The advent of International Financial Reporting Standards (IFRS) in India will have far-reaching implications for real estate, construction and infrastructure companies. It will impact the basis for recognizing revenues, take cognizance of multiple-element contracts and barter transactions, and allow the use of fair value for measurement of assets.
According to the current accounting standard on “investment property”, investment properties are defined as property (land or building, or both) held to earn rentals or for capital appreciation or both.
Under Indian generally accepted accounting principles (GAAP), there is no specific definition of investment property; hence, there are varying practices of classifying such properties held for rentals or capital appreciation. They are either shown under investments or as part of fixed assets at cost of acquisition or construction. If the property is classified as part of fixed assets, it is possible to undertake revaluation, but such gain is taken directly to reserves and the property needs to be depreciated over its economic useful life.
IFRS will allow real estate companies to adopt fair value for measuring and reporting their investment properties.
The fair-value gains as well as losses arising from adoption of this method will be routed through the profit and loss account. If the fair-value model is adopted, investment property is not depreciated; hence there will be no amortization cost. IFRS recognizes the fact that usually landed properties only appreciate in market values over the long term; therefore, they need not be depreciated (have a certain value written off every year, which is how most assets are currently treated).
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Being substance-driven, IFRS will have a significant impact on recognition of real estate sales. Usually, agreements for sale with buyers are made as soon as the projects are launched, typically well before completion of construction and handing over of possession. The IFRS provision on “agreements for the construction of real estate” requires developers to determine whether the contract is a construction contract, services contract or a sales contract, and revenue recognition will follow this substance. The agreement will be a construction contract if the buyer has control over the design and specification of the property till it gets completed. It will qualify as an agreement for services, if the materials are being provided by the buyer, which normally is not the case, but this may apply in certain joint development contracts. In all other cases, IFRS will treat sales of residential flats or properties as sale of goods on completion basis. Indian GAAP allows it to be done by the proportionate completion method once the agreement for sale has been entered into. However, in the case of IFRS, this will be possible only if the contract is a construction contract, wherein the buyer has control over the specifications. IFRS will allow recognition of multiple elements in the real estate contract. So, if there are two separate arrangements, one for sale of land and another for construction services, then it may be possible to recognize revenue from sale of land separately.
Under IFRS, barter transactions will need to be accounted for on a gross basis. In the real estate industry, joint developer agreements are quite common. In such cases, the landowner gets a specified portion of the constructed area from the developer in consideration for the land price. Under Indian GAAP, such barter transactions are not usually contemplated and accounted for except in barter transactions relating to fixed assets. However, under IFRS, the accounting for barter transactions will have to be reflected at fair value for both inventories of real estate as well as investment properties. The developer will, therefore, account for land purchase at its fair value as cost of the project with corresponding payable liability. He will also recognize revenues from construction services for the landowner’s share being developed by him over the period of the construction. The receivables for construction services would get adjusted with the price payable for land in the year of handover. Hence, for residential projects, under IFRS the revenues and costs reflected in the profit and loss account will be grossed up to include impact of the barter transaction, though at the net level, profits are expected to remain the same. It is possible that the fair value of land acquired is higher than the fair value of construction service revenues for the landowners’ share, in which case the profitability in IFRS may be higher.
For infrastructure companies, the IFRS provision on “service concession arrangements” will have far-reaching consequences, since concession arrangements would need to be accounted for differently. Under Indian GAAP, expenditure incurred by the infrastructure provider is capitalized as fixed or intangible asset, depreciated usually over the term of the service concession agreement. Under IFRS, this will have two elements. First, it will be treated as rendering of construction services where revenues will get recorded at the fair value of such services, that is, with appropriate mark-up over cost. Second, the provider will recognize an intangible asset in extinguishment of the receivables on completion of construction. The results of the service provider will be thus significantly different, since it will recognize revenues during the construction period under IFRS.
Another important aspect will be discounting of long-term payables and receivables, including retention money, in line with market interest rates to reflect the current fair value.
India will move to IFRS starting 2011. Navin Agrawal is a director with Ernst & Young India Pvt. Ltd. This is the fifth of a series that analyses the impact of IFRS on industries and regulatory issues pertaining to its convergence with Indian GAAP.
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