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KPMG FLASH NEWS

KPMG IN INDIA






































Accounting for Real Estate Transactions
The increase in complexity of the terms of real estate
transactions has resulted in diversity in practice around
revenue recognition by companies in this sector.
Accordingly, on 11 February 2012, the ICAI issued a
revised GN on Accounting for Real Estate Transactions
(revised GN). The revised GN supersedes the existing GN
and seeks to achieve uniformity in the accounting and
reporting practices in this area.





Currently, there is no separate Accounting Standard (AS) in
India for recognition of revenue from real estate sale
transactions and accordingly, in practice, the accounting and
reporting for such transactions is based on certain principles
specified in AS 9, Revenue Recognition and AS 7, Construction
Contracts, as supplemented by the Guidance Note (GN) on
Recognition of Revenue by Real Estate Developers which was
issued by the Institute of Chartered Accountants of India (ICAI)
in June 2006.

Background

Applicability
The revised GN applies to revenue recognition involving sale of
real estate in relation to all projects (this term is discussed
further in this note), which will commence on or after 1 April
2012. The revised GN will also apply to projects, which have
already commenced but where revenue is being recognized for
the first time on or after 1 April 2012.


The revised GN permits early adoption provided that it is
applied to all transactions, which commenced or were
entered into on or after such an earlier adoption date.


Guidance Note 2012


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Key provisions
The revised GN mandates the application of the POC method
as specified in AS 7, in respect of real estate transactions
where the economic substance is similar to construction-type
contracts and where significant risks and rewards of
ownership have been transferred to the buyer. The revised GN
provides that an agreement for sale entered into during the
construction phase is considered to have the effect of
transferring all significant risks and rewards of ownership to
the buyer provided the agreement is legally enforceable and
other conditions exist, which transfer risks and rewards even
though legal title is not transferred or possession is not given.


Additionally, the revised GN gives certain indicators for
determining if the economic substance of the transactions is
similar to construction-type contracts. These indicators are:
the period of such projects is in excess of 12 months; most
features of the project (land development, structural
engineering, architectural design, construction) are common to
construction contracts; individual units of the project are
interdependent upon or interrelated to completion of a number
of common activities and/or amenities; the construction or
development activities form a significant proportion of the
project activity.
Mandatory application of the percentage of completion (POC) method
POC method
The revised GN provides certain general conditions for
application of the POC method (reliable estimates of project
revenues; probability of economic benefits; identification and
estimation of project costs). Additionally, and more
significantly, the revised GN provides that the following
specific conditions should be satisfied for recognition of
revenue:
All critical approvals such as environmental clearances;
approvals of plans and designs; title to land or other
development rights; have been obtained;

The stage of completion of the project has reached a
reasonable level. A reasonable level of development is
not achieved if the expenditure incurred on construction
and development costs (excluding costs of land,
development rights and borrowing costs) is less than 25%
of the total estimated construction and development costs;

Atleast 25% of the saleable project area is secured by
contracts or agreements with buyers; and

Atleast 10% of the sale value has been realized from each
of the contracts and it is estimated that the customer will
comply with the balance contract payment terms for such
contracts.

For the purpose of applying the above conditions (and other
provisions of the revised GN), the term project has been
defined as the smallest group of units which are linked with a
common set of amenities in such a manner that unless the
common amenities are made available and functional, these
units cannot be put to their intended effective use. For
example, a project may comprise a cluster of towers or each
tower may be designated as a project.
Once it is determined that all the above conditions have been
met in relation to a project, revenue should be recognized for
the units sold using the POC method. For this purpose, the
POC should be calculated based on the total cost incurred
(including land, development right and borrowing costs).
Though the revised GN permits the use of other methods such
as survey of work done, the POC per such other methods
cannot exceed the POC based on total cost.
Additionally, the revenue recognized should not exceed the
total revenue from eligible contracts, which are defined to
mean contracts where at least 10% of the contracted amounts
are realized and there are no outstanding defaults in payment.
Transferable development rights
The revised GN provides that where development rights are
acquired directly or through construction of built-up area, the
purchase price or cost of construction would represent the cost
of the acquirer. Where development rights are acquired by
surrendering rights over existing assets, the development
rights should be recorded at the fair value, or net book value of
the asset given up, whichever is lower.

