Enquiry:

(i) A public unlisted company (the “Company”) has principal business of development of housing projects and commercial plazas. The Company being an Economically Significant Company (ESC) has prepared its financial statements in accordance with the International Financial Reporting Standards (IFRS/IAS).

(ii) The annual audited accounts of the Company for the year ended June 30, 2012 has entered into sales agreements with large number of its customers to deliver housing units or full: developed residential/ commercial plots as per the terms and conditions agreed between the parties.

(iii) The Company has policy on ‘Revenue’ as follows:

‘Revenue’ from sale of plots, houses commercial areas is recognized by applying stage of completion method. Revenue is recognized by the proportion that project costs incurred for work performed to date bears to the estimated total cost of the project. Unrecognized revenue represents the portion of the value of houses sold by the Company under agreement to sell to clients and would be recognized as revenue by transfer to profit or loss in subsequent years”.

The Company in response to the Commission’s letter, with regard to recognition of revenue has provided a copy of specimen agreement and stated as follows:-

“The full amount of property sold to a ‘Customer’ through the ‘Agreement to Sell’ is immediately recognized as ‘Trade Debts’ on the Debits side and ‘Un- recognized Revenue on the credit side. The amount of Down Payment’ and ‘Installments’ when received are adjusted against the ‘Trade Debts’ till the time the ‘Last Installment’ is received from such ‘Customer’ where by the balance of ‘Trade Debts’ for such ‘Customer’ becomes zero. This accounting treatment is based on the legal fact that ‘Risks and Reward,’ of the relevant property has transferred to the ‘Customer’ upon signing of the ‘Agreement to Sell’. On the other hand, ‘Un-recognized Revenue’ is based on the ‘Matching Principle’ concept of accounting where only that portion of the Revenue is recognized in Income Statement of the year which pertains to the actual cost incurred on the project on the date when Income Statement and Balance Sheet are drawn. At each Balance sheet date, the estimate total cost of the ‘Property ‘(if Single property) or the ’Project‘(in case the ‘Property’ is a part of an integrated project which consists of large number of properties and any single property cannot be completed) is revisited and ‘Stage of Completion’ method is applied to determine what portion of the Revenue has been earned and therefore should be transferred to the Income Statement currently. Costs incurred on projects for unsold housing units or plots are recorded as inventory’ which may include, but not limited to the purchase of land development and construction costs, etc. simultaneously, appropriate costs from the Inventory are transferred to the ‘Cost of Sale’ in the Income Statement of the period against the Revenue Recognized in the Income Statement of the period by applying the percentage completion method for such properties against which ‘Agreement to Sell’ have been signed with the ‘customers’.”

While clarifying the revenue recognition principles followed in terms of International Accounting Standard (lAS) 11 ‘Construction Contracts’ and lAS 18 ‘Revenue’ read with IFRIC Interpretation 15 ‘Agreement for the Construction of Real Estate’, the Company has stated as follows:~

“The Company is engaged in construction and development of real estate projects in Pakistan. The Company has sold and delivered numerous housing and infrastructure development projects in Pakistan where the Company has entered into agreements with large number of its customers to deliver a housing unit or a fully developed residential / commercial plot as per the terms and conditions agreed between the parties. IFRIC-15 ‘Agreements for the construction of Real Estate’ contains the detailed guidance to determine whether these agreements are within the scope of lAS 18 or IAS 11 and when the revenue from these contracts should be recognized.

According to Para 12 of IFRlC -15, an agreement the construction of real estate in which buyers have only limited ability to influence the design of the real estate, e.g. to select a design from a range of options specified by the entity, or to specify only minor variations to the basic design, is an agreement for the sale of good within the scope of IAS 18. The Company offers standard products to its clients whereby they can choose from a few models and sizes in terms of ground space and constructed space while no changes are accepted which are part of the approved plans from the development authorities (LDA, FDA, CDA etc.) therefore, the revenue shall be recognized within the scope of IAS 18 as sale of goods.

As per Para 16 and 1, IFRIC-15, if the entity is required to provide services together with construction materials in order to perform its contractual obligation to deliver the real estate to the buyer, the agreement is an agreement for the sale of goods and the criteria for recognition of revenue set out in paragraph 14 of IAS 18 apply. Simultaneously, the entity may transfer to the buyers the practical ownership control and the risks and rewards associated the ownership of the work in progress in its current state as construction progresses. In this case, if all the criteria in paragraph 14 of lAS 18 are met continuously as construction progresses, the entity shall recognize revenue by reference to the stage of completion applying the percentage of completion method. The requirements of lAS 11 are generally applicable to the recognition of revenue and the associated expenses for such transaction.

According to para 14 of IAS 18, Revenue from the sale of goods shall be recognized when all the following conditions have been satisfied:

(a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods.
(b) The entity retain neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
(c) the amount of revenue can be measured reliably;
(d) it is probable that the economic benefits associated with the transaction will flow to the entity; and:
(e) the costs incurred or to be incurred in respect of the transaction can be measured reliability.

As per para 25 of lAS 11, the recognition of revenue and expenses by reference to the stage of completion of a contract is often referred to as the percentage of completion method. Under this method, contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of’ work completed. This method provides useful information on the extent of contract activity and performance during a period.

