should either fall under AS -7 or AS-9. For example, a strict interpretation of a construction contract under AS-7 will lead one to the conclusion that a real estate sale is a product sale rather than a construction contract. By carving a new category in the Guidance Note, namely, in substance construction contract, for purposes of real estate development; some may argue that this Guidance Note falls in no -man’s-land and is not in accordance with the law. This line of thinking may be of particular interest to private companies that may find completed contract method more attractive for tax reasons.

Volatility in earnings

The Guidance Note imposes several conditions before a company can start applying the percentage of completion method on the real estate project. One of the conditions is that at least 25% of the construction and development costs should have been completed. One interesting aspect of the Guidance Note is that land cost is not included to determine if the 25% construction cost trigger is met. However, once the revenue recognition trigger is met, all costs including land cost is added to the project cost to determine percentage completion and the corresponding revenue and costs. This is likely to bring about a lot of volatility in the reported revenue and profit numbers. For example, let’s assume that land cost is 60% and development cost is 40%. As soon as 25% development cost is incurred, POCM commences. In this example, 70% of the costs (land cost of 60% and 25% of 40 on development), and corresponding revenue would be recognised at the point 25% development cost criterion is met. This would result in significant spike in the revenue and profit numbers. One of the main criticisms of the completed contract method is that it resulted in lumpy accounting. The manner in which POCM is applied as per the revised Guidance Note, it would fall into the same trap.

The examples below will explain more clearly how the revised Guidance Note results in volatility and how one could have avoided the volatility in the pre-revised Guidance Note.

RE Ltd. undertakes construction of a new real estate project having 20,000 square feet saleable area. The project will take 2 years to complete. Half the project is sold on day 1, and there are no further sales. All critical approvals are received upfront and all other POCM conditions are fulfilled at the end of Year 1. The construction and development cost is evenly spread in the two years at CU 150 million each. The total sale value of the units sold is Rs.400 million. Assume 50% amount is realised on all executed contracts and there are no defaults from customer side.

Revenue as per POCM under revised GN

As stated earlier, consider that under the revised Guidance Note land cost is not included to determine the revenue trigger; but once the revenue trigger is achieved, land cost is included to determine percentage completion and the corresponding revenue and costs. As one can see in the above table this Guidance Note results in significant volatility in the revenue and profit recognised in Year 1 and Year 2, though the construction activity was evenly spread in the two years. This is because the land costs and the associated revenues get recognised in Year 1.

Revenue as per POCM under pre-revised GN

In the pre-revised Guidance Note the practice many companies followed was to allocate the land cost and revenue proportionately over the development activity. As one can see in the above table, one of the practices under the pre-revised Guidance Note results in a more stable recognition of revenues and profits. This is because the land cost and corresponding revenues are recognised in proportion to the development activity.

Revenue as per POCM if only 24% construction is completed under revised GN

Assumptions

•    Same facts as POCM example except actual construction cost incurred

•     Assume company has incurred CU72 million of construction cost in Year 1

*    First year POC = 72/300 = 24% (actual construction cost/total estimated construction cost)

In a slightly tweaked example (as seen in the above table), assume in Year 1 that construction cost of CU 72 million is incurred. This works out to 24% of the total construction costs. Hence revenue recognition trigger is not satisfied in Year 1. All of the revenue and costs get recognised in Year 2. This example demonstrates two things. One is that the Guidance Note would result in significant volatility in the revenue and profit numbers. Secondly, this example demonstrates how a rule-based standard can be abused. For example, by incurring a little more cost and crossing the 25% threshold, the developer could have recognised significant revenue and profits in Year 1.

What is a project?

The application of the POCM under the Guidance Note is done at the project level. The Guidance Note defines project as 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. 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?

The definition is nebulous. 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 have 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. In the example, where two buildings are being constructed adjacently, and each have their own independent facilities and are not dependant on common facilities, one may argue that 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. In the author’s view, a company should exercise such choice at the beginning of each project and not change it subsequently.