The fair value may be based on fair value of the asset given up
or fair value of the development rights acquired, whichever is
more clearly evident.


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Total saleable area of the project 20,000 Sq. ft.
Estimated project costs (this comprises land cost of INR. 300 Lakhs
and construction costs of INR. 300 Lakhs)
INR. 600 Lakhs
Cost incurred till end of reporting period (this includes land cost of
INR. 300 Lakhs and construction cost of INR 60 Lakhs)
INR. 360 Lakhs
Total area sold till the date of reporting period 5,000 Sq. ft.
Total sale consideration as per agreements of sale executed INR . 200 Lakhs
Amount realized till the end of the reporting period INR. 50 Lakhs
Percentage of completion of work
60% of total project cost including land cost
or 20% of total construction cost
If the work completed till end of reporting period is (this includes
land cost of INR. 300 Lakhs and construction cost of INR. 90 Lakhs)
INR. 390 Lakhs
Percentage of completion of work would be 65% of total project cost including land cost
or 30% of construction cost
Revenue recognised (65 % of INR. 200 Lakhs as per Agreement of
Sale)
INR. 130 Lakhs
Proportionate cost (5000 sq.ft./20,000 sq.ft.) X 390 INR. 97.50 Lakhs
Income from the project INR. 32.50 Lakhs
Work in progress to be carried forward INR. 292.50 Lakhs
Illustration on application of POC method
At the end of the reporting period, the enterprise will not be able to recognise any revenue as reasonable level of
construction, which is 25% of the total construction cost, has not been achieved, though 10% of the agreement
amount has been realised.
The enterprise would be able to recognise revenues at the end of the accounting period. The revenue recognition and
profits would be as under:


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Implementation of the revised GN is likely to have a significant
impact on revenue recognition practices of several real estate
companies. In certain cases, companies may now be required to
apply the POC method where they previously applied the
completed contract method. In certain other cases, revenues
relating to certain projects may need to be recognised on a
Currently, certain companies follow the completed contract
method for revenue recognition based on the analysis that certain
conditions in the existing GN are not met (for example, the buyer
does not have the legal right to sell the interest in the property).
The revised GN prescribes a different set of conditions, which
focus on the economic substance of the transaction. Accordingly,
an entity that previously applied the completed contract method
may need to now apply the POC method.


Overview
deferred basis if specific conditions are not met.
The application of the revised GN would also throw up
certain new interpretation issues and certain issues relating
to the transitional provisions.

Mandatory application of the POC method
Further, certain entities may have recorded revenues from an
undivided interest in land upfront where separate agreements
were entered into for sale of the land and the subsequent
construction activity. The revised GN requires that such
related contracts be accounted for based on their economic
substance and not merely based on legal form. This may
require such contracts to be combined, with revenues
recorded on a POC basis for the overall contract.



Application of the POC method
Determination of the project
The revised GN requires the determination of eligibility for
revenue recognition at a project level. Determination of what
constitutes a project (complete township, cluster of towers or an
individual tower) may significantly impact the determination of
whether the project is eligible for revenue recognition.
For example, if an individual tower is determined to constitute
the project and 25% of the saleable area relating to that tower is
sold, the requirement of the revised GN relating to minimum sale
would be met. However, in the same situation if a cluster of
towers are determined to constitute the project, this criterion may
not be met if there are insufficient sales in other towers within the
cluster. Practice is likely to evolve in this area.
Additional specific conditions
The revised GN prescribes certain additional conditions, which
may result in a deferral of revenue recognition.
For example, certain companies currently recognize revenues as
construction progresses even if certain project approvals may be
pending. This may no longer be possible under the revised GN.
Further, several companies commence recognition of revenues on
a project when the POC reaches a particular stage, which may be
different than the 25% minimum prescribed under the revised
GN. Similarly, certain companies currently include land cost,
while determining whether the project has made sufficient
progress for revenue recognition.