In our case, the Company transfers all the significant risks and rewards associated with the properties sold to the customers. The customers are free to sell their properties to third parties to make gains provided that they have adhered to the other terms and conditions of the agreement. Further the Company retains neither the continuing managerial involvement to the degree usually associated with the ownership nor the effective control over the properties, once these have been sold to the clients, to an extent that would preclude recognition of some or all the consideration as revenue.

The company transfers to the buyer control and the significant risks and rewards of ownership of the properties being sold by the company to its clients as the constructions progresses. The benefit of the increase in prices of properties as a result of development and construction activities at individual projects goes to the clients and they can make gains by selling their properties as market prevailing prices which is normally on higher side than the prices charged by the Company.”

It is observed that the Clauses of the ‘Sale Agreement’ indicate that risks and rewards were not fully transferred to the customers and managerial involvements of the units sold remains with the Company, Hence, this arrangement may not be considered as a valid sale; and

In this regard, lCAP is kindly requested to provide technical opinion/ input that whether the recognition of trade debts and unearned revenue at the time of signing of sales agreements is in
line with the requirements of lAS 18 and IFR1C Interpretation 15, and, if not, please provide the accounting treatment in accordance with IFRS/ lAS.

Opinion:

The Committee considered your enquiry and would like to draw your attention to the following (underline is ours):

IAS 11 ‘Construction Contracts’:

11   Contract revenue shall comprise:

(a) the initial amount of revenue agreed in the contract; and
(b) variations in contract work, claims and incentive payments:
(i) to the extent that it is probable that they will result in revenue; and
(ii) they are capable of being reliably measured.

13   A variation is an instruction by the customer for a change in the scope of the work to be performed under the contract. A variation may lead to an increase or a decrease in contract revenue. Examples of variations are changes in the specifications or design of the asset and changes in the duration of the contract.

A variation is included in contract revenue when:

(a) it is probable that the customer will approve the variation and the amount of revenue arising from the variation; and
(b) the amount of revenue can be reliably measured.

IAS 18 ‘Revenue’:

14  Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied:

(a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
(b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
(c) the amount of revenue can be measured reliably;
(d) it is probable that the economic benefits associated with the transaction will flow to the entity; and
(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.

15  The assessment of when an entity has transferred the significant risks and rewards of ownership to the buyer requires an examination of the circumstances of the transaction. In most cases, the transfer of the risks and rewards of ownership coincides with the transfer of the legal title or the passing of possession to the buyer. This is the case for most retail sales. In other cases, the transfer of risks and rewards of ownership occurs at a different time from the transfer of legal title or the passing of possession.

16  If the entity retains significant risks of ownership, the transaction is not a sale and revenue is not recognised. An entity may retain a significant risk of ownership in a number of ways…….

19   Revenue and expenses that relate to the same transaction or other event are recognised simultaneously; this process is commonly referred to as the matching of revenues and expenses. ………………… However, revenue cannot be recognised when the expenses cannot be measured reliably; in such circumstances, any consideration already received for the sale of the goods is recognised as a liability.

IFRIC 15 ‘Agreements for the Construction of Real Estate’:

12   In contrast, an agreement for the construction of real estate in which buyers have only limited ability to influence the design of the real estate, e.g. to select a design from a range of options specified by the entity, or to specify only minor variations to the basic design, is an agreement for the sale of goods within the scope of IAS 18.

The agreement is an agreement for the sale of goods

16   If the entity is required to provide services together with construction materials in
order to perform its contractual obligation to deliver the real estate to the buyer, the agreement is an agreement for the sale of goods and the criteria for recognition of revenue set out in paragraph 14 of IAS 18 apply.

17   The entity may transfer to the buyer control and the significant risks and rewards of ownership of the work in progress in its current state as construction progresses. In this case, if all the criteria in paragraph 14 of IAS 18 are met continuously as construction progresses, the entity shall recognise revenue by reference to the stage of completion using the percentage of completion method. The requirements of IAS 11 are generally applicable to the recognition of revenue and the associated expenses for such a transaction.

18   The entity may transfer to the buyer control and the significant risks and rewards of ownership of the real estate in its entirety at a single time (e.g. at completion, upon or after delivery). In this case, the entity shall recognize revenue only when all the criteria in paragraph 14 of IAS 18 are satisfied.

The terms and conditions of Sale Agreement mentioned in clause 19, 20 and 23 state that:

• Completion of the Sale Deed of the House/ Property and registration in the name of the client will be done once all the dues have been cleared.
• This sales agreement will not create legal right, title in the property in favor of the client until a registered sales deed is executed in favor of the client.
• Client will not transfer the allotted Property until and unless prior written permission of the Company is obtained.

Based on information provided, risks and rewards are not fully transferred to the client as well as control/ managerial involvements of the units sold will remain with the Company and therefore, the requirements of para 14 (a) and (b) of IAS 18 are not being complied. Keeping in view of the requirements of para 17-18 of IFRIC 15, the Committee is of the view that the revenue from the sale of housing scheme will be recognized when all the requirements of para 14 of IAS 18 are fulfilled.

However, the Committee is also of the view that in order to record the liability, the recognition of receivable from Customers as per the payment schedule agreed in contract and unearned revenue/ advance received from customers at the time of signing of sales agreements is in line with the requirements of lAS 1.

(February 11, 2015)