Revenue Recognition is a very important aspect in Accounting & often many listed companies try to book higher revenue (popularly known as window dressing) for showing good performance by following proper basis to safeguard them.
IFRS 15 Revenue from contracts with customers is applicable from annual periods beginning 1st January 2018. On similar lines The Ministry of Corporate Affairs (MCA) has notified Ind AS 115 for application by Ind AS companies from financial years beginning on or after 1 April 2018. Ind AS 115 is largely aligned with the latest version of IFRS 15 except few exceptions.
An entity shall apply this Standard to a contract (other than a contract listed in paragraph 5 of the standard which is reproduced below) only if the counterparty to the contract is a customer.
Scope
An entity shall apply this Standard to all contracts with customers, except the following:
(a) lease contracts within the scope of Ind AS 17, Leases;
(b) insurance contracts within the scope of Ind AS 104, Insurance Contracts;
(c) financial instruments and other contractual rights or obligations within the scope of Ind AS 109, Financial Instruments, Ind AS 110, Consolidated Financial Statements, Ind AS 111, Joint Arrangements, Ind AS 27, Separate Financial Statements and Ind AS 28, Investments in Associates and Joint Ventures; and
(d) non-monetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers. For example, this Standard would not apply to a contract between two oil companies that agree to an exchange of oil to fulfill demand from their customers in different specified locations on a timely basis.
As per this standard below mentioned 5 steps are to be followed for Revenue Recognition
| 1 | Identify the contract(s) with the customer |
| 2 | Identify the separate performance obligations |
| 3 | Determine the transaction price |
| 4 | Allocate the transaction price to the performance obligations |
| 5 | Revenue Recognition when performance obligations are satisfied |
Step 1 Identify the contract(s) with the customer
A contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a matter of law. Contracts can be written, oral or implied by an entity’s customary business practices.
As per Para 9 of the standard An entity shall account for a contract with a customer only when all of the following criteria are met:
(a) the parties to the contract have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations;
(b) the entity can identify each party’s rights regarding the goods or services to be transferred;
(c) the entity can identify the payment terms for the goods or services to be transferred;
(d) the contract has commercial substance (ie the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract); and
(e) it is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. Consideration may not be the same due to discounts etc.
Step 2 Identify the separate performance obligations
Performance obligation is a promise to transfer to a customer :
- A good or service (or bundle of goods or services) that is distinct or
- A series of goods or services that are substantially the same and are transferred in the same way
- If a promise to transfer a good or service is not distinct from other goods & services in a contract, then the goods or services are combined into a single performance obligation.
A good or service that is promised to a customer is distinct if both of the following criteria are met:
(a) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (i.e. the good or service is capable of being distinct); and
(b) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (i.e. the good or service is distinct within the context of the contract).
Satisfaction of performance obligations
An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e. an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.
So based on above one can conclude that Ind AS 115 prescribes the “Control’ aspect for revenue recognition as against the “risk and reward” aspect under Ind AS 18.
Some performance obligations are satisfied over a period of time and some are satisfied at a point in time.
Step 3 Determine the Transaction Price
The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes now GST). The consideration promised in a contract with a customer may include fixed amounts, variable amounts or both.
When determining the transaction price an entity shall consider the effect of all of the following:
a) Variable consideration.
b) The existence of a significant financing component in the contract.
c) Non-cash consideration (to be valued at fair value) and
d) Consideration payable to a customer
For the purpose of determining transaction price, an entity shall assume that the goods or services will be transferred to the customer as promised in accordance with the existing contract and that the contract will not be cancelled, renewed or modified.
In Real Estate Industry many companies are entering into Option Deposit Agreement wherein one of the conditions is mentioned that if a developer will not obtain Intimation of Disapproval (IOD) within the specified time, then the said option deposit agreement will be cancelled and Developer has to refund option deposit collected together with the interest as specified in the said option deposit agreement. So in that case one cannot assume that the contract will not be cancelled as the cancellation clause is mentioned in the Option Deposit agreement only.
However with the introduction of RERA now entering of Option Deposit agreement will not be possible.
Step 4 : Allocate the transaction price to the performance obligations
The objective when allocating the transaction price is for an entity to allocate the transaction price to each performance obligation (or distinct goods or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.
Allocation of transaction price can be done proportionately based on stand-alone selling prices. The stand-alone selling price is the price at which an entity would sell a promised good or service separately to a customer.
Contract Costs
Incremental costs of obtaining a contract
An entity shall recognize as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs.
The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example a sales commission)
An entity may recognize the incremental costs of obtaining a contract as an expense when incurred if the amortization period of the asset is one year or less.
Brokerage in Real Estate Industry
Real estate developers usually pay Brokerage to brokers for finding buyers to enter real estate contracts of buying flats/commercial property with them.
Brokerage is either fully paid on receipt of full amount from the customer or
Brokerage is paid proportionately based on amount received from the customer or
Brokerage is fully paid on execution of the agreement for real estate sales & on receipt of more than 30% to 50% Sales consideration.
So under Ind AS 115, incremental costs of obtaining a contract i.e. Brokerage will be required to be capitalized as cost to obtain a contract as mentioned above. And such capitalized cost shall be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates. The asset may relate to goods or services to be transferred under a specific anticipated contract.
Step 5 Revenue Recognition when performance obligations are satisfied
Performance obligation is satisfied over time or at a point in time. Performance obligation is satisfied over time if one of the criteria is met out of three:
a) The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs
b) The entity’s performance creates or enhances an asset (for example work in progress) that the customer controls as the asset is created or enhanced or
c) The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
So based on above the Revenue Recognition for a performance obligation is done over time if one of the criteria is met out of three else Revenue Recognition for a performance obligation is done at a point in time. Therefore, Ind AS 115 focuses on “control approach” for revenue recognition as against the “risk and rewards” approach under Ind As 18.
