Brace up for realty changes

The volume of real estate transactions over the past few years has been significant when compared with the volumes a decade or so ago. The changes in demand for real estate in recent past mirror the Indian economy and could be seen as a reflection of movements in GDP growth.

Complex structures

The options for users or investors in real estate have resulted in the use of many complex sales transaction structures by real estate development companies. The way in which these companies have been reporting revenues, however, has been inconsistent considering the limited accounting guidance available, leaving scope of interpretations, resulting in different policies being adopted for similar transactions.

To address this inconsistency, the Institute of Chartered Accountants of India (ICAI) recently issued a new Guidance Note on Accounting for Real Estate Transactions which primarily deals with revenue recognition in the financial statements of a real estate developer.

For all real estate development projects for which revenue accrual starts after April 1, 2012, for the first time, either out of existing development or a new development, this new guidance for accounting would apply.

This guidance is expected to encourage consistency in terms of revenue recognition policies across the industry, although implementation of the new requirements will have its share of challenges.

Companies will need to gear themselves up by assessing in advance the possible impact on their financial statements, which could be significant for many real estate developers, particular in relation to their top-line.

Key highlights

Inclusion of land cost for determination of percentage of completion : Currently, there exist disparate practices in this area. Some real estate companies consider land cost in computing ‘stage of completion' whereas others do not.

The Guidance Note prescribes that land costs should be included in measuring the stage of completion. Since the land constitutes a significant portion of total cost, significant variation could arise in revenue on adopting this change (see example in Table).

With the land cost being fixed, higher revenue is likely in earlier years as against phasing of revenue over the development/sale if the land costs were not to be included.

It will be important to carefully assess the impact of the new model on revenue recognition in order to properly communicate the impact to investors and other key stakeholders, such as lenders.

In addition, bank covenants may be impacted by the changes in revenue recognition and require re-negotiation with lenders to reflect the revised phasing of revenue recognition.

What is a Project?: The Guidance Note defines a project as the “smallest group of units/plots/saleable spaces which are linked to common set of amenities in such a manner that unless the common amenities are made available and functional, these units/plot/saleable spaces cannot be put to their intended effective use.”

The Guidance Note goes on to state that “a larger venture CAN be split into smaller projects if basic conditions set out above are fulfilled. For example, a project may comprise a cluster of towers or each tower CAN also be designated as a project.”

Determination of what unit of account represents a project will be critical since it seems that a company has an option, but is not necessarily obliged to split a large venture into small projects for the purposes of accounting.

Different interpretation

Companies may interpret guidance differently, resulting in disparity at the level at which the term “project” is defined. Companies need to institute guidelines/parameters based on which they will define the term “project” and use it consistently.

IT systems also need to be reconfigured to define the term project as cost monitoring, and project tracking status will depend on the manner in which project is defined in the system.

The Guidance Note aims to enhance comparability in accounting for real estate transactions. However, the consequences are far wider than financial reporting issues and extend to various business and regulatory matters, including compliance with debt covenants, modification of IT systems and tax planning.

For many entities, financial statements may change dramatically. This will affect perception of analysts, bankers and investors. Lastly, a proper communication strategy will help ensure that all stakeholders understand the changes.

(The author is Partner in a member firm of Ernst & Young Global.)

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