IFRS
Background
Around the world, real estate development and sale
transactions are structured with various permutations and combinations, in order
to comply with local tax regulations, local practices and other market
conditions. As a result, a sale deed may be entered on the date of allotment or
it can be entered into on the date of delivery. Many geographies also permit the
developers to sell the underlying land first to be followed by the development
of land.
The divergence in the manner in which real estate
transactions are carried out was also reflected in the accounting principles
applied by companies prior to the introduction of IFRIC 15 in respect of revenue
recognition from real estate development. Some developers accounted for such
agreements under IAS 18 Revenue, i.e., revenue is recognised when the completed
real estate is delivered to the buyer. Other developers accounted for them under
IAS 11 Construction Contracts, i.e., revenue is recognised by reference to the
stage of completion as construction progresses.
The International Accounting Standards Board (‘IASB’) noted
that divergence in practice exists in these circumstances with regard to the
identification of the applicable accounting standard for the construction of
real estate and the timing of the associated revenue recognition. To address
this, IFRIC 15 – Agreements for the construction of real estate, was issued on 3
July 2008 and is effective for annual periods beginning on or after January
2009.
IFRIC 15 addresses this divergence and provides guidance on
the accounting for agreements for the construction of real estate with regard
to:
The scope of the interpretation also includes agreements that
are not solely for the construction of real estate, but which include a
component for the construction of real estate.
Revenue recognition
Broadly, the analysis required by IFRIC 15 has four possible
outcomes with the following revenue recognition requirements in each case:
(1) Agreements meet the definition of a construction
contract in accordance with IAS 11 Construction Contracts – revenue recognised
by reference to the stage of completion of the contract activity (“stage of
completion approach”).
Example:
Company A, owner of the land, appoints Company B to construct a residential
property for a fixed sum of INR 1 million. Company A decides the technical
specifications of the residential property and will remain the owner of the
land as well as the constructed property. This will be a contract specifically
negotiated for construction of an asset as specified in paragraph 3 of IAS 11.
Accordingly, revenue will be recognised by the stage of
completion set out in IAS 11.
(2) Agreements which are only for rendering of services in
accordance with IAS 18 Revenue – stage of completion approach.
If an entity is not required to acquire and supply
construction materials, the agreement may be only an agreement for the
rendering of services, which need to be accounted for under IAS 18. For
example: an agreement to maintain a real estate property.
(3) Agreements for the sale of goods but the
revenue recognition criteria of IAS 18.14 are met continuously as construction
progresses – stage of completion approach.
Example: Company A, a real estate developer, who owns a
piece of land, enters into an agreement with Company B to construct a bungalow
on the aforementioned land for a fixed sum of INR 1 million. As per the terms
of the agreement, the title and risk and rewards of the land as well as the
property under construction get transferred to Company B.
This principle is discussed in further detail in the
following paragraphs. In case a transaction meets the continuous transfer of
risk and rewards criteria, Company A will recognise revenue by the stage of
completion approach set out in IAS 11.
(4) Agreements for the sale of goods other than those in
type 3 – revenue recognised when all of the criteria of IAS 18.14 are
satisfied (“sale of goods approach”).
Example:
Company A, a real estate developer, who owns a piece of land, enters into an
agreement with Company B to construct a bungalow on the aforementioned land
for a fixed sum of INR 1 million. The title to the land and the property under
construction gets transferred to Company B. However, Company A still continues
to have managerial involvement and control over the property under
construction (for e.g. Company A controls the design and specifications of the
property, Company B’s right to sell / let / sub-let the property is
established only on physical completion of the property etc.).
Principle of continuous transfer of risk and rewards
One of the practical difficulties faced in the above assessment is the identification of agreements, which will fulfil the continuous transfer of risk and rewards and control (i.e. those which fall with in type 3 above), and so qualify for stage of completion accounting on the grounds that the revenue recognition criteria of IAS 18.14 are met continuously as construction progresses.
The approach of meeting the revenue recognition criteria in IAS 18.14 on continuous basis has not previously been common under IFRS. Historically, it was generally assumed that the stage-of-completion method for construction of real estate was only ap-plicable if the activity fell within the scope of IAS
11. However, other GAAPs (like Indian GAAP for example) have permitted stage-of-completion basis more readily than was generally the case under IFRS, prior to IFRIC 15. IFRIC 15 itself does not provide extensive guidance on identifying when this approach may be appropriate, though it includes some simplistic illustrative examples.
Paragraph 17 of IFRIC 15 states the following:
“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 con-struction 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”.
Paragraph 14 of IAS 18 states the following:
“14 Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied:
- the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
- the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
- the amount of revenue can be measured reliably;
- it is probable that the economic benefits associated with the transaction will flow to the entity; and
- the costs incurred or to be incurred in respect of the transaction can be measured reliably.”
Identifying indicators of continuous transfer under IAS 18.14
In the context of the requirement of paragraph 14 above, it will be important to identify which indicators / factors are more important to assess the question of whether continuous transfer is, or is not, occurring while the con-struction activity progresses.
