Percentage Of Completion Method (POCM) Illustration For Real Estate Companies Under Ind AS 115 & Comparison With Guidance Note (GN)

Background

On 28^th March
2018, the Ministry of Corporate Affairs (MCA) notified the new revenue
recognition standard, viz., Ind AS 115 Revenue from Contracts with Customers.
Ind AS 115 is applicable for the financial years beginning on or after 1^st
April 2018 for all Ind AS companies. It replaces virtually all the existing
revenue recognition requirements under Ind AS, including Ind AS 11 Construction
Contracts, Ind AS 18 Revenue and the Guidance Note on Accounting
for Real Estate Transactions (withdrawn by ICAI vide announcement dated
01-06-2018) (GN).

One of the industries where
the impact is significant is the real estate industry. In addition to not being
able to apply POCM invariably, there are numerous other accounting challenges.
Here we take a look at the following issues:

1.  Evaluating if building is a separate
performance obligation (PO) from the underlying land in a single-unit vs. a
multi-unit sale.

2.  Understanding clearly the requirements for
POCM eligibility under Ind AS 115.

3.  Where a real estate sale is eligible for POCM
– the differences in POCM between the GN and Ind AS 115.

4.  POCM illustrations under the GN and Ind AS
115, highlighting the underlying differences.

Whether Land &
Buildings are separate POs?

The diagram below depicts
the requirements with respect to identifying goods and services within a
contract.

Whether land and building
are two separate POs will depend upon whether the underlying real estate sale
is a single-unit or a multi-unit sale. An example of a single-unit sale is
where a customer is sold an individual plot of land with a construction of a
villa on that plot of land. In this example, the customer receives the
ownership of the land and the villa. On the other hand, a multi-unit sale is
where a customer is sold a flat in a multi-floor, multi-unit building. Here the
customer receives the finished apartment and the undivided interest in the
land.

In the case of a
single-unit sale, land and building in most circumstances will be separate POs.
The International Financial Reporting Interpretation Committee (IFRIC)
considered this issue and felt land and building are two separate POs for the
following reasons:

–   When
evaluating step 1 above, whether goods/services are capable of being distinct
based on the characteristics of the goods or services themselves; the
requirement in the standard is to disregard any contractual limitations that
might preclude the customer from obtaining readily available resources from a
source other than the entity. Further, customer could benefit from the plot of
land on its own or together with other resources.

–   When
evaluating step 2 above, it is important to understand if the relationship
between land and building is functional or transformative. The relationship
between land and building is functional, because building cannot exist without
the land; its foundations will be built into the land. However, in order for
the two POs to be combined as one PO, the relationship has to be
transformative. The relationship between land and building is not
transformative. The building does not alter or transform the land and vice-versa.
There is no integration or the two POs do not modify each other.

In the case of a multi-unit
sale, the undivided interest in the land and the building in most circumstances
will be one PO because the customer receives a combined output, i.e. a finished
apartment. The customer does not benefit from the undivided interest in the
land on its own or buy it independently or use it with other readily available
resources. The customer does not receive ownership of the land. The real estate
entity may probably transfer the land after project completion to a society
established by all the home-owners.

When is over-time (POCM) revenue recognition
criterion met under Ind AS 115?

An entity shall recognise
revenue when (or as) the entity satisfies a performance obligation by
transferring a promised good or service (i.e. an asset) to a customer. An asset
is transferred when (or as) the customer obtains control of that asset. For
each performance obligation, an entity shall determine at contract inception
whether it satisfies the performance obligation over time or satisfies the performance
obligation at a point in time. If a performance obligation is not satisfied
over time (explained later), an entity satisfies the performance obligation at
a point in time. The Standard describes when performance obligations are
satisfied over time. Consequently, if an entity does not satisfy a performance
obligation over time, the performance obligation is satisfied at a point in
time. The point in time is the time when the control in the goods or service is
transferred to the customer.

An entity transfers control
of a good or service over time and, therefore, satisfies a performance
obligation and recognises revenue over time, if one of the following criteria
is met:

(a) the customer simultaneously receives and
consumes the benefits provided by the entity’s performance as the entity
performs (for example, interior decoration in the office of the customer);

(b) the entity’s performance creates or enhances an
asset (for example, work in progress) that the customer controls (as defined in
the Standard) as the asset is created or enhanced; or

(c) the entity’s performance does not create an
asset with an alternative use to the entity and the entity has an enforceable
right to payment for performance completed to date.

