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, 2012. The
guidance also applies to projects that are already underway, but where revenue
recognition would start on or after April 1, 2012. 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
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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.
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[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
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Estate Real
At the end of Year 1: The following will be the revenue and profit booking
and the balance sheet entries will be as follows
:
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