8 March 2012 Update. Real Estate

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1 8 March 2012 Update Real Estate ICAI s guidance on accounting to bring uniformity in practice; Developers likely to shift to new norms from April 1, 2012; Near-term impact positive for HDIL, Prestige; Negative for DLF ICAI s latest guidance note The Institute of Chartered Accountants of India (ICAI) has issued a guidance note on accounting for real estate companies. The guidance applies to revenue recognition for projects which would commence on or after April 1, The guidance also applies to projects that are already underway, but where revenue recognition would start on or after April 1, Although the guidance is recommendatory in nature, we believe most real estate companies will adopt it as it would be the default accounting norms for most auditing firms. Key highlights of the guidance note Commencement of revenue from projects is eligible only when all critical approvals are in place. These include environment clearance, plans/designs, change in land usage, title of land, etc. Pre-requisites are (1) 25% of project is sold with secure agreement, (2) at least 10% of amount is collected on sold portion along with no outstanding customer default, and (3) at least 25% of construction cost has been incurred (excluding land cost or borrowing cost). Any loans and advances given to contractors in excess of actual work done would be excluded for the period and would only be counted once actual work is done. Recognition of revenue at any point of time should not exceed the estimated total sales revenue already under contract/agreements. Any expected loss due to cost overruns should be booked as an expense immediately irrespective of the stage of completion of the project. TDR revenue is booked when the title of development right is transferred to the buyer and the buyer of TDR would add acquisition cost of TDR to the actual project cost. Current accounting practices Barring a few real estate companies like HDIL and Sunteck Realty that follow the Project Completion Method (PCM) of accounting to recognize revenue, most follow the Percentage of Completion Method (POCM). Under POCM, the developers recognize revenue based on Pre-decided threshold level (a certain percentage of estimated construction cost); before crossing the threshold level, all collections from customers and cost incurred are treated as Advances and WIP. Post-threshold revenue is booked based on actual progress in execution. However, the developers are divided in exact application of POCM. There is 1

2 wide divergence among developers on various aspects of the method, which makes it extremely difficult for investors to compare the financials. For example On threshold levels DLF (30%), Unitech (20%), HDIL (100%) and Mahindra Lifespaces (25%). Inclusion of land cost in threshold levels Some developers (like DLF and Anantraj) include the land cost while calculating the threshold limit, and hence reach the limit very fast, sometimes even before construction commences. This is especially in cases where the land cost itself (as proportion of total cost) is higher than the threshold limit. However, other developers do not consider land cost while calculating the threshold level. Even after threshold, the method of land cost booking could be either proportional or entirely upfront (pro-rata to percentage sold). Revenue booking practices under POCM by different developers Potential impact Long-term positive for sector as it would result in uniformity; near-term negative for developers with aggressive accounting policies The accounting guidance is nothing but just a phasing of revenue booking according to a commonly-accepted way. Therefore, over the long-run, the policy would help in (1) bringing uniformity in accounting practices of real estate companies by removal of discretion, and (2) making a common base of comparison and evaluation for all stakeholders (investors, lenders, PE firms, etc). However, certain near-term term impacts are expected in the reported numbers of developers, especially those currently following comparatively aggressive revenue-recognition method. The conservative stated criteria for revenue booking would lead to deferment of revenue of certain projects which are in very early stages of construction, reducing the expected topline and bottomline. Also, given that fixed cost would be present (and is rising in most cases) in P&L, the accounting profitability would be adversely impacted initially. On the other hand, the P&L of developers like HDIL and Prestige are going to improve with faster revenue recognition. 8 March

3 [A] Charts below illustrate the phasing of revenue booking (cumulative) by different developers on a hypothetical project Project assumptions Total sales value 100 Land cost 30; Construction cost 30; hence total cost 60 To simplify the calculation, let s assume the project gets fully sold on the launch date Outcomes As evident from the charts that plot cumulative revenue booking against percentage of construction show DLF and Anantraj follow the most aggressive revenue-booking practices. Hence, the proposed accounting impact would be highest at individual project level. Moderate/minor modifications are expected from Unitech, Oberoi, GPL and Mahindra Lifespaces. HDIL and Prestige would see faster revenue-booking. Phasing of revenue booking v/s progress in construction of different companies [B] Understanding the nuances of accounting treatment by developers 8 March

4 At the end of Year 1 The following will be the revenue and profit booking and the balance sheet entries will be as follows 8 March

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