Recognition criteria — Some practical issues

Query
For the purposes of applying the POCM risks and rewards should be transferred to the buyer. Real estate construction involves various types of risks, such as the price risks, construction risks, environmental risks, ability of the real estate developer to complete the project, political risks, etc. There could be situations where the political or environmental risks may be very significant and put to doubt the developers ability to complete the project. Clearly both under the 2006 Guidance Note and the 2012 Guidance Note revenue should not be recognised. But in normal scenario’s how much weightage one would provide to price risks in determining the transfer of risks and rewards?

Response

As per the 2006 Guidance Note, the important criteria were the legal enforceability of the contract, the transfer of price risks to the buyer and the buyer’s legal right to sell or transfer his interest in the property. In contrast 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.” As can be seen the 2012 Guidance Note is nebulous, and is not explicit like the 2006 Guidance Note which clearly sets out the price risk as being most critical to the transfer of significant risks and rewards. At this stage it is not clear how this difference will impact accounting of the real estate sales. For example, a company may decide the construction, environment and regulatory risk as being more critical than the price risk. In those circumstances, would the company apply the completed contract method instead of the POCM? Therefore this will be a significant area of judgment, and could lead to diversity in practice if companies interpret this term differently. However, if a project has become highly uncertain because of political and environmental issues, revenue should not be recognised under either Guidance Note.

Query

Is payment of stamp duty and registration of the real estate agreement necessary to start applying POCM?

Response

In certain jurisdictions, one needs registered docu-ments for the purposes of obtaining a bank loan. In other cases, a customer may decide to register the documents later at the time of possession to save on the interest element on the stamp duty amount. It is important to understand this. POCM can be applied only when there is a legally enforceable contract. It is a matter of legal interpretation and the applicable legislation, whether an unregistered document is legally enforceable. If the agreement is legally enforceable, POCM can be applied. If the agreement is not legally enforceable, POCM cannot be applied. The same also holds true in the case of MOU or letter of allotment given by the builder to the customer instead of a complete legal agreement. The question to be answered invariably is whether the arrangement is legally enforceable.

Query

Very often real estate companies to protect the valuation of the property impose a lock-in restriction on a buyer for a reasonable period, which generally does not extend beyond the project completion period. Would lock-in restrictions preclude the application of the POCM till such time the lock-in rights exist?

Response
In the author’s view, such reasonable restrictive provision does not materially affect the buyer’s legal right. Accordingly, it can be argued that in such instances risks and rewards are transferred to the buyer. Hence POCM can be applied.

Query
In rare cases, real estate developers provide price guards to customers as an incentive to buy properties. For example, a guarantee is provided that should the real estate developer sell the property to subsequent buyers at a rate lower than the previous buyer, the real estate developer would reimburse the previous buyer for the fall in price. Would this preclude application of the POCM?

Response

If these restrictions are substantive, then it may be argued that price risks are not transferred and hence POCM should not be applied. In some situations the price guards may not be substantive, for example, a guarantee by the developer that subsequent sales would not be made at a price lower than 40% charged to the previous buyer may be irrelevant in a rising property market. In such cases POCM can be applied. In the author’s view if there are repurchase agreements or commitments, or put-and- call options, between the developer and the customer, which are substantive in nature, POCM cannot be applied in those circumstances.

Query

One of the conditions for POCM is environment clearance and clear land title. In few cases, this could be a highly judgmental area. Auditors may have difficulty in auditing the same.

Response

Past experience has been that some major projects were stalled mid-way in India, because of lack of environmental clearance, or the land title was questionable. The problem is further compounded because of myriads of clearances and complicated legislations. As an auditor, one would look at seeking clarity from the in-house legal department or an external law firm. Banks generally conduct due diligence on these projects before approving loan to the developer and the customer. Clearance of the project by various banks may provide additional evidence.

