Bottom Line: IND AS 115 mandates revenue recognition and profits to be booked on Project Completion Method and not Percentage Method. Ravi Sinha finds it is not only in sync with RERA’s escrow model but also promises to goad the sector to fair revenue projections.
Can a business claim in account books advance payments as income from sales? Well, in an ideal accounting practice an advance payment is a loan and not profit. But in the context of Indian real estate the prevalent revenue recognition was calculated on the basis of sales proceeds, even before the completion of the sales.
The real estate has been calculating the revenue on Percentage Completion Method and not Project Completion Method. With the Percentage Completion Method, the developers treated payment received from the home buyers for purchase of flats under construction as turnover of the company and net income generated from such projects was treated as profit.
However, with the Indian Accounting Standard IND AS 115 coming into effect from April 1, 2018, real estate developers are now being forced to show the payments of home buyers in an ongoing project as loans and not as income from sales. This promises to goad the sector to best practices as it will have a severe impact on the ways and means in which real estate developers run business and showcase their fiscal performance and debt equity ratio to raise more funds.
To a large extent the IND AS 115 is also in sync with the RERA that mandates the sales proceeds of an ongoing project to be kept in a separate escrow account. Globally too, in most of the developed markets the uniform accounting practices are only acceptable way of accounting for the real estate because income is recognised only after the project has been delivered. This is because before the delivery of the project the customer may cancel his bookings for whatever reasons and ask for his refund.
For instance, last fiscal one of the leading real estate developers from Delhi-NCR was unable to explain during its investor presentation as to how could it claim the sales figure to be INR 2100 crores when buyers worth INR 1200 crores had cancelled the booking.
Therefore, it is generally believed that the new accounting standard for revenue recognition will help in “improved disclosures” as well as reduce the scope for interpretation on various areas. The Institute of Chartered Accountants of India (ICAI) says the new revenue standard brings in a comprehensive and robust framework for recognition, measurement and disclosure of revenue.
“IND AS 115, based on IFRS 15 Revenue for Contracts with Customers, is the culmination of IFRS and US GAAP (Generally Accepted Accounting Principles) convergence project. Information about revenue is very important and is used to assess a company’s financial performance and position and to compare that company with other companies,” the Institute said in a statement.
A notification issued by the Ministry of Corporate Affairs says that the objective of IND AS 115 is to establish the principles that an entity should apply to report useful information to users of financial statements about the nature, amount, timing and uncertainty of revenue and cash flows arising from a contract with a customer.
IND AS 115—Reality bites
Developers can no longer book profits on Percentage Completion Method and it has to be accounted as per Project Completion Method
Globally the standard accounting practice is to book profits on Project Completion Method because any buyer in under construction project can exit and seek refund
Standard business accounting calculates payment received before transaction as advance payment or loan and now onwards buyers’ payments in under construction project would be treated as loan
IND AS 115 is in sync with RERA that mandates sales proceeds of under construction projects to be kept in a separate escrow account and not treat it as revenue recognition
From the financial year 2018-19, the other two standards IND AS 18 and 11, which are related to revenue and construction contracts, has been withdrawn. The ICAI says that IND AS 115 would improve the comparability of revenue across entities, industries, global capital markets and would require “more improved disclosures to help investors and analysts better understand entity’s revenue’’.
ICAI maintains that the standard prescribes only one underlying principle for revenue recognition – transfer of control over goods/services – and replaces the ‘fair value’ concept with ‘transactions price’, which is better suited for measurement of revenue.
JC Sharma, VC & MD of Sobha Limited agrees that IND AS 115 is likely to increase the paperwork of real estate developers. However, for the computation of income purpose, the company will continue to compute and pay taxes on the percentage completion basis. In all likelihood, there will be some issues pertaining to Minimum Alternate Tax (MAT).
“Companies will have additional compliance requirement. Optically, balance sheet will look weaker than what it is. Comparative data will be difficult to be analyzed. At the same time, it will not have any material impact on the cash flows and the overall profitability of an organisation.
Joe Verghese, Managing Director, Colliers International India maintains that making up for lost time, the government seems to be on an overdrive to remedy all ‘perceived’ lapses in the real estate sector. According to him, timing is not great considering that the sector is still recovering from previously introduced policy initiatives.
Nikhil Hawelia, Managing Director of Hawelia Group believes that for a business like real estate that is so very complex, the new regulations should have been made effective for the new launches henceforth. To implement it with the current fiscal year, the problem is in calculating the already booked profits and write it back.
“The perception is gaining ground that the new accounting norms will only erode the performance analysis of the listed companies. However, the fact of the matter is that the small developers with only a handful of projects but sound with account books due to good sales number will suddenly look like bankrupt. Their performance analysis and debt to equity ratio will give an impression that the developer lacks credit reliability,” says Hawelia.
Anuj Puri, Chairman of ANAROCK property consultants agrees that a significant change in the recognition method – leading to a massive revenue and cost reversal in the Q1 2018-19 results of the listed real estate developers, leading to a negative impact on the credit rating which may lead to sovereign/pension funds revisiting their future investment plans. These investors have strict norms under which they invest only in companies which are above a certain threshold of credit rating
“A few ongoing PE/institutional deals may be renegotiated – ongoing deals will be based on the historical and financial projections as per the previous accounting standards. With revisions to the accounting standards, the financial statements will also change. This may impact the developer’s fundraising process/cost and indirectly hamper the prices as well,” says Puri.
Will it lead to realty stock prices witness correction? Well, there is a general consensus that the stock prices are a function of the company’s profitability and leverage. With changes in the accounting standards, the price-to-book value ratio will change and will bear an impact on the current stock prices.
“With Ind-AS 115 the focus will shift to sustainable EBIDTA levels of listed real estate companies. Markets are mature enough to realise that valuations for real estate companies will have to be made with higher multiples on NPVs of future EBIDTA and, hence, the perception that listed real estate companies will suffer in valuations is only temporary,” believes Jaxay Shah, CREDAI President.
As per Colliers, this change will not only impact the revenue recognition but also alter the net profits and net worth of the real estate companies. However, it will be beneficial to both developers and investors in the long run as the adoption of the new IFRS based accounting rule will enable them to look at sustainable earnings based on actual deliveries rather than excessively relying on pre-sales and accounting margin.
In order to adopt the new accounting rule most of the developers will need to reverse the unrecognized profits in their balance sheets which may be detrimental for book values in the short term. However, it should get compensated on higher earnings from projects where revenues/profits will again get recognized thus the overall impact should get normalize within one to two years.
In conclusion, IND AS 115 is not only a new accounting norm that mandates to book profit on Project Completion Method instead of Percentage Completion Method. It also means that there will be large scale consolidation in the sector. Financially incapable and over-leveraged developers with multiple projects and looking good on balance sheets without focus on delivery would not be getting funds on the basis of overall revenue recognition without good track record of delivery.
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