F E B R U A R Y 2 , 20 13

-HIMANSHU KISHNADWALACONTRACTOR, NAYAK & KISHNADWALA

02/02/2013

Transparency in FS of RE Companies

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Applicable GAAP in India

02/02/2013

AS 9 – Revenue Recognition

AS 7 – Construction Contracts

ICAI Guidance Note on ‘Recognition of Revenue by RealEstate Developers’ (Jun 2006)

ICAI Guidance Note on ‘Accounting for Real EstateTransactions’ (Feb 2012)

Tax Accounting Standards issued by CBDT in Aug 2012

Construction Contracts [TAS (CC)]

Revenue Recognition [TAS (RR)]

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AS 9: Revenue Recognition

Scope

Rendering of services

Sale of goods

Use by others of entity’s

business

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Revenue Recognition from Sale of Goods

Transfer of risk and reward (R & R)

Ownership or effective control

Reliable measurement

of revenue

Flow of economic benefits

Reliable measurement

of costs Conditions

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AS 7: Construction Contracts

02/02/2013

Applies to Construction Contracts

Contract Costs, Revenues to be estimated

Based on progress of work, revenue recognised on Percentage of Completion method (POCM)

AS 7 does not apply to RE projects where construction carried out on own account (rather than as contractors).

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ICAI 2006 GN – Revenue Recognition

02/02/2013

Real Estate sales take place in variety of ways

Conditions for transfer of R & R of ownership as per AS 9 can besubject to different terms and conditions

For sale of RE, events such as transfer of legal title to thebuyer or giving possession of RE to the buyer usually providesevidence that all significant R & R of ownership have beentransferred

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ICAI 2006 GN - Transfer of risk and rewards of ownership

02/02/2013

Agreement should be Legally enforceable

Significant risks related to RE have been transferred to the buyer (e.g. Price risk)

Buyer has a legal right to sell or transfer his interest in the property:

Without any conditions or

such conditions which do not materially affect rights of a buyer

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ICAI 2006 GN - Transfer of risk and rewards of ownership …

02/02/2013

What are legally enforceable documents?

Nature of documents Yes/No

Order form No

Allotment letter No

M O U No

Agreement to sale Yes

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ICAI 2006 GN - Transfer of risk and rewards of ownership …

02/02/2013

Which risks are significant?

Nature of risks Yes/No

Price risk Yes

Construction risks Yes, (not discussed in GN)

Collection risk Yes

Quality risk Yes, (not discussed in GN)

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ICAI 2006 GN-Recognition and measurement

02/02/2013

Once the conditions as discussed above are met, any furtheracts are performed on behalf of the buyer (similar to acontractor)

No significant obligations exist

Significant obligations exist

Recognize revenue using thePOCM as per AS 7

Reasonable to expect ultimate collection

Revenue to be Recognized when

Immediately, with anappropriate provision forfuture expenditure

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ICAI 2006 GN- Methods for determining stage of completion

02/02/2013

Methods

Output• Surveys of work performed• Completion of a physical

proportion of the contract work

Input

Cost incurred to date % Total estimated cost

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Areas of subjectivity in Revenue Recognition

02/02/2013

Areas of subjectivity

Method of revenue recognition

Method for determining POC

Threshold for revenue recognition

Components of project cost

Sale of undivided interest in land

Capitalisation of borrowing costs

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Areas of subjectivity …

02/02/2013

Method of revenue recognition:

POCM – Project revenue and project cost is recognized basedon determination of stage of completion at every reportingperiod

Completion Contract (CC) method – Project costs getsaccumulated under ‘Work in progress’ in the balance sheet untilcompletion of project

Decision of the method can be driven either by taxconsiderations or by shareholder/analyst expectations

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Areas of subjectivity …

02/02/2013

Method for determining POC:

Input (or cost) method is generally popular

Challenges exist in revising project cost on a regular basis

In case of township / multi- phase projects, no specific guidance on how POC is computed

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Areas of subjectivity …

02/02/2013

Threshold for revenue recognition:

Diversity exists even in POCM

Percentages used as minimum threshold limit for revenuerecognition by RE cos. differ considerably and range between20% to 35%.

