Accounting for Real Estate Transactions The increase in complexity of the terms of real estate transactions has resulted in diversity in practice around revenue recognition by companies in this sector. Accordingly, on 11 February 2012, the ICAI issued a revised GN on Accounting for Real Estate Transactions (revised GN). The revised GN supersedes the existing GN and seeks to achieve uniformity in the accounting and reporting practices in this area.
Currently, there is no separate Accounting Standard (AS) in India for recognition of revenue from real estate sale transactions and accordingly, in practice, the accounting and reporting for such transactions is based on certain principles specified in AS 9, Revenue Recognition and AS 7, Construction Contracts, as supplemented by the Guidance Note (GN) on Recognition of Revenue by Real Estate Developers which was issued by the Institute of Chartered Accountants of India (ICAI) in June 2006.
Background
Applicability The revised GN applies to revenue recognition involving sale of real estate in relation to all projects (this term is discussed further in this note), which will commence on or after 1 April 2012. The revised GN will also apply to projects, which have already commenced but where revenue is being recognized for the first time on or after 1 April 2012.
The revised GN permits early adoption provided that it is applied to all transactions, which commenced or were entered into on or after such an earlier adoption date.
Guidance Note 2012
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Key provisions The revised GN mandates the application of the POC method as specified in AS 7, in respect of real estate transactions where the economic substance is similar to construction-type contracts and where significant risks and rewards of ownership have been transferred to the buyer. The revised GN provides that an agreement for sale entered into during the construction phase is considered to have the effect of transferring all significant risks and rewards of ownership to the buyer provided the agreement is legally enforceable and other conditions exist, which transfer risks and rewards even though legal title is not transferred or possession is not given.
Additionally, the revised GN gives certain indicators for determining if the economic substance of the transactions is similar to construction-type contracts. These indicators are: the period of such projects is in excess of 12 months; most features of the project (land development, structural engineering, architectural design, construction) are common to construction contracts; individual units of the project are interdependent upon or interrelated to completion of a number of common activities and/or amenities; the construction or development activities form a significant proportion of the project activity. Mandatory application of the percentage of completion (POC) method POC method The revised GN provides certain general conditions for application of the POC method (reliable estimates of project revenues; probability of economic benefits; identification and estimation of project costs). Additionally, and more significantly, the revised GN provides that the following specific conditions should be satisfied for recognition of revenue: All critical approvals such as environmental clearances; approvals of plans and designs; title to land or other development rights; have been obtained;
The stage of completion of the project has reached a reasonable level. A reasonable level of development is not achieved if the expenditure incurred on construction and development costs (excluding costs of land, development rights and borrowing costs) is less than 25% of the total estimated construction and development costs;
Atleast 25% of the saleable project area is secured by contracts or agreements with buyers; and
Atleast 10% of the sale value has been realized from each of the contracts and it is estimated that the customer will comply with the balance contract payment terms for such contracts.
For the purpose of applying the above conditions (and other provisions of the revised GN), the term project has been defined as the smallest group of units 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 cannot be put to their intended effective use. For example, a project may comprise a cluster of towers or each tower may be designated as a project. Once it is determined that all the above conditions have been met in relation to a project, revenue should be recognized for the units sold using the POC method. For this purpose, the POC should be calculated based on the total cost incurred (including land, development right and borrowing costs). Though the revised GN permits the use of other methods such as survey of work done, the POC per such other methods cannot exceed the POC based on total cost. Additionally, the revenue recognized should not exceed the total revenue from eligible contracts, which are defined to mean contracts where at least 10% of the contracted amounts are realized and there are no outstanding defaults in payment. Transferable development rights The revised GN provides that where development rights are acquired directly or through construction of built-up area, the purchase price or cost of construction would represent the cost of the acquirer. Where development rights are acquired by surrendering rights over existing assets, the development rights should be recorded at the fair value, or net book value of the asset given up, whichever is lower.
The fair value may be based on fair value of the asset given up or fair value of the development rights acquired, whichever is more clearly evident.
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Total saleable area of the project 20,000 Sq. ft. Estimated project costs (this comprises land cost of INR. 300 Lakhs and construction costs of INR. 300 Lakhs) INR. 600 Lakhs Cost incurred till end of reporting period (this includes land cost of INR. 300 Lakhs and construction cost of INR 60 Lakhs) INR. 360 Lakhs Total area sold till the date of reporting period 5,000 Sq. ft. Total sale consideration as per agreements of sale executed INR . 200 Lakhs Amount realized till the end of the reporting period INR. 50 Lakhs Percentage of completion of work 60% of total project cost including land cost or 20% of total construction cost If the work completed till end of reporting period is (this includes land cost of INR. 300 Lakhs and construction cost of INR. 90 Lakhs) INR. 390 Lakhs Percentage of completion of work would be 65% of total project cost including land cost or 30% of construction cost Revenue recognised (65 % of INR. 200 Lakhs as per Agreement of Sale) INR. 130 Lakhs Proportionate cost (5000 sq.ft./20,000 sq.ft.) X 390 INR. 97.50 Lakhs Income from the project INR. 32.50 Lakhs Work in progress to be carried forward INR. 292.50 Lakhs Illustration on application of POC method At the end of the reporting period, the enterprise will not be able to recognise any revenue as reasonable level of construction, which is 25% of the total construction cost, has not been achieved, though 10% of the agreement amount has been realised. The enterprise would be able to recognise revenues at the end of the accounting period. The revenue recognition and profits would be as under:
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Implementation of the revised GN is likely to have a significant impact on revenue recognition practices of several real estate companies. In certain cases, companies may now be required to apply the POC method where they previously applied the completed contract method. In certain other cases, revenues relating to certain projects may need to be recognised on a Currently, certain companies follow the completed contract method for revenue recognition based on the analysis that certain conditions in the existing GN are not met (for example, the buyer does not have the legal right to sell the interest in the property). The revised GN prescribes a different set of conditions, which focus on the economic substance of the transaction. Accordingly, an entity that previously applied the completed contract method may need to now apply the POC method.
