The ICAI should ensure that the guidance note specifies in detail on how to recognise revenue in real estate transactions in India.
Slush and ill-gotten funds invariably get parked into real-estate. With limited exceptions, real-estate companies have not embraced international accounting and governance standards.
Accounting standards encouraged this laxity by prescribing the percentage-of-completion (POC) method for recognising revenue since real-estate projects are invariably long-gestation projects and waiting for the ribbon-cutting ceremony to recognise revenue just did not seem right. However, the liberty provided by the POC method encouraged a few to recognise revenue though only a small portion of the project was visible.
The International Accounting Standard Board (IASB) was seized of the problem and decided to tackle it from the conceptual stage. Technically speaking, there were two accounting standards dealing with revenue recognition for real estate companies- IAS 11 on Construction Contracts and IAS-18 on Revenue.
Some entities decided to adopt either of these accounting standards on a convenience basis. The IASB decided to tackle the problem head-on by getting the Interpretation Committee to issue IFRIC-15- Agreements for the Construction of Real-Estate. IFRIC sought to end the debate on which accounting standard would apply.
IAS 11 defines a construction contract to be a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.
IFRIC-15 clarified that an agreement for the construction of real estate meets the definition of a construction contract when the buyer is able to specify the major structural elements of the design of the real estate before construction begins and/or specify major structural changes once construction is in progress (whether or not it exercises that ability).
If the agreement meets the definition of a construction contract, revenue could be recognised on the basis of the percentage of completion. If not, IAS-18 on Revenue would operate which would mean that revenue can be recognised only when the significant risks and rewards have been transferred and the amount of revenue can be measured reliably. In real-estate lingo, this event would occur on the registration of the sale deed.
The Institute of Chartered Accountants of India (ICAI) has recently issued a Guidance Note (GN) on Recognition of Revenue by Real-estate developers. Though the overall direction of the GN is according to IFRIC-15, it deviates in some aspects.
The GN mandates that the POC method is applied to the accounting of all real estate transactions/activities where the economic substance is similar to construction type contracts. Indicators of such contracts are when the period of such projects is in excess of 12 months, most features of the project are common to construction-type contracts, while individual units of the project are contracted to be delivered to different buyers these are interdependent upon or interrelated to completion of a number of common activities and/or provision of common amenities and the construction or development activities form a significant proportion of the project activity.
The GN also specifies that the POC method can be applied only when all necessary approvals for the commencement of each project have been obtained, the expenditure on project costs exceeds 25 per cent of the construction and development costs, atleast 25 per cent of the estimated project revenues are secured by contracts or agreements with buyers and at least 10 per cent of the total revenue according to the agreements of sale or any other legally enforceable documents are realised at the reporting date in respect of each of the contracts.
When the earnings process of a real-estate project is complete (typified by transfer of significant risks and rewards, possession has been handed over, there is no uncertainty on the amount of consideration and it is not unreasonable to expect ultimate collection), AS-9 on Revenue Recognition would come into play. The GN follows IFRS norms in requiring multiple contracts to be unbundled into their various components.
IFRIC-15 rightly attempted to focus on Agreements though critics state that putting clauses into an agreement is harmless.
The clause on the buyer specifying structural changes is cited as an example- it can be innocuously put in an agreement triggering the POC method. Real estate transactions in India involve innovative and byzantine agreements. The ICAI should ensure that the GN provides detailed guidance on how to recognise revenue in such cases. The adoption of the GN and Ind-AS 11 on construction contracts could force real estate entities to recognise revenue later than at present.
(The author is a Bangalore-based chartered accountant.)