Query

One of the conditions for POCM is the 25% completion of construction and development costs. Whether borrowing cost capitalised would be included to determine if this 25% threshold is achieved?

Response

There is some confusion on this. In paragraph 2.2 of the Guidance Note borrowing cost is treated as a distinct category separate from construction and development costs. But paragraph 2.5 lists down borrowing cost as construction and development costs. Based on paragraph 2.2 borrowing costs will not be included to determine the trigger. Based on paragraph 2.5 borrowing costs will be included to determine the trigger. The best way to resolve this anomaly is to include borrowing costs relating to construction and development costs and exclude proportionate borrowing costs on land to determine the trigger.

The other issues around borrowing cost relate to allocation of borrowing cost and which borrowing cost qualify for capitalisation for the purposes of determining project cost and corresponding revenue. The EAC had earlier opined that borrowing cost relating to security deposit for the purposes of acquiring land or other assets is not eligible for capitalisation, because security deposit is not a project cost. Another question that arises when determining project cost for calculating POCM is whether proportionate borrowing cost on land should be included. One view is that land is ready for its intended use when acquired and hence borrowing cost should not be capitalised. Another view is that land and building should be seen as part of a project. If the project is considered as a unit of account, borrowing cost should be capitalised on the project which includes the land component till the project is ready for its intended use. The author believes that the latter is more appropriate given the emphasis on project as the unit of account in the Guidance Note.

Query

Real estate developers enter into innovative schemes with customers. A customer may pay the entire consideration upfront of CU 100 and receive the possession of the property after 2 years of construction. Alternatively the customer pays CU 121 after 2 years on receiving the possession of the property. Would the real estate developer consider time value of money and recognise an interest expense of CU 21 and revenue of CU 121 in the former case?

Response

Well, generally interest imputation is not done under Indian GAAP.

Query

Real estate developers usually pay selling commission to various brokers for getting real estate booking. Can a real estate company include such commission in project cost to apply POCM?

Response

The Guidance Note does not explicitly deal with selling commission paid to brokers. According to paragraph 2.4 of the Guidance Note, selling costs are generally not included in construction and development cost. This suggests a company cannot include selling commission in the project cost and it will need to expense the same to P&L immediately. However, some real estate companies may argue that this view is not in accordance with paragraph 20 of AS-7. Since the Guidance Note refers to AS-7 for application of POCM, implication of its paragraph 20 should also be considered. According to this paragraph “costs that relate directly to a contract and which are incurred in securing the contract are also included as part of the contract costs if they can be separately identified and measured reliably and it is probable that the contract will be obtained.” This is one more instance where the Guidance Note conflicts notified accounting standards. The ICAI should clarify this issue.

Query

With respect to onerous contract, at what level would the developer evaluate onerous contract – is it at the individual contract level or project level?

Response

At the project level, the overall project may be profitable, as the profitable contracts may outnumber the loss -making contracts. If the unit of account was the individual contract, then all contracts that are loss making, will require a provision for onerous contract. The Guidance Note requires such evaluation to be done at the project level rather than on each individual contract. Some may argue that this requirement of the Guidance Note is in contravention of the requirements of the notified accounting standard, namely, AS-29 which requires the provision to be set up at the individual contract level.

Query

How is warranty costs accounted for?

Response

Warranty costs are included in project cost. In practice there are different ways in which warranty costs are treated in the application of the POCM. Warranty costs are unique in the sense that they are incurred after the project is completed and can only be estimated. Firstly warranty is not a separate multiple element or service or sale of good or service. Rather it is part of the obligation of the developer to hand over the constructed property to the buyer. The author has seen mixed accounting practices for warranties. Some companies recognise warranty costs and the corresponding revenue when the project is completed, because that is the time, the warranty period effectively starts. Other companies recognise warranty costs and corresponding revenue throughout the construction period, on the basis that a percentage of the cost incurred would need reworking.