Joint Development Agreement
Sometimes Landowners enter into Joint Development Agreement with the Developer & grant Development rights to construct real estate on its land and in return either ask the developer to share the percentage of Sales Value of constructed/to be constructed Real Estate Property or demand from developer some portion of completed Real Estate Property.
Ind AS 115 applies only to Revenue from contracts with the customer for sale of goods or services in the ordinary course of business. So in case of Joint Development Agreement Ind AS 115 applies only if landowner falls under the definition of a customer.
Customer as per Ind AS 115 means “A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration”
So if Landowner will get fix percentage of sales value of constructed /to be constructed Real Estate then it is just a sale of Land transaction & will be outside the ambit of Ind AS 115.
If the landowner will get certain portion of completed property in exchange for development rights given, then the landowner may fall under the definition of customer so in that case Ind AS 115 applies & in that case revenue will be recognized at a point in time when landowner will get completed property in lieu of development rights parted with the Developer.
However, if it is a Joint Arrangement then it will fall under the ambit of Ind AS 111 Joint Arrangement.
Sale of Completed Property
It is possible that Real Estate Developer will sell Real Estate flats/commercial units after the construction of property is completed. Nowadays if Real Estate Developer will sell property after it is completed then the same can be outside the ambit of RERA & also at the same time the same will be outside the ambit of GST. But mainly for funding purpose Developer tries to sell under construction property so that with internal accruals they can complete the construction to save interest burden on Loan/Debt.
In case of sale of completed property as per Ind AS 115 Real Estate Developer will be required to recognize revenue when control is transferred to the customer i.e. at a point in time.
Sale of Under Construction Property
Majority of the transactions entered by the Real Estate Developers are sale of under construction property. With the introduction of Ind AS 115 now Real Estate Developer has to account for Revenue by following above stated 5 steps approach wherein as per step 5 revenue is to be recognized when entity satisfy each performance obligation. So now question is performance obligation is satisfied when real estate unit is handed over to customer on delivery or it can be proved that performance obligation is satisfied over a period of time. However we have seen above that to prove performance obligation is satisfied over a period of time one of the criteria to be met out of three which are
a) The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs
Comments: if certain slab is completed then the customer neither receives nor consumes any benefit.
b) The entity’s performance creates or enhances an asset (for example work in progress) that the customer controls as the asset is created or enhanced or
Comments: Again going by the same example if certain slab is completed then customer cannot control that asset.
c) The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
Comments : Here again if certain slab is completed then the Real Estate Developer does not have any alternative use of that part construction as the same is done only for the customer to whom completed units will be given. Similarly entity does not have an enforceable right to payment for performance completed to date. As nowadays majority of the schemes are 20 (advance): 80 (on possession) / 10: 90 / 30: 70 etc where in advance is taken from the customer on registration of agreement & balance amount will be taken only when possession of completed property is given.
Based on above one can conclude that Real Estate Developer have to recognize Revenue on Completed contract method as against percentage of completion method (POCM). The same is against Guidance note on Real Estate Transactions & Draft Income Computation & Disclosure Standard (ICDS) on Real Estate transactions as both are advocating on booking of revenue as per percentage of completion method. As Ind AS 115 is now applicable instead of guidance note & also as the principles mentioned in Ind As 115 & Guidance note on real estate transactions to whom Ind As is applicable were different so on 01-06-2018 ICAI had withdrawn the said Guidance Note on Accounting for Real Estate Transactions (for entities to whom Ind AS is applicable).
Conclusions :
1) Real Estate Developer to whom Ind As is applicable now with the introduction of Ind AS 115 from 01-04-2018 & also in the same lines abolition of Guidance Note on Accounting for Real Estate Transactions (for entities to whom Ind AS is applicable), Real Estate Developer will recognize revenue on completed contract method in case of under construction property as against percentage of completion method advocated by Draft ICDS on Real Estate Transactions.
2) So companies will have to maintain two sets of working one for booking of revenue on competed contract method as per Ind AS 115 & another for income tax purpose as they will have to show revenue as per percentage of completion method to avoid income tax disputes with the income tax authorities.
3) If Developer has to follow percentage of completion method as liked by Income tax department then they have to modify contracts/sale deed of real estate sale transactions in line with Ind AS 115 which is not an easy task as the same should also be in line with RERA provisions.
4) Else Income tax department has to accept completed contract method in line with Ind AS 115 & the way CA Institute has withdrawn Guidance note on Real Estate Transactions (for entities to whom Ind As is applicable), same way they need to amend Draft ICDS on Real Estate transactions as per Ind AS 115 once the same will be notified.
5) So company’s profitability will increase in a year when Real Estate projects will be completed & vice versa.
6) Now in one hand Government is trying to integrate all laws & in another hand such type of different treatment in books of accounts & income tax is posing a challenge on ease of doing business.
7) Real Estate Industry is facing a tough time due to demonetization & RERA so at this difficult time Developers were waiting for some bailout package to be announced by the Government like they have come up for sugar industry but instead of that due to some difficult provisions of Ind As 115 as enumerated above, there will be a dent on profitability of Real Estate companies in years when construction is going on which will result into more pressure on them.
CA Jinesh P. Gada
B.Com., A.C.A., ISA, M.B.A., Dip IFR (U.K.)
Head of Accounts & Taxation with HBS Realtors Pvt Ltd
e-mail id [email protected]
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