New guidelines for Revenue Recognition in Real Estate Companies

Real Estate companies follow “Percentage of Completion Method” of accounting. According to this method, revenue from sale of properties is recognized in the statement of profit and loss in proportion to the actual cost incurred as against the total estimated cost of projects under execution with the Company on transfer of significant risk and rewards to the buyer. If the actual project cost incurred is less than 20% of the total estimated project cost, no income is recognized in respect of that project in the relevant period. This is good, as the companies cannot inflate their profit and loss just on the basis of revenues collected during pre-launch. Companies are required to incur atleast 20% of total project cost estimated.

But determination of revenues under the percentage of completion method necessarily involves making estimates, some of which are of a technical nature, concerning, where relevant, the percentages of completion, costs to completion, the expected revenues from the project or activity and the foreseeable losses to completion. Estimates of project income, as well as project costs, are reviewed periodically. The effect of changes, if any, to estimates is recognized in the financial statements for the period in which such changes are determined. Losses, if any, are fully provided for immediately. Now the drawback of this method is that it involves inherent risk of relying upon estimates. The very fact that no rules exist to compute the project cost as well as for recording the revenues at different stages gives builders an undue advantage in their accounting system. 

But the best part is that new guidance have been issued prescribing new conditions for revenue recognition.

Companies should have all critical approvals that are needed to commence a project.

Company should incur 25% of construction and development (excluding land cost, cost of development rights and rehabilitation costs) to be incurred. The process still involves estimation leading to ambiguity. This will also result in deferral of revenue recognition for projects launched in FY13, as projects launched in that year will be reported in FY14 as it usually takes 12-15 months to achieve 25% of construction and development costs.

Companies should have sold at least 25% of saleable area. Again, it doesn’t make sense when let say the project is a 100 acre project or it is a 1 acre project. The PNL statement will get inflated the year a company sells 25% in a 100 acre project, which might take 1.5 to 2 years.

Collection of 10% or more at the reporting date, at the individual contract level.   

Still, these conditions will do away with some ambiguities and bring some uniformity across all real estate companies. It will be easier to compare financial statements of these companies now.