Let us consider an example,
to see how the above criterion is applied.

Example 1 – Application of Over time revenue
recognition criterion

Issue

–   An
entity is constructing a multi-unit residential complex

–   Customer
enters into a binding sales contract with the entity for a specified unit

–   The
customer makes milestone payments as per contract, which cumulatively are less
than work completed to date plus a normal profit margin

–    A
significant contract price is paid by customer to entity on delivery (but the
contract is enforceable under Ind AS 115)

–   In
case customer wishes to terminate the contract, either customer or entity can
identify a new customer, who will pay the remaining amount as per milestone
schedule.

–    The
new customer compensates the original buyer, for payments made to date. The
compensation may be higher or lower than the cumulative payments made by the
original customer

–    The
contract is silent when new buyer cannot be identified. However, as per local
laws, the entity cannot enforce claim for remaining payments from the original
customer.

Whether the performance
obligation is satisfied at a point in time or over time?

Response

Similar issue was
considered by IFRIC.

IFRIC Agenda Decision : Revenue
recognition in constructing a multi-unit building:

Many real estate companies in India may not
qualify for POCM on transition date contracts. 
However, the third criterion discussed above can be incorporated in
future contracts to achieve POCM recognition.

Example 2 – Over time revenue recognition requirement
met

Issue

–   An
entity is constructing a multi-unit residential complex. A customer enters into
a binding sale contract with the entity for a specified unit.

–   The
customer pays a non-refundable deposit upon entering into the contract and will
make progress payments during construction of the unit. The contract has
substantive terms that preclude the entity from being able to direct the unit
to another customer.

–    In
addition, the customer does not have the right to terminate the contract unless
the entity fails to perform as promised.

–    If
the customer defaults on its obligations by failing to make the promised
progress payments as and when they are due, the entity would have a right to
all of the consideration promised in the contract if it completes the
construction of the unit.

–   The courts have previously
upheld similar rights that entitle developers to require the customer to
perform, subject to the entity meeting its obligations under the contract.

Does the
real estate entity meet the criterion for overtime recognition of revenue?

Response

–   The
entity determines that the asset (unit) created by the entity’s performance
does not have an alternative use to the entity because the contract precludes
it from transferring the specified unit to another customer.

–    The
entity does not consider the possibility of a contract termination in assessing
whether the entity is able to direct the asset to another customer.

–   The
entity also has a right to payment for performance completed to date. This is
because if the customer were to default on its obligations, the entity would
have an enforceable right to all of the consideration promised under the
contract if it continues to perform as promised.

–   Therefore,
the terms of the contract and the practices in the legal jurisdiction indicate
that there is a right to payment for performance completed to date.

Consequently, the criteria
for recognising revenue over time under Ind AS 115 are met and the entity has a
performance obligation that it satisfies over time.

What is enforceable right to payment?

There are a couple of
points one needs to consider to understand if a real estate contract provides
an enforceable right to payment:

1.  The enforceable right to payment for work
completed to date would include cost incurred to date plus a normal profit
margin.

2.  The right should be enforceable both under the
contract as well as legislation.

3.  The law may provide contract enforceability,
however the RERA authorities may issue interpretations and judgement that are
consumer friendly. The Maharashtra Estate Regulatory Authority in Mr.
Shatrunjay Singh vs. Arkade Art  Phase 2
opined that the customer is not eligible for refund of the amounts paid to the
developer even if customer is not able to pay due to financial difficulty.
However, it did not rule that the contract was enforceable against the
customer, and that the entity had a right to collect payment for work completed
to date. Real estate entities should therefore clearly evaluate the legal
position and obtain legal opinions to support over time revenue recognition.
Since different RERA authorities may take different positions, a real estate
entity should obtain legal opinion for all major states where it has
operations.

4.  The right to payment does not mean that the
entity has the right to invoice every day or week or month or other than based
on mile-stone. Rather, if the customer walks-away from the contract, the entity
should be able to enforce payment for work completed to date (plus normal
profit margin).

5.  The existence of the right is important.
Whether the real estate entity chooses to exercise the right is not relevant.

