Nightmare of Indian Accounting Standard 115 comes to haunt firms in the real estate sector3 min read . Updated: 17 Jul 2018, 10:55 AM IST
Most realty firms in the listed universe such as DLF, Godrej Properties, Phoenix Mills and Sobha would take a one-time hit in their profit and loss account
No sooner had realty firms steered past the issue of compliance with the Real Estate (Regulation and Development) Act that another nightmare started to haunt them. From the June quarter, realty firms have to follow the Indian Accounting Standard (Ind AS) 115 that aims to align them with global accounting standards.
As a fallout of this, the June quarter performance of most realty firms is likely to see dramatic changes. Balance sheets, and profit and loss accounts of real estate firms will be thrown out of gear. Investors need to brace themselves for this.
Ind AS 115 requires that realty firms switch from the present percentage completion method to project completion method.
Currently, the revenue and profit accrues in proportion to the percentage of the project that has been completed. However, under the new system, revenue can be booked only after the project is completed and the customer has taken possession of the unit (house/flat).
What’s worse is that the retrospective enforcement would have far-reaching implications for real estated firms at least for a few quarters.
Such a paradigm shift is bound to upset the revenue and profit pattern, at least through fiscal year 2019, for many reasons. What does it mean for investors and other stakeholders?
Firstly, revenue and profits booked in the previous quarters, on projects that are yet to be completed, will have to be written back in the June quarter results. So, most realty firms in the listed universe such as DLF Ltd, Godrej Properties Ltd, Phoenix Mills Ltd and Sobha Ltd would take a one-time hit in their profit and loss account.
Secondly, profit write-back from the earlier quarters will drag reserves down. Not just that. Revenue growth is bound to drop for most realty firms, except for those with completed projects during the quarter.
Thirdly, the advance collected from buyers will be treated as “customer advances" unlike earlier when it was treated as revenue. This will push up current liabilities in the realty firm’s balance sheet.
According to Mudassir Zaidi, executive director (north) at Knight Frank India Pvt. Ltd, the increase in liabilities and drop in net worth may skew the debt-equity profile of most realty firms that adapt to Ind AS 115. He adds, “However, it is a welcome step as it brings greater transparency. With time, stakeholders will learn to read the numbers contextually."
That said, the change would not disturb the cash flows of the company. Real estate analyst Adhidev Chattopadhyay of ICICI Securities Ltd said, “The optical illusion would not change the actual cash flows and net asset value of the firm."
But cash flows statements are declared by most firms only every six months, making it hard for retail investors to assess performance. Revenue and profit track records may get lumpy. According to Icra Ltd, only those firms with a steady record of project completion will have less volatility in revenue and profit growth.
Ind AS 115 hopes to usher in greater transparency in a sector that was losing credibility. Several grey areas such as the manner of accounting for project delays, cancellations, customer withdrawals, etc. were loopholes that gave room for manipulation of accounts. Therefore, this system ensures that revenue on a project can be accounted for by the realty firm only when full payment is realized from the customer and the asset is transferred to the buyer.
“Profit & loss account will henceforth be a reflection of deliveries concluded by the company," explained Icra, adding that this system would enthuse firms to disclose accurate details on new launches, units sold and cash flows for the benefit of investors.
With the percentage completion method buried, corporate overheads and other costs that are accounted quarterly will have a negative impact on profitability, till the project is complete. This may make a year-on-year or quarter-on-quarter comparison meaningless.
It remains to be seen whether the ups and downs in quarterly performance would lead to volatility in realty firms’ stock prices. For now, the BSE Realty index has underperformed the benchmark Sensex since early January. This may remain so until this hurdle that proposes to clean up realty balance sheets is crossed.