The revised GN precludes inclusion of cost of land,
development rights and borrowing costs, while determining
whether the minimum 25% progress has been achieved.
The additional conditions relating to sale of atleast 25% of
the saleable area, collection of 10% of the revenues for each
contract and restriction on total revenues recognized to a
maximum of total revenues on eligible contracts (non-
defaulting contracts where at least 10% of the sale value has
been collected); may also result in a deferral of revenues.
For companies that currently determine POC using a method
other than the cost method, the revised GN would require
deferral of revenues to the extent they exceed revenues
computed based on the cost method.
For application of the above conditions, the revised GN
seems to make a distinction between legally enforceable
agreements (used for assessment of the sale of 25% saleable
area), agreements where 10% has been collected (for
recognition of revenues on individual contracts) and eligible
contracts (for determining the maximum revenue that can be
recognized on a project).
The revised GN does not directly address how cash collected
on contracts, which are not eligible contracts (for example,
due to a default), should be considered, while determining the
maximum revenue that can be recognized on a project.
Similarly, the revised GN does not specifically provide if the
costs recognized on a POC basis should be adjusted if
revenue recognition is limited due to application of the
maximum revenue requirements. In the absence of specific
guidance, practice is likely to evolve in these areas.

Key implementation challenges


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Transition to the revised GN
The revised GN will apply to all projects that commence after
1 April 2012 or where no revenues have been recognized prior to
1 April 2012. Accordingly, for companies that previously applied
the completed contract method, and where the revised GN
requires the application of the POC method; companies may
need to record a transition adjustment when they first apply
the revised GN.
The revised GN does not provide guidance on the manner in
which such transition adjustments need to be recorded.
Impact on direct taxation
Most real estate developers follow the same accounting policies
both for financial reporting and for tax purposes in the absence of
any specific guidance in the Income Tax Act. Hence, the
corporate tax liability and the associated cash outflows would be
impacted. Even in situations where the developers propose to
follow a different revenue recognition policy for tax purposes, the
revised GN would impact the liability under the Minimum
Alternate Tax (MAT) provisions since the MAT liability is based
on the statutory financial statements.
Further, it needs to be noted that the amount of revenue
recognized in a particular finance period also plays an
important role in determining aspects such as the need for a
compulsory tax audit. There could also be issues in relation
to aspects where the draft Tax Accounting Standard (TAS)
issued by the Central Board of Direct Taxes (CBDT) recently
differ with the revised GN. Once the TAS is notified by the
CBDT and if there exists inconsistencies between the TAS
and the revised GN, developers may be required to maintain
two different sets of records.

How can KPMG assist
The implications of the revised GN are varied and are expected
to present a large number of implementation issues. Companies
should plan and implement modifications in their accounting
systems and procedures to enable reporting under the revised
GN.
Based on our knowledge of the sector and experience in
providing our clients with training and implementation
assistance on similar accounting and reporting changes, KPMG
professionals can assist in the following areas:
Training
Customized training sessions to help accounting and financial
reporting teams to gain an in-depth understanding of
requirements of the revised GN and understand the practical
challenges in implementing the new accounting and reporting
requirements.
Accounting manual
We can assist in developing a comprehensive accounting
manual around revenue recognition policies and practices to
be followed by the company after incorporating different
aspects of authoritative literature and the entitys business
practices.
Implementation assistance
The revised GN will have an impact not only on accounting
and reporting but also in the areas of budgets. We can assist
in implementation of these changes on a broad ranging basis
or provide accounting support on specific areas.
We can also assist in making revised presentation and
disclosures in the first financial statements after the
implementation of the revised GN.



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The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide
accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one
should act on such information without appropriate professional advice after a thorough examination of the particular situation.
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(KPMG International), a Swiss entity.
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Director
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E: skhetan@kpmg.com




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