Accounting of real estate sales is a contentious issue, not only in India but also globally
Real estate developers enter into agreements to sell the real estate before they have completed or, at times, even begun construction. Each buyer enters into an agreement to acquire a specified unit when it is ready for occupation.
Typically, the buyer pays a deposit and makes progressive payments as the real estate is being constructed. Real estate sale may take various forms. For example, they may relate to commercial/industrial development, a flat in a building, or a villa that is being exclusive constructed to the specification of the buyer.
The accounting of real estate sales is a contentious issue not only in India but also globally.
AS-7 or AS-9
The question often faced by developers is whether the development is a construction contract and hence percentage of completion method under AS-7 should be applied or whether the sale of the real estate is a product sale to which the requirements of AS-9 relating to sale of product should be applied.
If AS-9 is applied then the sale is recognised on delivery of the product at which time the risk and rewards are also transferred to the buyer.
This question has been addressed in the “Guidance Note on Recognition of Revenue by Real Estate Developers”, issued by the ICAI. It may be noted that the interpretation contained in the Guidance Note is different from a recently issued proposed interpretation under IFRS.
As per the Guidance Note, in the case of real estate sales, all significant risks and rewards of ownership are normally transferred when legal title passes to the buyer (for example, at the time of the registration in the name of the buyer) or if there is a legally enforceable agreement for sale and (a) the significant risks (price risk, for instance) have been transferred to the buyer (b) the buyer has a legal right to sell or transfer his interest in the property, without any material impediment.
Once the seller has transferred all the significant risks and rewards of ownership to the buyer, any further acts on the real estate performed by the seller are, in substance, performed on behalf of the buyer in the manner similar to a contractor.
Accordingly, 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 the percentage of completion method in the manner explained in AS 7, Construction Contracts.
Under the IFRS framework, the International Financial Reporting Interpretations Committee (IFRIC) has prepared a draft IFRIC interpretation “D-21 Real Estate Sales” in the light of divergent revenue recognition practices for sales of units by real estate developers.
The draft IFRIC interpretation concluded that a construction contract is ‘a contract specifically negotiated for the construction of an asset or a combination of assets …’ A sale agreement meets this definition if it is an agreement for the seller to provide construction services to the buyer’s specifications.
Features that, individually or in combination, may indicate that an agreement is for the seller to provide construction services to the buyer’s specifications, include:
the buyer being 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 it exercises that ability or not); and
the seller transferring to the buyer control and the significant risks and rewards of ownership of the work-in-progress in its current state as construction progresses.
Indications that the seller transfers control of the work-in-progress this way may include, for example:
the construction taking place on land that is owned or leased by the buyer;
the buyer having a right to take over the work-in-progress (albeit with a penalty) during construction — for example, to engage a different contractor to complete the construction;
in the event of the agreement being terminated before construction is complete, the buyer retaining the work-in-progress and the seller having the right to be paid for work performed (subject to buyer acceptance).
Sale of goods
Conversely, features that, individually or in combination, may indicate that an agreement is for the sale of goods (completed real estate) include:
the negotiation between the buyer and seller primarily concerning the amount and timing of payments, with the buyer having only limited ability to specify the design of the real estate, for example, to select a design from a range of options or specify minor variations to the basic design;
the agreement giving the buyer only a right to acquire the completed real estate at a later date, with the seller retaining control and the significant risks and rewards of ownership of the underlying work-in-progress until that date.
If a sale agreement is for the sale of goods, revenue shall be recognised if the entity has transferred to the buyer the significant risks and rewards of ownership of, and effective control over, the goods sold.
These conditions shall be applied to the underlying real estate in its current state, not to the buyer’s right to acquire the fully constructed real estate at a later date. This effectively means that revenue on real estate sales is recognised when the real estate is constructed and delivered to the buyer.
Stage of completion
The rationale for applying the stage of completion method to construction contracts is not just that it recognises the value of the entity’s activity in the period. Rather it also recognises the economic benefits that the entity has delivered (via continuous transfer of control and risks and rewards of ownership) to the buyer as construction progresses.
This continuous transfer is often not a feature of agreements for the sale of real estate units — control of the unit tends to pass from seller to buyer at a single point in time, usually when the unit is ready for occupation.
Going by D-21, if the real estate developer is constructing a villa for a purchaser, with the purchaser having control over that construction and the villa is to the specification of the purchaser, then the construction of the villa would be a construction contract and the same would be accounted using the percentage of completion method.
If the real estate developer is constructing a multi-storey building and a purchaser is buying a flat in the building, with little control over the technical specification of the flat and no control over the construction, the sale of the flat would be accounted for as a product sale. In other words, the sale would be recognised by the real estate developer when the purchaser is given the possession of the flat.
Clarity to interpretation
To make the above interpretation clear, the IFRIC has included the proposed new guidance on applying IAS 18 within D-21 and has proposed the withdrawal of Example 9 from the appendix to IAS 18, which was creating some confusion, relating to accounting for real estate sales.
The IFRIC noted that a binding agreement for the sale of real estate — like other forms of binding customer order — gives the buyer an asset in the form of a right to acquire, use and sell the completed real estate at a later date. The buyer controls this right and obtains risks and rewards associated with it, such as movements in the market value of the completed real estate.
However, an agreement for the sale of a real estate unit typically does not give the buyer control of the underlying real estate in its existing partially-constructed state. The seller typically retains significant risks of ownership, such as construction risk and risk of damage or default. The seller also typically retains the right to use — that is, continue development of the work-in-progress. The seller is likely to retain these rights until the buyer obtains possession, usually at contractual completion.
The IFRIC notes that it is necessary to distinguish a right to acquire goods from the underlying goods themselves — for recognising the sale the entity should have transferred to the buyer the significant risks and rewards of ownership of, and effective control over, the goods sold, not the right to acquire the goods. Hence, a binding agreement for the sale of a real estate unit is usually insufficient to satisfy the conditions for revenue recognition.
As can be seen from the discussion, the revenue recognition criterion under the “Guidance Note on Recognition of Revenue by Real Estate Developers”, and D-21 are different. The interpretation in D-21 as to what is a product and what is a construction contract, and the time when risks and rewards are transferred, are far more acceptable considering the core principles of the standards on revenue recognition and contract accounting.
The Indian Guidance Note is fundamentally flawed and may lead to totally unintended conclusions if applied as a general principle, for example, revenue recognition under the Guidance Note would commence on entering into non-cancellable purchase orders, rather than at the time of delivery of goods. Consequently, the Indian Guidance note is ripe for a revision.