6.  A satisfactory resolution of the problem as
explained in Example 1, does not mean that the real estate entity has an
enforceable right to payment. A clear enforceable right to payment should be
granted both under the contract and the legislation.

7.  If a customer can walk away by paying a
penalty (which is not equal to or greater than cost incurred to date plus
normal profit margin), then there is no enforceable right to payment.

8.  In a 10:90 scheme, the contract itself may not
be enforceable. However, in a mile-stone based real estate contract, a 10%
received upfront, may be sufficient to demonstrate contract enforceability.
Evaluating contract enforceability and right to payment is a continuous process
throughout the project period.

POCM under GN vs Ind AS 115

Even when real estate
entities meet the POCM criterion under Ind AS 115, the POCM as per the GN
(withdrawn) and Ind AS 115 are dissimilar in many respects. A comparison is
given below.

POCM under GN

Illustration

Response

1.  In Scenario 1, construction and development
cost criterion of 25% is not fulfilled and since threshold is not met, no
revenue is recognised.

2.  Scenario 2 where land is considered as
contract activity is clearly in accordance and as illustrated in the GN. Once
the 25% criterion is met, land is included in the determination of the POCM and
revenue/cost is recognised on that basis.

3.  Scenario 2 where land is not considered as
determining the contract activity (POCM) is the author’s interpretation of
Paragraph 5.4 of the GN. Paragraph 5.4 of the GN states that “Whilst the method
of determination of state of completion with reference to project cost incurred
is the preferred method, this GN does not prohibit other methods of
determination of stage of completion, eg, surveys of work done, technical
estimation, etc.”

POCM under Ind AS 115 in single-unit apartment

As already discussed above,
in a single-unit apartment, in most cases, land and building will be two
separate POs. The question that arises at what point in time revenue on land is
recognised. Theoretically there are three options on how land revenue is recognised
at (a) commencement, (b) settlement or (c) over time. These options are
presented below based on the earlier illustration (scenario 2).

The author believes that
View 1 below is the most appropriate response.

View 1: Control of the land
at commencement

The author believes land
revenue is recognised at commencement since the control of the land transfers
once the contract is enforceable. The contract restricts the ability of the
real estate entity to redirect the land for another use. Besides, the customer
has the significant risks and rewards of ownership from that time. Although the
legal title of the land does not transfer until settlement, this view considers
that the retention of legal title in this fact pattern is akin to a protective
right because the customer will not pay for the land until settlement.
Therefore, this contract is like many other contracts where the asset is
acquired on deferred payment terms. In this view, the real estate entity will
need to confirm that the existence of a contract criteria are met in IND AS
115.9, in particular that it is it is probable that the builder will collect
the consideration to which it will be entitled in exchange for the land and
house (single-unit) construction services.

View 2: Control of the land
transfers at settlement

Control of the land
transfers at settlement, which is when legal title transfers to the customer.
This provides clear evidence that the customer has obtained control of the
land. This outcome would also be consistent with other real estate sales
contracts that do not have a specific performance clause.

However, the major drawback
of this view is that it is counterintuitive for a  customer
to obtain  control
(forInd AS 115 purposes) of the
house prior to the obtaining control of the land. Hence this view is not
appropriate.

View 3: Control of the land
also transfers over time to the customer

Over time revenue
recognition is applicable to land because the real estate entity is
contractually restricted from redirecting the land to others. Besides the right
to sue for specific performance applies to the contract as a whole ( i.e land
and house construction). However, the major shortcoming of this view is that
the real estate entity’s performance does not create or enhance the land—the
land already exists. In other words land is not getting created, enhanced or
transformed overtime. Hence, this view is not appropriate.

POCM under Ind AS 115 in multi-unit apartment

As already discussed above,
in a multi-unit apartment land and building is treated as one performance obligation.
Theoretically there are 3 options available on how to apply POCM in a
multi-unit apartment where construction meets the overtime requirement in
35(c).

View 1 and 3 seem
acceptable views, and are demonstrated below (Scenario 2)

Conclusion

Ind AS 115 is very
complicated. The interpretations around Ind AS 115 are still emerging globally
and in India. Real estate entities will need to carefully study, analyse and
apply the requirements, without jumping to straight-forward conclusions.