An Exposure draft namely Ind AS 115 Revenue from Contracts with
Customers is awaiting approval by the Ministry of Corporate Affairs. There is uncertainty on the effective date of
the Standard, but it may apply as early as from accounting periods beginning on
or after 1 April, 2018. In this article,
we discuss the impact of Ind AS 115 on real estate companies, particularly in
the context of development and sale of multi-unit residential or commercial
property before the entity constructs the property.
Ind AS 115 specifies the requirements an entity must apply to measure
and recognise revenue and the associated costs. The core principle of the
standard is that an entity will recognise revenue when it transfers control of
the underlying goods and services to a customer. The principles in Ind AS 115
are applied using the following five steps:
1. Identify the contract with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations
5. Recognise revenue when or as the entity satisfies each performance
obligation.
Ind AS 115 requires recognition of revenue when or as the entity
satisfies each performance obligation. This requirement is one of the key
hurdles for real estate companies. Currently, the Guidance Note on
Accounting for Real Estate Transactions (GN) requires real estate companies
to apply the percentage of completion method.
Under Ind AS 115, an entity will have to evaluate whether it satisfies
the performance obligation to its customer at the time of delivery of the real
estate unit or over time as the construction is in progress. If an entity
cannot demonstrate that the performance obligation is satisfied over time, it
will not be able to recognis e revenue over time. In simpler terms, the entity
will have to record real estate sales on the completed contract method, instead
of the percentage of completion method (POCM).
Satisfaction of
performance obligations
An entity recognises revenue only when it satisfies a performance
obligation by transferring control of a promised good or service to a customer.
Control may be transferred at a point in time or over time. Control of the good
or service refers to the ability to direct its use and to obtain substantially
all of its remaining benefits. Control also means the ability to prevent other
entities from directing the use of and receiving the benefit from a good or
service. The benefits of an asset are the potential cash flows (inflows or
savings in outflows) that can be obtained directly or indirectly in many ways,
such as by:
a) using the asset to produce goods or provide services;
b) using the asset to enhance the value of other assets;
c) using the asset to settle liabilities or reduce expenses;
d) selling or exchanging the asset;
e) pledging the asset to secure a loan; and
f) holding the asset.
The control model is different from the ‘risks and rewards’ model in
current Ind AS 18 and the GN. As per the GN, the completion of revenue
recognition process is usually identified when the following conditions are
satisfied.
a) the entity has transferred to the buyer the significant risks and
rewards of ownership of the real estate;
b) the entity retains neither
continuing managerial involvement to the degree usually associated with
ownership nor effective control over the real estate sold;
c) the amount of revenue can be measured reliably;
d) it is probable that the economic benefits associated with the
transaction will flow to the entity; and
e) the costs incurred or to be incurred in respect of the transaction
can be measured reliably.
The differences in the model may result in different accounting
outcomes.
Performance
obligations satisfied over time
An entity transfers control of a good or service over time, rather than
at a point in time when any of the following criteria are met:
1) The customer simultaneously receives and consumes the benefits
provided by the entity’s performance as the entity performs. For example, when
cleaning services are provided, the customer simultaneously receives and
consumes the benefits.
2) The entity’s performance creates or enhances an asset that the
customer controls as the asset is created or enhanced. For example, an entity
constructs an equipment for the customer at the customer’s site.
3) 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.
The first criterion is not applicable because the entity’s performance
creates an asset, i.e., the real estate unit that is not consumed immediately.
The second and the third criteria are discussed below. The Standard contains
requirements on when performance obligations are satisfied over time. When a
performance obligation is not satisfied over time, it will be deemed to have
been satisfied at a point in time.
Customer
controls asset as it is created or enhanced
The second criterion in which control of a good or service is
transferred over time, is where the customer controls the asset as it is being
created or enhanced. For example, many construction contracts contain clauses
indicating that the customer owns any work-in-progress as the contracted item
is being built. In many jurisdictions, the individual units of an apartment
block are only accessible by the purchaser on completion or near completion.
However, the standard does not restrict the definition of control to the
purchaser’s ability to access and use (i.e., live in) the apartment. In Ind AS
115.33, the standard specifies: The benefits of an asset are the potential cash
flows (inflows or savings in outflows) that can be obtained directly or
indirectly in many ways, such as by:
a) using the asset to produce goods or provide services (including
public services);
b) using the asset to enhance the value of other assets;
c) using the asset to settle liabilities or reduce expenses;
d) selling or exchanging the asset;
e) pledging the asset to secure a loan; and
f) holding the asset.