Some factors, collectively or individually, may in-dicate that continuous transfer is occurring while construction progresses:
- The construction activity takes place on land owned by the buyer and the buyer has clear title to the land and the construction work in progress;
- The buyer cannot cancel the contract before the construction is complete;
- If the agreement is terminated before construc-tion is complete, the buyer retains the work in progress and the entity has the right to be paid for the work performed; and
- The agreement gives the buyer the right to take over the work in progress (albeit with a penalty) during construction, e.g., to engage a different entity to complete the construction.
Some other factors, collectively or individually, may indicate that continuous transfer is not occurring while construction progresses:
- The sales agreement gives the buyer the right to acquire a specified unit in an apartment building when it is ready for occupation;
- The sales agreement restricts the right of the buyer to sell / let or sub-let the property while under construction, or requires the developer’s explicit permission;
- The deposit paid by the buyer is refundable if the entity fails to deliver the completed unit in accordance with the contractual terms;
- The developer is required to perform significant obligations (for e.g. rental guarantee commitment) subsequent to completion of the property; and
- the balance of the purchase price is paid only on contractual completion, when the buyer obtains possession of its unit.
Other factors to be considered
It will be important to consider all the relevant facts and circumstances of the agreement before reaching a conclusion on which category the sale agreement should fall into. In addition to the illustrative examples set out in IFRIC 15, the following questions, collectively or individually, may provide indicators as to whether the continuous transfer of risk and rewards and control is met during the construction phase:
- Which party is able to sell / let / sublet or mortgage the property under construction?
- What are the rights of the buyer in case the developer is unable to complete the construction (i.e. if the developer files for bankruptcy)?
In such a case, will the buyer be able to enforce his rights on the property under construction? Will the buyer have preferential rights over other parties i.e. creditors of the developer?
- Are the payments made by the buyer to the developer held in an escrow account to be used solely for the construction of the property? Or are these funds available for the developer to fund his other projects?
- Which party bears the construction risk and which party bears the market risk related to the value of the property?
- Who bears the risk of loss or damage to the construction in progress and who pays the insurance cost of damage to the construction work? Who bears the loss in case the actual loss exceeds the insurance cover?
- Which party has the right to cancel / withdraw from the contract?
- Does the buyer have the right to complete the construction by replacing the developer?
Accounting for real estate development under current Indian GAAP
Based on the Guidance note on recognition of revenue by real estate developers issued by the Institute of Chartered Accountants of India, on the seller transferring all significant risks and rewards of ownership to the buyer, revenue can be recognised at that stage, provided the following conditions of AS 9, Revenue recognition, are fulfilled:
a) no significant uncertainty exists regarding the amount of the revenue; and
b) it is not reasonable to expect ultimate collection, provided the seller has no further substantial acts to complete under the contract.
However, in case the seller is obliged to perform any substantial acts after the transfer of all significant risks and rewards of ownership, revenue is recognised by applying percentage of completion method as stated under AS 7, Construction Contracts.
In India, the title to the property is considered to be transferred on entering into a sale deed / agreement to sell with the buyer. However, the developer retains control and has managerial involvement in the property under development till physical possession is handed over to the buyer. The developer also retains the significant obligation of completing and handing over the property to the buyer.
As the developer still retains the obligation to construct and deliver the property, revenue is generally recognised on stage of completion basis under Indian GAAP. However, the Guidance note on recognition of revenue by real estate developers does not explicitly require the entity to consider if the risk and rewards and control over the property under construction have been transferred to the buyer on a continuous basis throughout the construction period, as required by IAS 18 and IFRIC 15.
Summary
To summarise, under IFRS, there is specific guidance on when one can use the completed contract method vis -à-vis the stage of completion method, in order to recognise revenue from real estate development held for sale. IFRS lays emphasis on absence of continuing managerial involvement to the degree usually associated with ownership and effective control over the constructed real estate, which impact the timing of revenue recognition.
Further, determining whether an agreement falls within one of the four categories outlined earlier is not a matter of accounting policy choice, but rather an application of a single accounting policy to specific facts and circumstances. That is, the specific terms of each agreement should be analysed in the context of the relevant legal jurisdiction in
order to determine which of the aforementioned categories it falls into.
In case an entity wants to continue the current Indian GAAP mode of recognising revenue on percentage of completion basis (as per the Guidance note on recognition of revenue by real estate developers), it will have to make a positive assertion in respect of continuous transfer of risk and rewards and control (to be classified as a type 3 arrangement mentioned earlier) based on the various indicators discussed earlier in this article. This positive assertion will be based on facts and circumstances specific to each arrangement, taken individually or collectively. Such judgements in the application of the accounting policy will need to be disclosed in accordance with IFRIC 15.20(a).
Currently there is limited guidance available on ‘continuous transfer’ requirements in the nature of illustrative examples and this will be developed over a period of time. In the interim, there will continue to be some divergence in actual implementation of IFRIC 15, based on the legal laws practised in different geographies. Due to the practical challenges in being able to demonstrate continuous transfer of risk and rewards and control, IFRIC 15 will prompt more and more entities to recognise revenue on completion or delivery of the projects.