Thus for a similar project, Company A may recognize revenueswhen 20% of the project is complete , while Company B may notrecognize revenues until 35% of the project is complete.

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Areas of subjectivity …

02/02/2013

Components of project cost:

No specific guidance on what constitutes project cost.

Some companies consider cost of land, development rights ascosts incurred to determine POC as against consideration ofonly actual cost by other cos. In metro cities, such costssignificantly influence POC workings

Admin and general overheads are treated as period costs bysome cos. and are charged to statement of Profit and loss asagainst including them in project cost for determination of POC.

Accounting treatment for allocation of indirect cost,advertisement/ publicity costs for sample flats etc is divergent.

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Areas of subjectivity …

02/02/2013

Capitalisation of Borrowing costs:

In India, some companies treat borrowing costs as period cost and charge it P & L. However, several other companies capitalise the same.

Unlike IFRS, no specific guidance on capitalisation of borrowing costs

IFRS prohibits capitalisation of borrowing costs in case of homogeneous projects

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Areas of subjectivity …

02/02/2013

Sale of undivided interest in land:

Some cos. treat the undivided interest in land as part of theoverall contract for sale of a unit of an apartment.

Hence POC / CC method is applied to the total revenues fromthe customers.

Others treat the same as a separate component and recognizethe sale of this component upfront even though construction ofthe apartment may span over a longer period.

ImpactDiversity in practice in the above mentioned keyareas leads to difficulty in comparing financialresults and true assets of companies in RE sector.

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Accounting Policies followed by RE Cos

02/02/2013

Company Rev RecPolicy

How cost is determined Thresholdlimit (%)

POCM Project cost (Land cost + construction cost)

30

POC M Construction cost (including proportionate land cost)

20

CC Not mentioned -

POCM Construction cost Not mentioned

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Extracts of Accounting Policies followed by RE Cos

02/02/2013

Company Rev RecPolicy

How cost is determined Thresholdlimit (%)

POCM Project cost (Land cost + construction cost)

30

POCM Construction cost project wise

POCM Construction cost 20

POCM Project cost (Land cost + construction cost)

30

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Extracts of Accounting Policies followed by RE Cos

02/02/2013

Company Inventory Policy

• Land and plots (other than area transferred to constructed properties at thecommencement of construction) are valued at lower of cost/approximateaverage cost/as revalued on conversion to stock and NRV.

• Cost includes land (including development rights and land underagreements to purchase), acquisition cost, BC, estimated internaldevelopment cost and external development charges.

• Finished stock of completed RE projects, land and land development rightsare valued at lower of cost or NRV on the basis of actual identified units.

• Completed property for sale and transferable development rights arevalued at lower of cost or NRV.

• Cost includes cost of land, land development rights, acquisition of tenancyrights, materials, services, BC and other related overheads.

• Projects in progress are valued at cost.

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Extracts of Accounting Policies followed by RE Cos

02/02/2013

Company Inventory Policy

• Direct expenditure relating to construction activity isinventorised. Other expenditure (including BC) duringconstruction period is inventorised to the extent the expenditureis directly attributable cost of bringing the asset to its workingcondition for its intended use.

•RE work in progress is valued at lower of cost and NRV.•FG : flats and plots valued at lower of cost and NRV.

•Finished stock of completed projects and stock in trade of unitsis valued at lower of cost or market value.

•Construction work in progress is valued at lower of cost or NRV.•Cost includes cost of land, development rights, rates and taxes,

construction costs, BC, other direct expenditure, allocatedoverheads and other incidental expenses.

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Extracts of Accounting Policies followed by RE Cos

02/02/2013

Company Borrowing Cost (BC) policy

BC attributable to the acquisition and/or construction ofqualifying assets (QA) are capitalised.

BC that are attributable to the project in progress and qualifyingland advances as well as CWIP are charged to respective QA. Allother BC, not eligible for inventorization / capitalization arecharged to revenue.

