Enquiry:

The Technical Committee is requested to give its opinion on the revenue recognition policy of the Company which is engaged in the real estate development, sale and management business (the “Company”), including housing schemes (plots, townhouses), shopping plazas, multistoried apartment towers, etc. The Company already sold many projects of developed plots and also has sold some projects of constructed houses. The Company being an economically significant entity is required to prepare its accounts in accordance with Financial Reporting Standards as notified by the SECP. The Company consistently applied percentage completion method since its inception for the recognition of its revenue on all its project sales. Assuming there has been no change in the auditors and auditors never had any question about the appropriateness of the percentage completion method.

Understanding Business of the Company

Before discussing revenue recognition policy of the Company, it is pertinent to understand here the business model of the Company which is similar to general norms of the Real Estate Development business in Pakistan. The Project starts with the acquisition of Land in the areas where the Company plans to launch its projects. When sufficient land has been acquired by the Company, an application is submitted to the concerned Regulatory Authority (LOA, FDA, CDA, etc.) for preliminary planning permission. The relevant Authority, after taking care of the stakes of the other parties including the Government itself in accordance with the Master Plan of the city, grants such approval for the development and launch of the project. After this initial approval, a detailed layout plan along-with other technical drawings (Electrical Water and Sewerage etc.) as approved by the concerned Government Agencies is formally submitted with the Regulatory Authority for its approval of the scheme’s layout plan. After the approval from the Regulatory Authority, the Company starts the initial physical development activities at the Project site.

After all the above has taken place, and at the initial stages of development, the project is normally launched on installment plans. The upfront land purchase cost which is a significant portion of the total project cost is mostly financed by the Company from equity funds; however, major development cost is financed through bank loans and receipts of initial booking and installments monies from clients after the launch of the project. Approved detailed plans include plot numbers / house numbers which are allocated to the applicants through balloting if sales are more than available inventory. Monies to the un-successful applicants are returned at such stage whereas the successful applicants become clients of the Company whose units (plots or houses) are identifiable on the approved drawings. These clients keep on paying installments and the Company keeps on completing the development work.

The project’s estimated revenue, project estimated cost and the project completion time-lines are planned in such a way that all inflows and outflows of the project correspond to ensure the project completion within the expected time lines. Please note all these estimates can be reliably calculated keeping in view the sale price (already fixed), construction contracts awarded to contractors by the developer, materials current costs and anticipated inflation, etc. According gross profits can also be reliability computed for the year as well as for the entire life of the project. Any changes in subsequent years are considered changes in estimates and are accounted for in accordance with the relevant accounting standards. Revenue and costs are reflected in profit and loss account in accordance with matching principle using percentage completion method. (In cases where no land is purchased, naturally no development work can be done on ‘non-existent land’ and despite advance booking of plots and receipt of money from bookings, no revenue can be booked as the completion will be Zero therefore such instances are not subject of our this discussion as those do not qualify for percentage completion concept). The process ends on when the entire product (Plots/Houses) in the project has been delivered and the project has also been handed over to the local Project Management Society (PMS) for onward project management.

Project Sales

Going into further details of the project launch, it is being explained that on every project booking applications are invited from the general public for subsequent balloting by the Company for allocation of plots/houses to the general public against their applications. In some cases, applications received are equal to or less than the total inventory of the plots/houses available with the Company (Hereinafter referred to as “Category X sales” where all the clients are allocated plots/ houses against their applications through balloting process. The clients are communicated with their relevant house/ plot number along-with copy of the approved map of the project. They can trace their plot/ house on the approved map which can’t be changed without their consent once the same has been communicated to them. In some other cases the applications received by the Company from general public exceed the total inventory of the plots/ houses available with the Company. In this case, those clients who got the plot/house allocated through balloting process of the Company are communicated with their relevant house/plot number along-with copy of the approved map of the project. These sales are hereinafter referred to as “Category Y sales”. The rest of the clients are then accommodated by the Company in 2nd phase of the project after acquiring further land adjacent/near by the existing project (Phase 1) of the Company. Sales to such clients are hereinafter referred to as “Category Z sales”. These clients are communicated about their plot/house number once the Company has acquired the requisite land and the project extension/Phase 2 of the project has also been approved by the regulatory Authority.

Installment sales and Securitization of Project receivables

Since all the sales are based on installment plans therefore to securitize the project receivables following clauses are used in the sale agreements entered into by the Company with its clients purely from the credit management point of view:

• 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.

It is pertinent to mention here that the objective of these clauses is purely to secure the project receivables and not to restrict the rights of the clients towards the ownership of the property. All risks and rewards are fully transferred (One of the main conditions for revenue recognition in Para 14 of IAS 18) to the clients as they can resell their properties in open market at gain or loss by clearing all his dues to-date with the Company. In this way all benefits of progress in construction and development goes to the client and the Company is not beneficiary of such gains. The Company is only entitled to recover the booked price and not the market price from its clients before transferring the legal title in favor of clients.

