Guidance Note on Accounting for Real Estate Transactions Dinesh Jangid
Agenda Background and current accounting practices 2
Background Current accounting is mostly driven by the GN of the Institute of Chartered Accountant of India (ICAI) on Recognition of Revenue by Real Estate Developers which was issued in June 2006 On 11 February 2012, the ICAI finalized the revised GN on Accounting for Real Estate Transactions. This GN supersedes the above existing GN of ICAI The revised GN seeks to align the current diverse accounting practices by giving certain bright-lines for determining the eligibility of real estate projects for revenue recognition The revised GN should be applied to all projects in real estate which will commence or on which the revenue is recognised for the first time on or after 1 April 2012. Early application is permitted 2012 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights 3
Key principles of the existing GN of 2006 (1/2) For recognition of revenue in case of real estate sales, it is necessary that ALL the following conditions, specified in paragraphs 10 and 11 of Accounting Standard (AS) 9, Revenue Recognition are satisfied: Ultimate collection is reasonably assured the property in the goods or all significant risks and rewards of ownership have been transferred to the buyer Seller retains no effective control of the goods transferred to a degree usually associated with ownership no significant uncertainty exists regarding the amount of the consideration Issue The point of time at which all significant risks and rewards of ownership can be considered as transferred, is required to be determined on the basis of the terms and conditions of the agreement for sale. 4
Key principles of the existing GN of 2006 (2/2) As per the existing GN, legally enforceable agreement for sale with the buyer at initial stages of construction is considered to have the effect of transferring all significant risks and rewards of ownership to the buyer provided the following conditions have been satisfied: a) Price risk has been transferred to the buyer b) The buyer has a legal right to sell or transfer his interest in the property In case the seller is obliged to perform any substantial acts after the transfer of all significant risks and rewards of ownership, revenue should be recognised on proportionate basis as the acts are performed. Issue The existing GN does not give guidance on the application of the Percentage of Completion (POC) method but refers to AS 7, Construction Contracts. 5
Current accounting practices A great diversity in practice Some of the key areas where there is inconsistency in application of the erstwhile GN: Completed contract vs. POC method Method for determining the POC Input vs. output method Threshold for revenue recognition Project costs whether cost of land and development rights are part of the project costs Borrowing costs capitalization and the manner of computation Impact Because of the diversity in practice in the above key areas, it has been extremely difficult to compare the financial results and true assets of companies in this sector 6
Agenda Highlights of the revised GN 2012 7 7
The revised GN 2012 Percentage of Completion Method The GN mandates the application of the POC method in respect of transactions in real estate where the economic substance is similar to construction type contracts Indicators for determining if the economic substance of the transactions is similar to construction type contracts : Period of project is in excess of 12 months Project features include land development, structural engineering, architectural design, construction etc. Individual units are interdependent upon completion of a number of common activities or amenities Construction or development activities form a significant proportion of the project activity Impact Agreement for sale is considered to have the effect of transferring all significant risk and rewards of ownership to the buyer provided the agreement is legally enforceable 8
The revised GN 2012 Key principles There is a rebuttable presumption that the outcome of a real estate project can be estimated reliably and that revenue should be recognised based on POC method only when all the following events are completed: All critical approvals necessary for commencement of the project have been obtained Expenditure incurred on construction and development is higher than 25 percent of the construction and development costs At least 25 percent of the saleable project area is secured by contracts or agreements with buyers; and At least 10 percent of the total revenue realized from each contracts Impact Revenue recognition to be deferred until key approvals (environmental and other clearances, approval of plans & designs, title to land, change in land use) are obtained Land and development right costs to be excluded for computation of the 25% cost threshold (as above) 9
The revised GN 2012 Key principles Revenue from sale of undeveloped plots of land (including long term sale type leases) not to be recognized before possession is effectively handed over to the buyer and other conditions have been satisfied For POC, input method is preferred but other methods are also allowed. Revenue per the other method shall not exceed the revenue per the input method Overall restriction on recognition of revenue when there are outstanding defaults in payment by customers TDRs acquired by giving up of rights over existing structures or open land to be valued at lower of the fair market value and net book value of the portion given up For contracts with multiple deliverables, the total sales consideration to be split based on fair market value of each component Companies that are currently following output method, may either switch to the Impact input method or maintain a parallel input method based computations Companies to keep track of defaulting customers to determine the overall cap of revenue recognition 10
The revised GN 2012 Project costs Project cost includes Cost of land and cost of development rights Borrowing costs and Construction and development costs. Cost of land and cost of development rights may include cost of land itself or development rights and other related costs such as stamp duty, registration, brokerage and other incidental expenses. It also includes rehabilitation costs. Borrowing costs are capitalized in accordance with AS-16, Borrowing Costs which are incurred directly in relation to a project 11
The revised GN 2012 Project costs 3) Construction and development costs include: Costs that relate directly to a specific project including: land conversion costs, betterment charges, municipal sanction fee and other charges for obtaining building permissions; site labour costs, including site supervision; costs of materials used in construction or development of property; depreciation of plant and equipment used for the project; costs of moving plant, equipment and materials to and from the project site; costs of hiring plant and equipment; costs of design and technical assistance that is directly related to the project; claims from third parties estimated costs of rectification and guarantee work, including expected warranty costs 12