BC that are directly attributable to the acquisition orconstruction of a QA (including RE projects) are considered aspart of the cost of asset.

BC directly attributable to acquisition / construction of QA arecapitalised until the time all substantial activities necessary toprepare the QA for their intended use are complete.

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Extracts of Accounting Policies followed by RE Cos

02/02/2013

Company Borrowing Cost (BC) policy

BC attributable to the acquisition and/or construction of QA arecapitalised.

BC directly attributable to the acquisition and/or construction ofqualifying fixed assets or for long term project development arecapitalised as part of their costs.

BC attributable to the acquisition and/or construction of QA arecapitalised.

BC attributable to the acquisition and/or construction of QA arecapitalised.

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Other disclosure areas …

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• Not defined in most cases

• Relevant for classification in FS

Operating Cycle

• Can be significant in RE companies

• Disclosure often cluttered

Related Party Transactions

Other Disclosure Areas

02/02/2013

Operating Cycle (OC):

Not defined in most cases

Rev Schedule VI lays down a rebuttable OC of 12 months

Necessary to define OC in RE companies since the time forproject execution can exceed 12 months in most cases

OC can be different for RE companies at construction stage andwhen inventory of flats is held

ImpactHas relevance in bank funding, other ratios and overall valuation.

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Extracts of Accounting Policies followed by RE Cos

02/02/2013

Company Operating cycle

•The company’s normal operating cycle in respect of operationsrelating to under construction RE may vary from project toproject depending upon size of the project, type ofdevelopment, project complexities and related approvals.Operating cycle for all completed projects and hospitalitybusiness is based on 12 months period. Assets and liabilitieshave been classified into current and non current based on theoperating cycle of respective business.

•Projects construction activities normal operating cycle isapproximately of 4-5 years depending on the size of theproject.

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Related Party Transactions

02/02/2013

Most RE companies have maze of subsidiaries / associates / JVs

In most cases, the execution of different projects is in different entities – this could be avoid liabilities, due to different partners for funding, regulatory issues, etc.

Multiple entities are used to transfer assets / incomes / expenses inter-se the group due to: Taxation issues Managing profitability

Such complex structures often lead to concealment of the real results of the RE companies.

Preparing CFS may-not always unravel such complexities.

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Related Party Transactions …

02/02/2013

To Illustrate the structure of some leading RE companies:

o DLF Ltd: 278 Subsidiaries, 15 Associates, 13 JVs, 9 firms

o Unitech Ltd: 293 subsidiaries, 6 Associates, 24 JVs

Percentage of incomes from RPT:

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Name of Company Sales and other income

To Related parties

Profit After Tax % of RPT

DLF Ltd. (Rs. in lacs) 3,44,699 51,396 1,04,179 14.91%

Sobha Developers (Rs. in millions)

14,020 1,516 944 10.81%

Parsvnath Developers Ltd. (Rs. in lacs)

71,390 14,468 7,548 20.27%

ICAI 2012 GN – Key principles

02/02/2013

To achieve a degree of consistency in the said practices, ICAIissued revised GN in 2012.

The revised GN seeks to align the current diverse accountingpractices by giving certain bright lines for determining theeligibility of RE projects for revenue recognition.

GN covers all forms of RE transactions such as sale of plots ofland, development and sale of residential and commercial units,redevelopments, joint developments etc.

Applicable to RE projects which commence on or after01.04.12 or Projects where revenue is being recognized forthe first time subsequent to 01.04.12

Early application is permitted.

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ICAI 2012 GN – Key principles …

02/02/2013

For RE transactions which are in substance similar to delivery ofgoods, principles enunciated in AS 9 to be applied

GN mandates application of the POCM in respect of REtransactions where the economic substance is similar toconstruction type contracts.

Input costs for application of POC:

• No prohibition on inclusion of land cost

• Once the actual construction cost reaches 25%, revenue canbe recognized on construction cost + land cost

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ICAI 2012 GN – Key principles and its impact

02/02/2013

Rebuttable presumption that outcome of a RE project can beestimated reliably and revenue should be recognized based onPOCM only when all the following events are completed:

All critical approvals necessary for commencement of projecthave been obtained.