As mentioned in earlier paragraphs, the project’s completion and recovery of installments from clients are timed in such a way that the last installment is paid to the company upon handing over of completed unit’s possession. According to market norms clients stop making installments payments in case developer slows down or is delaying completion of the project. Upon completion of the unit, assuming all the dues by the clients are clear, clients can apply for sale deed in their favor, the Company never refused to entertain such requests of its clients provided that nothing stands outstanding against the clients in the books of account of the Company. However a sale deed technically/ legally may not be signed if the project is yet not completed as relevant authorities will not record a registry or if the Company offers sale deeds to its clients without recovering all its dues, especially when physical possession of the property is already with the client as per the terms of agreement, it will become impossible to recover the pending dues from the clients. However, the increases in unit’s (plot or townhouse) price or a reduction in price of the unit is totally to the account of the client and company neither benefits nor accepts losses from the same.

Therefore the objective of the insertion of these clauses is just to ensure recoveries from the clients. This is also in accordance with substance over form concept of the Accounting Principles. Further these clauses are also in conformity with the requirements of Para 15 of IAS 18 as given below:

“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.”

It is clearly stated in the above mentioned Para of IAS 18 that transfer of risks and rewards may occur at some different time than transfer of legal title or passing of possession.

Revenue Recognition Policy of the Company

Company has entered into sale agreements (Developed plot, Constructed house or Commercial plot) with large number of its clients. The revenue recognition policy consistently being applied and as disclosed in its Financial Statements is given as under:

“Revenue from sale of plots, houses and 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”

It is pertinent to mention here that in case of “Category X sales” and “Category Y sales”, the Company has incurred major project cost in shape of land buying and in shape of part development of the project as on the date of project launch, whereas, in case of “Category Z sales” no cost is yet incurred by the Company as on the date of project launch. Accordingly only revenue pertaining to “Category X sales” and “Category Y sales” is recognized using percentage completion method whereas no revenue is recognized in case of “Category Z sales” till the date the Company has started incurring costs in respect of these sales. These sales shall appear as liability in the Balance Sheet under the heading “Unrecognized revenue” till the date the Company has started incurring costs in respect of these sales. The accounting treatment for “Category X sales” and “Category Y sales” is same.

The Company is recognizing its revenue according to the percentage completion method in accordance with International Accounting Standards as explained below:

IFRIC- 15 ‘Agreements for the construction of Real Estate’ contains the detailed guidance to determine whether these agreements are within the scope of IAS 18 or IAS 11 and when the revenue from these agreements should be recognized.

According to Para 12 of IFRIC-15, 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 Company in question 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 not 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 17 of 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 with 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 IAS 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.

According to para 14 of IAS 18, Revenue 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 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.

As already discussed, the Company in question 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 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 construction 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 at market prevailing prices which is normally on higher side than the prices charged by the Company. The Company is only entitled to recover the booked price from its clients.

In light of the above discussions, the Company is recognizing its revenue by reference to the stage of completion of the individual projects by applying the percentage completion method. This accounting policy is being consistently followed by the Company since many years.

The Institute of Chartered Accountants, based on information provided by SECP in its query along-with sample agreement, is of the view that 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.

According to ICAP, 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. Whereas, in the same opinion the Institute is of the opinion that the accounting treatment of Receivables is correct.

Institute’s opinion that risks and rewards are not fully transferred merely on the basis of above mentioned clauses in the agreement is in conflict with para 15 of IAS 18 and the concept of Substance over form as well .The view point of the Company has already been summarized above on the objective of these clauses used in the agreement.

Further there is a confusion that if the Company can’t recognize revenue then how receivables as a result of these sales could be recognized.

Tax laws in Pakistan also require the accounting of long term contracts using percentage completion method.

The Technical Committee of the Institute is requested to provide clarifications on these confusions raised by the Company so that correct accounting treatment could be ensured in Real Estate Industry.

Opinion:

The Committee considered your enquiry and would like to draw your attention to paragraph 14-16 of IAS 18 ‘Revenue’ which deals with revenue recognition on the basis of the requirement of transfer of risk and rewards of ownership of the goods. Based on the information provided in the previous TAC query which you have referred, risks and rewards were not fully transferred as well as control/ managerial involvements of the units sold remained with the Company and therefore, the Committee was of the view that requirements of para 14 (a) and (b) of IAS 18 were not being complied. Further, para 17-18 of IFRIC 15 ‘Agreements for the construction of Real Estate’, also reinforce that the revenue from the sale of housing scheme will only be recognized when all the requirements of para 14 of IAS 18 are fulfilled. Accordingly, this Committee maintains the previous opinion on the matter.

However, paragraphs 35-37 of IFRS 15 ‘Revenue from Contracts with Customers’, which is applicable for periods beginning on or after 1st January, 2018 but not yet adopted and notified in Pakistan, set out the criteria where an entity should recognize the revenue over time and failing which an entity satisfies the performance obligation at a point of time and therefore should recognize the revenue in accordance with requirements stipulated in paragraph 38.

With respect to recognition of receivable with a corresponding credit to advance from customers, the Committee agrees that this was perhaps not consistent with the current practice. Advance from customer is to be recognized as liability as and when installments are received rather than recording of receivable from customer on an accrual basis as per the installment plan.

(07 September 2016)