The revised GN 2012 Project costs Costs that may be attributable to protect activity in general and allocated to specific projects includes: insurance; costs of design and technical assistance that is not directly related to a specific project; construction and development overheads (includes preparation and processing of construction personnel payroll cost) borrowing costs NOTE: These allocation is to be based on the normal level of project activity. Exclusion from project cost, if they are material: general administration costs; research and development costs; depreciation of idle plant and equipment; cost of unconsumed or uninstalled material delivered at site; and payments made to sub-contractors in advance of work performed. selling costs (like brokerage charges); 13
The revised GN 2012 Cost of TDR Transferable development rights (TDRs) Mode of acquisition Direct purchase Development and construction of built-up area Exchange of rights over existing structures or open land Cost of acquisition Cost of purchases Amount spent on development or construction of built-up area Lower of * Fair market value or Net book value *Fair market value may be determined by reference either to the asset or portion thereof given up or to the fair market value of rights acquired whichever is more clearly evident. Purchase/ Acquisition: When TDRs are utilized in a real estate project by an entity, the cost of acquisition should be added to the projects costs. Sale/ Transfer: When TDRs are sold or transferred, revenue should be recognized when: title to the development rights is transferred to the buyer it is not unreasonable to expect ultimate realization of revenue. 14
The revised GN 2012 Sale of plot of land 15
The revised GN 2012 Implementation challenges The Guidance Note should be applied to all projects in real estate: which are commenced on or after April 1, 2012; and to projects which have already commenced but where revenue is being recognized for the first time on or after April 1, 2012. An enterprise may choose to apply the Guidance Note from an earlier date provided it applies it to all transactions which commenced or were entered into on or after such earlier date. Project is the smallest group of units/plots/saleable spaces 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 /plots / saleable spaces cannot be put to their intended effective use. Issues Transition Long term projects where even a small revenue is recognised before 1 April 2012, will be accounted for based on the existing GN 16
The revised GN 2012 Implementation challenges Impact on revenue recognition if there are restriction of transfer during construction period Transition Long term projects where even a small revenue is recognised before 1 April 2012, will be accounted for based on the existing GN Payment defaults It is not clear if post balance sheet date defaults or payments to be considered. Accounting for costs in case if the revenue is restricted to non-defaulting contracts Communication with stake holders On deferral of revenue, some of the debt covenants may get broken. Time and effective communication with different stakeholders is going to be a key in managing the transition A project is defined as a smallest group of units / plots / saleable spaces which are Issues linked with a common set of amenities For a few years, the real estate companies may have to keep two separate revenue recognition computations for projects pre and post the implement of the revised GN 17
Agenda Example 18 18
Examples Construction type contract (No revenue recognition) Example (1/2) Illustration: Relevant details of the project are* : Total saleable area Land cost Estimated construction cost Estimated project costs 20,000 square feet INR 30 million INR 30 million INR 60 million Work completed till the reporting date : Land cost Construction cost Total area sold till reporting date Total sale consideration as per agreements of sale executed Amount realized till the end of reporting period** INR 30 million INR 6 million 5,000 square feet INR 20 million INR 5 million *It is assumed that all critical approvals for commencement have been received **It is assumed that there are no defaults from customers
Examples Construction type contract (No revenue recognition) Example (2/2) Solution: Level of development construction cost) Stage of development 20% (percentage of total construction cost incurred of total estimated 60% (percentage of total project cost incurred of total estimated project cost) Project area sold 25% Agreement amount realized 25% As at the end of the reporting period the entity will not be able to recognize any revenue as reasonable level of development, which is 25% of the total construction cost, has not been achieved.
Examples Construction type contract (Revenue recognized) Example (1/2) Illustration: Relevant details of the project are* : Total saleable area Land cost Estimated construction cost Estimated project costs 20,000 square feet INR 30 million INR 30 million INR 60 million Work completed till the reporting date : Land cost Construction cost Total area sold till reporting date Total sale consideration as per agreements of sale executed Amount realized till the end of reporting period** INR 30 million INR 9 million 5,000 square feet INR 20 million INR 5 million *It is assumed that all critical approvals for commencement have been received **It is assumed that there are no defaults from customers
Examples Construction type contract (Revenue recognized) Example (2/2) Solution: Level of development construction cost) Stage of development cost) 30% (percentage of total construction cost incurred of total estimated 65% (percentage of total project cost incurred of total estimated project Project area sold 25% Agreement amount realized 25% As all the criteria for revenue recognition are being met, revenue can be recognized using the POCM. However, revenue should not exceed estimated total revenue from legally binding contracts. The revenue recognition and profits are: Revenue recognized INR 13 million (65% of INR 20 million as per agreement of sale) Proportionate cost of revenue INR 9.75 million (39 million X 5,000 sq ft/ 20,000 sq ft) Income from project INR 3.25 million Work in progress to be carried forward INR 29.25 million (INR 39 million INR 9.75 million)
Questions & Answers 2012 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights 23
Thank You Dinesh Jangid Associate Director Accounting Advisory Services KPMG in India Phone: +91 (22) 30901953 Email: dinesh@kpmg.com firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights The KPMG name, logo and "cutting through complexity" are registered trademarks or trademarks of KPMG International Cooperative ("KPMG International").