Overview deferred basis if specific conditions are not met. The application of the revised GN would also throw up certain new interpretation issues and certain issues relating to the transitional provisions.
Mandatory application of the POC method Further, certain entities may have recorded revenues from an undivided interest in land upfront where separate agreements were entered into for sale of the land and the subsequent construction activity. The revised GN requires that such related contracts be accounted for based on their economic substance and not merely based on legal form. This may require such contracts to be combined, with revenues recorded on a POC basis for the overall contract.
Application of the POC method Determination of the project The revised GN requires the determination of eligibility for revenue recognition at a project level. Determination of what constitutes a project (complete township, cluster of towers or an individual tower) may significantly impact the determination of whether the project is eligible for revenue recognition. For example, if an individual tower is determined to constitute the project and 25% of the saleable area relating to that tower is sold, the requirement of the revised GN relating to minimum sale would be met. However, in the same situation if a cluster of towers are determined to constitute the project, this criterion may not be met if there are insufficient sales in other towers within the cluster. Practice is likely to evolve in this area. Additional specific conditions The revised GN prescribes certain additional conditions, which may result in a deferral of revenue recognition. For example, certain companies currently recognize revenues as construction progresses even if certain project approvals may be pending. This may no longer be possible under the revised GN. Further, several companies commence recognition of revenues on a project when the POC reaches a particular stage, which may be different than the 25% minimum prescribed under the revised GN. Similarly, certain companies currently include land cost, while determining whether the project has made sufficient progress for revenue recognition.
The revised GN precludes inclusion of cost of land, development rights and borrowing costs, while determining whether the minimum 25% progress has been achieved. The additional conditions relating to sale of atleast 25% of the saleable area, collection of 10% of the revenues for each contract and restriction on total revenues recognized to a maximum of total revenues on eligible contracts (non- defaulting contracts where at least 10% of the sale value has been collected); may also result in a deferral of revenues. For companies that currently determine POC using a method other than the cost method, the revised GN would require deferral of revenues to the extent they exceed revenues computed based on the cost method. For application of the above conditions, the revised GN seems to make a distinction between legally enforceable agreements (used for assessment of the sale of 25% saleable area), agreements where 10% has been collected (for recognition of revenues on individual contracts) and eligible contracts (for determining the maximum revenue that can be recognized on a project). The revised GN does not directly address how cash collected on contracts, which are not eligible contracts (for example, due to a default), should be considered, while determining the maximum revenue that can be recognized on a project. Similarly, the revised GN does not specifically provide if the costs recognized on a POC basis should be adjusted if revenue recognition is limited due to application of the maximum revenue requirements. In the absence of specific guidance, practice is likely to evolve in these areas.
Key implementation challenges
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Transition to the revised GN The revised GN will apply to all projects that commence after 1 April 2012 or where no revenues have been recognized prior to 1 April 2012. Accordingly, for companies that previously applied the completed contract method, and where the revised GN requires the application of the POC method; companies may need to record a transition adjustment when they first apply the revised GN. The revised GN does not provide guidance on the manner in which such transition adjustments need to be recorded. Impact on direct taxation Most real estate developers follow the same accounting policies both for financial reporting and for tax purposes in the absence of any specific guidance in the Income Tax Act. Hence, the corporate tax liability and the associated cash outflows would be impacted. Even in situations where the developers propose to follow a different revenue recognition policy for tax purposes, the revised GN would impact the liability under the Minimum Alternate Tax (MAT) provisions since the MAT liability is based on the statutory financial statements. Further, it needs to be noted that the amount of revenue recognized in a particular finance period also plays an important role in determining aspects such as the need for a compulsory tax audit. There could also be issues in relation to aspects where the draft Tax Accounting Standard (TAS) issued by the Central Board of Direct Taxes (CBDT) recently differ with the revised GN. Once the TAS is notified by the CBDT and if there exists inconsistencies between the TAS and the revised GN, developers may be required to maintain two different sets of records.
How can KPMG assist The implications of the revised GN are varied and are expected to present a large number of implementation issues. Companies should plan and implement modifications in their accounting systems and procedures to enable reporting under the revised GN. Based on our knowledge of the sector and experience in providing our clients with training and implementation assistance on similar accounting and reporting changes, KPMG professionals can assist in the following areas: Training Customized training sessions to help accounting and financial reporting teams to gain an in-depth understanding of requirements of the revised GN and understand the practical challenges in implementing the new accounting and reporting requirements. Accounting manual We can assist in developing a comprehensive accounting manual around revenue recognition policies and practices to be followed by the company after incorporating different aspects of authoritative literature and the entitys business practices. Implementation assistance The revised GN will have an impact not only on accounting and reporting but also in the areas of budgets. We can assist in implementation of these changes on a broad ranging basis or provide accounting support on specific areas. We can also assist in making revised presentation and disclosures in the first financial statements after the implementation of the revised GN.
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