Stage of completion of the project reaches a reasonable level ofdevelopment i.e. when actual cost incurred is not less than 25%of construction and development costs .

At least 25% of the saleable project area is secured by contractsor agreements with buyers.

At least 10% of the total revenue as per legally enforceabledocuments are realized at reporting date.

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ICAI 2012 GN- Key principles and its impact ..

02/02/2013

Impact

Revenue recognition to be deferred until keyapprovals (environmental and otherclearances, approval of plans and designs,title to land, change in land use) areobtained.

Land and development right costs to beexcluded for computation of the 25% costthreshold.

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ICAI 2012 GN – Key Principles and its impact

02/02/2013

Revenue from sale of undeveloped plots of land not to berecognized before possession is effectively handed over to thebuyer and other conditions have been satisfied.

For POC, input method is preferred but other methods are alsoallowed.

Overall restriction on recognition of revenue when there areoutstanding defaults in payment by customers.

TDRs acquired by giving up of rights over existing structures oropen land to be valued at lower of the fair market value and netbook value of the portion given up.

For contracts with multiple deliverables, the total salesconsideration to be split based on fair market value of eachcomponent.

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ICAI 2012 GN- Key principles and its impact ..

02/02/2013

Impact

Companies that are currently followingoutput method, may either switch to theinput method or maintain parallel inputmethod based computations.

Companies to keep track of defaultingcustomers to determine the overall cap ofrevenue recognition.

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ICAI 2012 GN – Sale of plot of land

02/02/2013

Sale of land or plots and units similar to delivery of goods

Without development With significant development

e.g. sale of specified plots withoutany development of those plots(including long term sale typeleases)

e.g. sale of specified plots withoutany development of those plots(including long term sale typeleases)

Revenue not to be recognizedbefore possession is effectivelyhanded over to the buyer and otherconditions are satisfied.

Accounting treatment same asconstruction type contracts.

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ICAI 2012 GN – Transferable Development Rights

02/02/2013

Methods to acquire TDR:

Direct purchase

Development and construction of built up area

Giving up rights over existing structures/ open land

Cost of acquisition of TDR:

Method of purchase Determination of cost

Direct purchase Cost of purchase

Development and construction of built up area

Amount spent on development or construction of built up area

Giving up rights over existing structures/ open land

Lower of Fair market value or Net Book Value

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ICAI 2012 GN – TDR

02/02/2013

Accounting for sale of TDR:

Revenue should be recognized when both the following conditionsare fulfilled:

Title to the development rights is transferred

It is not unreasonable to expect ultimate collection

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ICAI 2012 GN: Multiple Elements Contracts

02/02/2013

Sale of property contract could include:

• Property management services

• Sale of decorative fittings

• Rental in respect of unoccupied premises

Contract consideration to be split into separately identifiablecomponents

Consideration to be allocated based on fair market value of eachcomponent

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ICAI 2012 GN- Implementation challenges

02/02/2013

Issues

Transition- Long term projects where even asmall revenue is recognized before 1 April,2012, will be accounted for based on 2006 GN.

A project is defined as a smallest group ofunits / plots / saleable spaces which are linkedwith a common set of amenities …

For a few years, the real estate companiesmay have to keep two separate revenuerecognition computations –for projects preand post the implement of the revised GN

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AS 9 vis-à-vis TAS (RR)

02/02/2013

AS 9 TAS (RR)

Revenue to be recognized if it ismeasurable or realizable at thetime of sale

No such requirement, exceptfor price escalation claims andexport incentives, providedother conditions as mentionedin TAS are fulfilled.

Bad debt deduction can beclaimed in accordance with theprovisions of the Act.

Revenue to be recognized as perCCM or POCM

Only POCM is permitted.

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AS 7 vis-à-vis TAS (CC)

02/02/2013

AS 7 TAS (CC)

No provision for accrual of income inrespect of retention money.

TAS specifically provides forrecognition of revenue on retentionmoney.

Revenue already recognised can bereversed on account of uncertaintyarising on realization of contractrevenue.

