Complications and Facts of Accountancy

CA Nikita , Last updated: 23 August 2007
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With the opening up of the real-estate industry, there has been an increase in Foreign Direct Investment (FDI) in the sector. According to a report by property consultants Jones Lang LaSalle, an estimated $10 billion foreign investment is expected to enter the Indian real-estate sector in the next 12-18 months. FDI in the real-estate sector and globalisation of the accounting profession require Indian companies to be more transparent, and compliant with global best pra ctices. The Institute of Chartered Accountants of India (ICAI) has done a commendable job in this area with the issue of “Guidance note on Recognition of Revenue by Real Estate Developers”.

This is just the beginning in the direction towards adopting global best practices. However, evaluating and benchmarking the real-estate industry accounting literature brings to light some concerns.

Currently, there are general accounting standards issued by the ICAI which are of relevance for the industry. In addition, the ICAI has issued a “Guidance note on Recognition of Revenue by Real Estate Developers”. On the contrary, under IFRS (International Financial Reporting Standards) and US GAAP (Generally Accepted Accounting Principles) there are specific accounting standards which are customised guidance for the real-estate industry.

Compliance with accounting standards has more enforceability than a guidance note, which ultimately helps bring uniformity and comparability of financial information. In addition to the accounting standards under IFRS and US GAAP, there is a whole lot of literature on FAQs, Best Practices Policy Recommendations, EITFs, etc., — this is one area we need to make progress in.

Revenue recognition by developers

This is one of the areas in which there are varied practices in the construction industry. Generally, developers execute two agreements, that is, ‘Agreement for construction’ and ‘Agreement for sale of land’. The treatment of land element and the application of the percentage of completion method can be as follows:

Purchase of land amounts to construction activity:

Under this option, the actual land cost is included as part of estimated cost and actual cost used for the purposes of computation of percentage of completion; and

The percentage of completion derived above is the basis on which the revenue is recognised for both ‘Sale of land’ and ‘Construction activity’.

Treatment of ‘Agreement for sale of land’ as a standalone agreement:

Here, the actual land cost is not included as part of estimated cost and actual cost used for the purposes of computation of percentage of completion;

The percentage of completion derived above, excluding actual land cost, is the basis on which the revenue is recognised for ‘Construction activity’; and

Revenue recognition for land is done under Accounting Standard 9, without taking cognisance of the risk and rewards linked to the construction contract. Full recognition of revenue from sale of land is done when the revenue recognition criteria for transfer of risk and reward are satisfied.

Hybrid method: The risk and rewards of ‘Agreement for construction’ and ‘Agreement for sale’ are interlinked, in view of which the revenue and cost recognition are done in combination.

Under this option, the computation of percentage completion is based on actual construction cost as compared to total estimated cost. In view of which, the actual land cost is not included as part of estimated cost/actual cost for the purposes of computation of percentage of completion; and

The percentage of completion derived thus is the basis on which the revenue is recognised for both ‘Sale of land’ and ‘Construction activity’.

Though there are varying accounting practices and each has a good justification for itself, it would result in inconsistency in financial results of peer group real-estate companies. In this context, the hybrid method seems more logical as it takes cognisance of the following:

Risk and rewards of the contracts are interlinked in substance;

Purchase of land itself may not be a construction activity and should not be included as part of actual/estimated cost for computation of percentage of completion; and

The total pricing of a constructed property allocated between the two contracts may not be at fair value and accounting of revenue for sale of undivided land on a standalone basis may not reflect the substance of the transaction.

Regulators are looking closely at the accounting practices of the real-estate industry players and there are areas that are open to multiple interpretations. It is important for the ICAI to come out with an industry-specific guidance on real-estate accounting that, in addition to the basic accounting principles for revenue recognition, provides literature and guidance on accounting for tricky issues in line with, say, the US GAAP and IFRS literature.

This would go a long way in helping the real-estate industry.

Adarsh Ranka
(The author is a senior professional in a member firm of Ernst & Young Global.)