In some jurisdictions, it may be possible to pledge, sell or exchange
the unfinished apartment. Careful consideration will be required of the
specific facts and circumstances. The September 2017 Update of IFRIC, discusses
this issue in detail, and concluded that the second criterion is not fulfilled
in most developments of a multi-unit complex. Consequently, PCOM cannot be
applied in such cases. Particularly, the IFRIC emphasised the following:
1) In applying the second criterion, it is important to apply the
requirements for control to the asset that the entity’s performance creates or
enhances. In a contract for the sale of a real estate unit that the entity
constructs, the asset created is the real estate unit itself. It is not, for
example, the right to obtain the real estate unit in the future. The right to
sell or pledge this right is not evidence of control of the real estate unit
itself.
2) The entity’s performance creates the real estate unit under
construction. Accordingly, the entity assesses whether, as the unit is being
constructed, the customer has the ability to direct the use of, and obtain
substantially all of the remaining benefits from, the part-constructed real estate
unit. The Committee observed the following:
a) although the customer can resell or pledge its contractual right to
the real estate unit under construction, it is unable to sell the real estate
unit itself without holding legal title to it;
b) the customer has no ability to direct the construction or
structural design of the real estate unit as the unit is constructed, nor can
it use the part-constructed real estate unit in any other way;
c) the customer’s legal title (together with other customers) to replace
the entity, only in the event of the entity’s failure to perform as promised,
is protective in nature and is not indicative of control.
d) the customer’s exposure to changes in the market value of the real
estate unit may indicate that the customer has the ability to obtain
substantially all of the remaining benefits from the real estate unit. However,
it does not give the customer the ability to direct use of the unit as it is
constructed.
Thus, the customer does not control the part-constructed unit. In
simpler terms, the performance obligation is satisfied when the real estate
entity delivers the constructed unit to the customer. At that point in time the
real estate entity recognises revenue.
Asset with no
alternative use and right to payment
The third situation in which control is transferred over time has the
following two requirements that must both be met:
–The
entity’s performance does not create an asset with alternative use to the
entity.
– The
entity has an enforceable right to payment for performance completed to date.
Asset with no
alternative use
An asset created by an entity has no alternative use if the entity is
either restricted contractually or practically from readily directing the asset
to another use (e.g., selling it to a different customer). A contractual
restriction on an entity’s ability to direct an asset for another use must be
substantive. In other words, a buyer could enforce its rights to the promised
asset if the entity sought to sell the unit to a different buyer. In contrast,
a contractual restriction may not be substantive if the entity could instead
sell a different unit to the buyer without breaching the contract or incurring
significant additional costs. Furthermore, a practical limitation exists if an
entity would incur significant economic losses to direct the unit for another
use. A significant economic loss may arise when significant costs are incurred
to redesign or modify a unit or when the unit is sold at a significantly
reduced price.
Enforceable
right to payment for performance completed to date
An entity has an enforceable right to payment for performance completed
to date if, at any time during the contract term, the entity would be entitled
to an amount that at least compensates it for work already performed. This
right to payment, whether by contract or by law, must be present, even in
instances in which the buyer can terminate the contract for reasons other than
the entity’s failure to perform as promised. The entity’s right to payment by
contract should not be contradictory to any law of the land.
Many real estate companies sell real estate on a small down payment,
followed by the rest of the payment being made at the time of delivery of the
real estate; for example, a 20:80 scheme, wherein 20% of the consideration is
paid upfront on booking, followed by 80% payment on delivery of the unit. The
customer can walk away without making the rest of the payment, if he is not
interested in taking delivery of the unit. Such real estate contracts do not
meet the criterion of enforceable right to payment for performance completed to
date.
To meet this criterion, the amount to which an entity is entitled must
approximate the selling price of the goods or services transferred to date,
including a reasonable profit margin. The standard clarifies that including a
payment schedule in a contract does not, by itself, indicate that the entity
has an enforceable right to payment for performance completed to date. The
entity needs to examine information that may contradict the payment schedule
and may represent the entity’s actual right to payment for performance
completed to date (e.g., an entity’s legal right to continue to perform and
enforce payment by the buyer if a contract is terminated without cause).
In some contracts, a customer may have a right to terminate the contract
only at specified times during the life of the contract or the customer might
not have any right to terminate the contract. If a customer acts to terminate a
contract without having the right to terminate the contract at that time
(including when a customer fails to perform its obligations as promised), the
contract (or other laws) might entitle the entity to continue to transfer to
the customer the goods or services promised in the contract and require the
customer to pay the consideration promised in exchange for those goods or
services. In those circumstances, an entity has a right to payment for
performance completed to date, because the entity has a right to continue to
perform its obligations in accordance with the contract and to require the
customer to perform its obligations (which include paying the promised
consideration).
Conclusion
In light of the requirements of Ind AS 115, many real estate companies
in India may not qualify for POCM. However, the third criterion discussed above
is a small window available for real estate companies in India to achieve POCM
recognition. To qualify for POCM recognition, real estate companies should
ensure that they have a contractual right to collect payment from the customer
for work completed to date and that the contractual right is not in
contradiction with any law of the land. _