Assume the same facts as POCM example. Consider that RE also gives a 5-year warranty from water leakage and other structural defects. Based on past experience, RE estimates that it will incur warranty cost equal to 5% of total construction cost. Hence, additional warranty cost is CU 15 million (i.e., 5% of CU 300 million construction cost).

Option 1 — Consider warranty cost only when tower is handed over

In this case, the company recognises warranty cost and related revenue only when tower is handed over. Warranty cost is factored in total estimated construction cost. Since no provision for warranty is made in Year 1, stage of completion is lower resulting in lower revenue being recognised in Year 1 (i.e., CU 293 million vis-à-vis CU 300 million in earlier scenario when there was no warranty cost). Lower revenue recognised in Year 1 gets recognised in Year 2 on completion of the project.

Option 2 — Consider warranty cost as and when revenue is recognised

In this option, company follows a policy of recognising warranty as and when revenue is recognised. Hence company provides for warranty as and when work is carried out. In Year 1, company incurs actual construction cost of CU 150. Hence, it makes a warranty cost equal to 5% of actual construction cost incurred i.e., CU 7.5 in Year 1. Since warranty provision is made on an ongoing basis, stage of completion in Year 1 is higher vis -à-vis option 1. This results in higher revenue being recognised in Year 1.

Transfer of development rights

TDRs are recorded at the cost of acquisition; but interestingly in an exchange transaction, TDR is recorded either at fair market value or at the net book value of the portion of the asset given up, whichever is less. For this purpose, fair market value may be determined by reference either to the asset or portion thereof given up or to the fair market value of the rights acquired, whichever is more clearly evident. The principle of recording TDRs at lower of cost or fair value ensures that fair value gain on exchange of TDRs is not recognised in the financial statements but when fair value is lower than cost, it is recorded at fair value, so that impairment is captured upfront.

Typically under AS-26 and AS-10, recording of exchange transactions at fair market value is permitted. Under IFRS principles, exchanges that have substance are also recorded at fair market value. It is not clear why recording of exchanges with substance at fair market value is not permitted. By conjecture, the standard setters may be concerned about the possibility of abuse by recognising profits on exchanges that may not have substance.

Transactions with multiple elements

An enterprise may contract with a buyer to deliver goods or services in addition to the construction/ development of real estate. The Guidance Note gives example of property management services and rental in lieu of unoccupied premises as multiple elements. It further states that sale of decorative fittings is a separate element, but fittings which are an integral part of the unit to be delivered is not a separate element. Where there are multiple elements, the contract consideration should be split into separately identifiable components including one for the construction and delivery of real estate units. 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. 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.

As already mentioned, 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 in IFRS, the allocation is done on a proportion of the relative market value. This in the author’s view is the preferred method. However, some may argue that the residual or reverse residual method may also be applied, in the absence of any prohibition in the Guidance Note. Under the residual method the entire discount is allocated on the first component and in the reverse residual method the entire discount is allocated to the last component.

Would one consider revenue on sale of parking slots as a multiple element? Unfortunately the Guidance Note does not elaborately define multiple elements. In the author’s view, parking slots are an extension of the construction and development of the real estate unit and hence should not be treated as a separate multiple element.

What about lifetime club membership fees? Will it be treated as a separate element? If the club is going to be transferred to the tenants or the housing society, then it should be treated as an extension of the real estate unit rather than a separate element. However, if the real estate developer will own and operate the club, it should be treated as a separate element.

Conclusion

As discussed at several places in this article, there are too many loose ends and too many matters of conflict between the notified accounting standards and this Guidance Note. Some may argue that the Guidance Note is ultra vires the law. These matters need to be appropriately addressed by the ICAI. In the author’s view, an appropriate response would have been to participate in the standard-setting process of the IASB; particularly with respect to the development of the new IFRS standard on revenue recognition, which requires the application of the POCM on real estate contracts.