Revenue Recognition Methods for Real Estate Developers

INTRODUCTION

The method of revenue recognition for real estate developers—whether to follow the Percentage of Completion Method (POCM) or the Project Completion Method (PCM)—is a critical decision with significant accounting and tax implications. This study examines the appropriate methods for building construction and the sale of plots in a township, considering the positions outlined in AS 9, the ICAI Guidance Note, and relevant provisions of the Income Tax Act, supported by relevant case laws.

Historical Context and Position in Accounting Principles Issued by ICAI

Accounting Standard 7 (AS 7)

1. Original AS 7 (1985):

• Allowed both POCM and PCM for revenue recognition in construction contracts.

• This dual allowance provided flexibility to real estate developers.

 2. Revised AS 7 (2002):

• Prescribed only POCM for revenue recognition in construction contracts.

• Specifically stated that the revised AS 7 does not apply to real estate developers, who should follow AS 9 instead.

 Accounting Standard 9 (AS 9)

1. Revenue Recognition:

• AS 9 applies to transactions involving the sale of goods, rendering of services, and other income streams.

• For real estate developers, AS 9 supports PCM when the outcome of the project cannot be reliably estimated.

• Revenue is recognized when the significant risks and rewards of ownership are transferred to the buyer, aligning with PCM.

Relevant Extracts from AS 9:

Paragraph 10: “Revenue from sales or service transactions should be recognised when the requirements as to performance set out in paragraphs 11 and 12 are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection.”

Paragraph 11: “In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:

(i) the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and

(ii) no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.”

ICAI Guidance Note

2006 Guidance Note

1. Recommendations:

• Recommended the use of POCM for real estate developers.

• Lacked detailed guidance on the application of POCM, leaving developers uncertain about implementation.

2012 Revised Guidance Note

1. Detailed Mechanism:

• Provided comprehensive guidance and illustrations for applying POCM in real estate transactions.

• Emphasized recognizing revenue based on the stage of completion of the project.

2. Consistency with AS 9:

• Clarified that real estate developers could use POCM when the outcome of the project can be reliably estimated, otherwise PCM should be used.

Position under Ind-AS

Ind-AS 11 (Now Omitted)

1. Application:

• Initially applicable to construction contracts and aligned with POCM.

• Required revenue recognition based on the progress of the construction activity.

Ind-AS 115 (Effective April 1, 2018)

1. Revenue Recognition:

• Replaced Ind-AS 11, focusing on revenue recognition when control of the asset is transferred to the customer.

• This strict criterion often results in revenue being recognized using PCM, as control typically transfers upon project completion.

2. Implications for Real Estate Developers:

• Real estate developers under Ind-AS must follow Ind-AS 115, leading to PCM due to the stringent control transfer requirement.

Position under the Income Tax Act, 1961

Section 43CB

1. Introduction:

• Inserted by Finance Act, 2018, mandates POCM for construction and certain service contracts.

• Specifically applies to the computation of business income for these contracts.

ICDS (Income Computation and Disclosure Standards)

1. ICDS III and ICDS IV:

• Align with AS 7 and AS 9 respectively, suggesting POCM for construction contracts.

• Lack of specific ICDS for real estate developers creates ambiguity.

2. CBDT Circulars and Clarifications:

• Stated that ICDS III and IV do not explicitly apply to real estate developers.

• Recognized the need for specific ICDS for real estate transactions, pending notification.

Relevant Case Laws

1. Chamber of Tax Consultants v. Union of India:

The Hon’ble Delhi High Court quashed the compulsory application of POCM under ICDS, leading to the introduction of Section 43CB of the Income Tax Act.

2. Tuticorin Alkali Chemicals & Fertilizers Ltd. v. CIT [1997]:

The Supreme Court held that accounting practices, while relevant, cannot override the specific provisions of the Income Tax Act.

3. CIT v. McMillan & Co. [1958]:

The Supreme Court held that the choice of method of accounting lies with the assessee, provided it is consistently followed.

4. CIT v. Hyundai Heavy Industries Co. Ltd. [2007]:

The Supreme Court recognized the acceptability of POCM for construction contracts.

5. CIT v. Manish Build Well (P.) Ltd. [2011]:

The Delhi High Court held that PCM is an acceptable method of accounting if consistently followed.

6. Paras Buildtech India (P.) Ltd. v. CIT [2017]:

The Delhi High Court upheld the acceptability of PCM, especially where it leads to an accurate determination of profits and prevents premature revenue recognition.

Analysis of Applicability

Building Construction Projects

1. Recommended Method: POCM:

Criteria:

• Long-term project duration.

• Reliable estimation of costs and project progress.

• Ability to match revenue with the stage of completion.

Guidance Note Alignment:

The ICAI Guidance Note supports POCM for such projects, providing detailed application mechanisms.

2. Case Law Support:

• The case of CIT v. Hyundai Heavy Industries Co. Ltd. supports the use of POCM for construction contracts.

• The decision in Paras Buildtech India (P.) Ltd. v. CIT reinforces the method’s suitability for long-term projects.

Sale of Plots in a Township

1. Recommended Method: PCM:

Criteria:

• Short-term, straightforward transactions.

• Revenue recognized upon transfer of significant risks and rewards.

• Control of the plot typically transfers at the point of sale.

Guidance Note and AS 9 Alignment:

PCM is supported for simpler transactions, aligning with AS 9 principles of revenue recognition when risks and rewards transfer.

2. Case Law Support:

• The decision in CIT v. Manish Build Well (P.) Ltd. supports the acceptability of PCM if consistently followed.

• The case of CIT v. McMillan & Co. highlights that the choice of method lies with the assessee if it accurately reflects profits.

Can a real estate developer use POCM for building construction and PCM for the sale of plots simultaneously in their financial statements?

Yes, a real estate developer can utilize both the Percentage of Completion Method (POCM) and the Project Completion Method (PCM) within the same financial statements, applying each to different project types.

POCM for Building Construction: This method is suitable for long-term building projects where costs and revenues are spread over time. It allows for accurate representation of ongoing financial performance by recognizing revenue based on project completion stages.

PCM for Sale of Plots: This method aligns with short-term plot sales, recognizing revenue upon completion when risks and rewards transfer to the buyer, typically coinciding with the sale.

Conclusion

The choice between POCM and PCM for real estate developers depends on the nature of the projects. For building construction projects, POCM is recommended due to its alignment with long-term project progress and reliable estimation criteria. For the sale of plots in a township, PCM is more suitable, providing clear revenue recognition upon transaction completion. These recommendations ensure compliance with relevant standards and offer accurate financial performance representation. This study provides a comprehensive overview of the appropriate revenue recognition methods for real estate developers, covering key points from accounting standards, guidance notes, and the Income Tax Act, supported by relevant case laws.