Such amount have to be written off inbooks of account as bad debts as perprovisions of the Act.

Provides for full recognition of expectedlosses and not in proportion to POC.

Losses incurred shall also be allowedonly in proportion to POC. Anticipatedlosses shall not be allowed.

Revenue not to be recognized duringearly stage of a contract. An early stageof a contract is not defined.

Revenue has to be recognized once acontract crosses 25% of stage ofcompletion.

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ICAI 2012 GN vis-à-vis TAS

02/02/2013

Particulars ICAI 2012 GN TAS

When should POCM beapplicable

Indicators laid down Applicable to all constructioncontracts

Situations in whichrevenue can berecognized under POCM

Cumulative conditions as discussed earlier are laid down.

During the early stages of thecontract, where the outcomecannot be reasonably estimated,revenue to be recognized only tothe extent of cost incurred.

Mechanism to ascertainthe stage of completionor percentagecompleted

Does not restrict anymethodology but therevenue recognizedcannot, in any case, exceedthe revenue computedwith reference to ‘projectcost incurred’

• Proportion that contract costsincurred for work performed upto the reporting date bear tothe total estimated costs

• Surveys of work performed; or• Completion of a physical

proportion of the contract work

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ICAI 2012 GN vis-à-vis TAS …

02/02/2013

Particulars ICAI 2012 GN TAS

Recognition ofexpected losses

When it is expected thatproject cost will exceedeligible projectrevenues, expected lossto be recognizedimmediately.

Does not provide for such ascenario.

Others Does not provide forsuch a scenario.

Where contract revenuerecognized is written offsubsequently asuncollectable, the same shallbe recognized as an expenseand not as an adjustment ofthe amount of contractrevenue.

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Accounting under IAS / IFRS

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IAS 18: Revenue

IAS 11: Construction Contracts

Provisions almost similar to AS 9 and AS 7

IFRIC 15 however lays down specific requirements for recognition in case of ‘Agreements for construction of RE’

IFRIC 15 - Agreements for the Construction of Real Estate…

Agreement for construction of Real Estate

Property management services

Construction activities

IAS 18 Revenue

Buyer can specify major structural elements in design

and during construction

IAS 11 Construction Contracts

Yes

No

A B

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IFRIC 15 - Agreements for the Construction of Real Estate…

AB

Recognize Revenue as per Stage of completion method

Agreement for the sale of goods

Agreement for the rendering of

services

If the criteria in paragraph20 of IAS 18 are met,revenue to be recognizedas per the stage ofcompletion

transfer of control, significant risks &rewards of ownership of the WIP asconstruction Progresses.

Recognize Revenue as per Stage of

completion method

Recognize revenue at completion or when conditions of Para 14 of IAS 18 are satisfied

YesNo

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Impact of IFRIC 15

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As published in interim condensed CFS of Nakheel PJSCand it’s subsidiaries:

IFRIC 15 Agreements for the Construction of Real Estatewas issued in July, 2008 and became effective for periodsbeginning on or after 1 January, 2009.

• The group has reviewed the impact of IFRIC 15 and has determined the appropriate accounting policy for revenue recognition.

Impact of IFRIC 15 ...

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The following revised accounting policy adopted incompliance with IFRIC 15 is applicable with effect from 1st Jan2009:

Revenue Recognition “Provided it is probable that the economic benefits will flow tothe Group and the revenue and costs, if applicable, can bemeasured reliably, revenue on sale of plots of land, buildingscondominiums and villas is recognised on transfer of risks andrewards of ownership of the property in its entirely at a singlepoint in time. Risks and rewards of ownership of a property aretransferred at the time when the buyer takes possession of theproperty”.

Impact of IFRIC 15 ...

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The impact of the application of thisnew accounting policy is thattransactions which in the pastrecognised revenue progressivelythroughout the construction periodwill now not have revenuerecognised until the time ofhandover to the buyer.

