Friday, November 11, 2011

New Accounting Rules to Hit Realty Top Lines

              In a move that will depress the top line of several leading real estate companies, an upcoming accounting change aims to reduce the discretion available to them on how to compute revenues. The accounting regulator is working on a ‘guidance note’ that will, for the first time, define when and how developers should recognise revenues from a project, say two senior officials of the Institute of Chartered Accountants of India (ICAI) working on the note, on the condition of anonymity. The new rules will be a blow to companies that adopt an aggressive tack in recognising revenues, including frontline ones like DLF and Parsvnath Developers. In the case of DLF, for example, the proposed change would have placed in question 75% of the revenues declared by India’s largest developer in 2010-11. For Parsvnath, that figure would be 79%.
              In India, real estate firms mostly follow the ‘percentage completion’ method to recognise revenues. Under this, a developer recognises revenues from a project not when it is finished, but continuously, in proportion to the spending on it. So, in a given year, if a builder has spent 30% of the estimated project cost, it can recognise 30% revenues from it. Next year, if the spend increases to 50%, it can recognise 20% more as revenues, and so on.
              The absence of rules on how to compute project cost, or how much revenue to record at what stage, gives builders much accounting discretion. Take India's top two builders, DLF and Unitech. DLF includes land in its project cost, but Unitech excludes it. DLF starts recognising revenue on incurring 30% of project expenditure, Unitech at 20%. “The proposed guidance note will bring a common base of comparison for investors,” says Saumil Daru, chief financial officer of Mumbai-based Oberoi Realty.
              The two ICAI officials say the guidance note (technically, called ‘exposure draft’) will broadly specify three things. One, the minimum threshold of completion only after which a builder can start recognising income from a project.
              Guidance Note not Binding on Cos
Two, the percentage of land cost to be included in the project cost. Three, linking revenues booked to cash received. “We will decide on the completion threshold after receiving feedback to the proposed changes,” says one of the two ICAI officials.
              ICAI President G Ramaswamy confirmed the institute was planning a guidance note for real estate companies, but declined to provide further details. Unlike accounting standards, a guidance note is not binding on a company. However, companies tend to follow a guidance note, as a deviation from it leads to their auditors making a qualification in their statement of accounts. The main objective of the note is to ensure that revenues booked by a company from a project are an accurate reflection of the work done on it and the cash received towards it. For example, in pricey locations like Mumbai and Delhi, land accounts for almost half the total project cost. So, in some cases, immediately after starting the excavation work, companies begin recognising revenues, though customer payments, which are construction-linked, have not started coming in.
              This will end in the proposed dispensation, says one of the two ICAI officials. He says, going forward, the milestones for revenue recognition will be based only on construction cost. At present, it is based on the total cost, including land cost. Say, in a project, only 5% construction work (excavation) is complete, but 50% of project cost is incurred. Under the proposed rules, the company will be unable to recognise revenues if the prescribed threshold — which will be linked to construction work — is higher. PA Ananthanarayanan, CEO of Universal Dwellings, says the proposed changes might improve practices under the percentage completion method, but it still leaves some discretion with builders. Another builder who did not want to be identified says it’s very difficult for auditors to assess percentage of completion. “They have to rely on external certification from architects,” he says.
              The second big change is making cash a pre-condition to recognising revenues, which is likely to eliminate a balancesheet entry that is telling for Indian real estate companies: unbilled receivables. This represents those revenues booked by a builder the money for which is yet to come from buyers. This happens either if a builder overbooks revenues, or in projects with a high land cost and where companies include land cost while computing project cost. Of the 14 companies in the BSE Realty Index, four had sizeable unbilled receivables (See table: Revenues Under Threat). Take DLF. Of its total 2010-11 income of 9,560 crore, 7,200 crore — or 75% of revenues — were unbilled receivables. DLF declined comment as it was in a silent period till the declaration of its second-quarter results, which were announced.
              Parsvnath is another company with high levels of unbilled receivables — 88% of revenues in 2009-10 and 79% in 2010-11. Repeated calls to Pradeep Jain, managing director of Parsvnath, went unanswered.
              By comparison, Sobha Developers had unbilled receivables of about 20%. Admitting that the company’s revenue recognition was slightly higher than cash received from customers, S Bhaskaran, CFO of Sobha Developers, said the impact of the proposed changes on the company would be marginal. “It will impact our top line by not more than 2%,” he said.
              The move also has larger accounting implications. Revenue recognition by real estate companies was one of the deviations between Indian accounting standards (IAS) and the International Financial Reporting Standards (IFRS), which the world, including India, is converging towards.
              When ICAI was doing the groundwork on how and when to integrate IAS with IFRS, real estate companies lobbied intensely to be treated as an exception. Under IFRS, a builder can recognise revenues from a project only after its completion. Under current Indian standards, a builder can recognise revenues continuously and has discretion.
              The proposed rule change sits somewhere in between. However, says Jamil Khatri, head of accounting advisory at KPMG: “It (the proposed change) is neither here nor there. It will not achieve much from the longterm perspective of converging with IFRS.” But Daru of Oberoi Realty says the guidance note will help in reducing litigation with government authorities, be it the Income-Tax Department or state governments. “Having one set of numbers prepared as per ICAI guidelines will eliminate scope for dispute and litigation from government authorities,” he says.
              According to one of the two ICAI officials, the guidance note is likely to be put in the public domain for comments within 10 days. Then, an internal ICAI board will prepare the final draft and forward it to the ICAI council, which needs to approve and release it.