The effects of the change inaccounting policy are given below:(not reproduced)

Some Other Illustrative Disclosures - UAE

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Emmar Properties:Sale of Property:The group recognises revenue when it isprobable that the economic benefits fromthe sale will flow to the group, therevenue and costs can be measuredreliably and the risks and rewards ofownership of property have beentransferred to the buyer, which is normallyon unconditional exchange of contracts.

For conditional exchanges, sales arerecognised only when all significantconditions are satisfied.

Some Other Illustrative Disclosures -UAE…

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In jurisdictions where the group transfers to the buyer the control and thesignificant risks and rewards of ownership of the work-in-progress in it’scurrent state as the work progresses, the revenues and related costs ofdevelopment are recognised on a progressive basis using percentage ofcompletionmethod.

In jurisdictions where the group transfers risks and rewardsof ownership of the property in it’s entirety at a singlepoint of time, revenue and the associated costs arerecognised at that point of time. Although this trigger isdetermined by reference to the sales contract and therelevant local laws, and so may differ from transaction totransaction, in general the group determines the pointof recognition to be the time at which the buyer isentitled to take possession of property.

Some Other Illustrative Disclosures - USA

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Standard Pacific Corp.:

Revenue Recognition:In accordance with ASC Topic 360-20, PPE – Real Estate Sales (“ASC360-20”), homebuilding revenues are recorded after construction iscompleted, a sufficient down payment has been received, title haspassed to the homebuyer, collection of the purchase price isreasonably assured and we have no other continuing involvement. Ininstances where the homebuyer’s financing is originated by ourmortgage financing subsidiary and the buyer has not made an adequateinitial or continuing investment as prescribed by ASC 360-20, the profiton such home sales is deferred until the sale of the related mortgage loanto a third-party investor has been completed and the contractual termsof the applicable early payment default provisions have lapsed. Totalprofits that were deferred on such home sales for the years endedDecember 31, 2011, 2010 and 2009 were approximately $165,000,$100,000 and $25,000 respectively.

Some Other Illustrative Disclosures - USA…

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Cost of Sales:

Homebuilding cost of sales is recognized in the period when therelated homebuilding revenues are recognized. Cost of sales isrecorded based upon total estimated costs to be allocated to each homewithin a community. Certain direct construction costs are specificallyidentified and allocated to homes while other common costs, such asland, land improvements and carrying costs, are allocated to homeswithin a community based upon their anticipated relative sales or fairvalue. Any changes to the estimated costs are allocated to theremaining undelivered lots and homes within their respectivecommunity. The estimation of these costs requires a substantial degreeof judgment by management.

Some Other Illustrative Disclosures - UK

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Barratt Developers PLC (2011):

Basis of Preparation:

These financial statements have been prepared in accordancewith International Financial Reporting Standards (‘IFRS’) as issuedby the International Accounting Standards Board (‘IASB’),International Financial Reporting Interpretations Committee(‘IFRIC’) interpretations and Standing Interpretations Committee(‘SIC’) interpretations as adopted and endorsed by the EuropeanUnion (‘EU’) and with those parts of the Companies Act 2006applicable to companies reporting under IFRS and therefore theGroup financial statements comply with Article 4 of the EUInternational Accounting Standards Regulation.

Some Other Illustrative Disclosures – UK …

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Revenue:

Revenue is recognised at legal completionin respect of the total proceeds of buildingand development and an appropriateproportion of revenue from constructioncontracts is recognised by reference to thestage of completion of contract activity.Revenue is measured at the fair value ofconsideration received or receivable andrepresents the amounts receivable for theproperty, net of discounts and VAT. The saleproceeds of part-exchange properties arenot included in revenue.

To Conclude …

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Applicable GAAP (AS 9, AS 7) in India does not lay down specific guidance for RE companies

ICAI GN 2012 may not be followed by all companies

For taxation specific rules now laid down

RE Companies in India need to achieve much higher level of transparency (and reliability) in FS

RE companies in ICAI Best Presented Annual Awards list?

Some provisions of Companies Bill 2012 with provisions for compulsory CFS and stringent penalty may lead to more consistency in accounting practices in RE Cos

02/02/2013

himanshu@cnkindia.com

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