Revenue recognition is a cornerstone of accrual accounting system which determines the accounting period in which revenues and expenses are to be realized. With effect from 1st April, 2018, Ind AS 115-Indian Accounting Standards ("the Standard") superseded the IAS 11 vide a notification dated 28th March, 2018 by the Ministry of Corporate Affairs. It is pari passu with the International Financial Reporting Standards (IFRS) pertaining to revenue from contracts with customers. With the introduction of Ind AS 115, the real estate entities will need to determine revenue recognition on the basis of whether performance obligations is satisfied 'over time' or 'at a point in time'. There may be a change in the accounting system of real estate entities for recognizing revenues arising out of contract with customers. The actual impact on each company will depend on their specific customer contracts and how they will apply this Standard and the existing standards.
The Institute of Chartered Accountants of India has clarified vide a press release dated 20th July, 2018 that Ind AS 115 does allow recognition of revenue using percentage of completion method and has explicit and specific requirements to recognize revenue, where performance obligation is specified over a period of time. Through this article, we want to shed light on whether real estate entities can recognize their revenue over time or at a point in time.
Revenue recognition when performance obligations are satisfied:
Paragraph 31 of the Standard provides that revenue is to be recognized when/as the entity satisfies a performance obligation by transferring a promised good or service (i.e. an asset) to a customer who has obtained control over the asset. Performance obligation is satisfied either (i) over time, or (ii) at a point in time. The Standard through Paragraph 32 clearly discloses that if an entity does not satisfy performance obligation over time, it shall be deemed to have performed obligations at a point in time. With respect to a real estate entity, Paragraph 35 of the Standard inter alia provides that any real estate entity transfers control of an asset over time if the entity's performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
Whether the real estate entity's performance creates an asset with an alternative use?
- Paragraph 36 of the Standard provides that an asset created by an entity's performance does not have an alternative use to an entity if the entity is restricted contractually from readily directing the asset for another use during the creation or enhancement of that asset or limited practically from readily directing the asset in its completed state for another use.
- Appendix B6, (which is an integral part of this Standard) while assessing whether an asset has an alternative use to an entity, an entity shall consider the effects of contractual restrictions and practical limitations on the entity's ability to readily direct that asset for another use, such as selling it to a different customer. The possibility of the contract with the customer being terminated is not a relevant while considering the same.
- Further Paragraph B7 of the Standard provides that a contractual restriction on an entity's ability to direct an asset for another use must be substantive for the asset not to have an alternative use to the entity.
Therefore, in view of the relevant provisions of this Standard and the standard agreements which a real estate entity enters with purchasers, the performance obligations of real estate entities do not create an asset for alternative use.
Whether there is an enforceable right with the real estate entity, to payment for performance completed to date?
- Paragraph B10, explicitly states that an entity's right to payment for performance completed to date need not be a present unconditional right to payment. In many cases, real estate entities will have unconditional right to payment only at an agreed-upon milestone or upon complete satisfaction of the performance obligation. In assessing whether it has a right to payment for performance completed to date, an entity is required to consider whether it would have an enforceable right to demand or retain payment for performance completed to date if the contract were to be terminated before completion for reasons other than the entity's failure to perform as promised.
- Also, Paragraph B9 of the Appendix has made it clear that an entity has a right to payment for performance completed to date if the entity would be entitled to an amount that at least compensates the entity for its performance completed to date in the event that the customer or another party terminates the contract for reasons other than the entity's failure to perform as promised.
- Usually, as a normal trade practice, application form, allotment letter, agreement for sale, etc ("Customer Documents") do not contemplate termination by the customer, unless the real estate entities are in default. Termination of contract by the customer in the absence of failure on the part of the real estate entities would not only be wrongful but also constitute a default thereby enabling the entity to seek performance of payment obligations.
- We now analyse whether the real estate entity would have an enforceable right to demand or retain payment for performance completed to date, if the contract were to be terminated before completion, for reasons other than the entities' failure to perform as promised.
- Prior to the enactment of the Specific Relief (Amendment) Act, 2018 ("Amendment Act"), the remedy of specific performance was not available to a party as a matter of right, but it was granted based on the discretion of the court. Pursuant to the amendment by the Amendment Act to Section 10 of the Specific Relief Act, 1963 ("the Act"), the courts are bound to enforce the specific performance of a contract as a rule, subject to limited exceptions.
- Save and except in the situations
contemplated in Section 14 of the Act the courts are bound to
enforce the specific performance of a contract as a rule. We have
discussed each exception and our analysis thereof hereunder.
- The first exception in Section 14(a) of the Act which deals with substituted performance of contract. In our opinion this exception applies only if the person seeking specific performance has already obtained performance of the same contract from another person. Real estate contracts do not contemplate such substituted performance and this clause would generally not apply to such contracts.
- The second exception contained in Section 14(b) of the Act deals with the performance of a continuous duty which the court cannot supervise. In our opinion, this exception does not apply to a real estate contract, where the developer is seeking specific performance as the performance of the contract by the flat purchaser being payment of the consideration is not in the nature of continuous duty which cannot be supervised by the Court.
- The third exception contained in Section 14 (c) of the Act which deals with contracts so dependent on the personal qualifications of the parties that the court cannot enforce specific performance of its material terms, In our opinion, again, this exception does not apply to a real estate contract as payment of monies under a real estate contract by a buyer does not as such depend on the personal qualifications of the parties. Therefore, in our opinion, this exception will also not prevent specific relief to the real estate entity.
- The fourth exception contained in Section 14 (d) of the Act states that a contract which is determinable in nature cannot be specifically enforced. In our view a real estate contract will not fall within the purview of this exception as it is not by its nature terminable. We also note that this exception was contained in Subsection (1)(c) of the erstwhile Section 14 of the Act in the same manner. We consider some of the judgements passed by High Courts in India in relation to the interpretation of this section.
The Orissa High Court in one of its judgements, while referring to the erstwhile 14 (1) (c) of the Act held that the agreement is not determinable unless the condition therein contained for termination of the contract are satisfied. Therefore, Section 14(1) (c) had no application to the facts of the said case where the termination clause of the agreement clearly provided that before termination of the agreement either party to the agreement may give 90 days notice to remedy the breach. Admittedly, neither party specifically the appellant had given any notice in terms of the said clause to remedy any breach and therefore the agreement is not determinable unless the condition therein is fulfilled. An appeal against this judgment of the Orissa High Court was referred before the Hon'ble Supreme Court of India (AIR (2007) SC 2563) wherein the Hon'ble Supreme Court did not overturn the Orissa High Court's finding on this point.
In Indian Oil Corporation Ltd. v. Nilofer Siddiqui and Ors. (2016 (3) SCJ 720 / 2015 (13) SCALE 313), the Hon'ble Supreme Court of India after noting that the letter of allotment in question had a termination clause which permitted the Corporation to terminate the distributorship without assigning any reason by giving 30 days' notice, held that from the terms of agreement, namely, the letter of allotment and the conduct of the parties, it appeared that neither the contract was revocable nor it had become void for any reason whatsoever. Thus even when there was a provision of termination at will in the agreement, the Apex Court decided that the contract is not determinable only because of it having a termination clause. Hence, provision of Section 14(1)(c) of the Specific Relief Act was not applicable to the facts and circumstances of the said case and the suit cannot be legally held to be maintainable under the said provision...."
Therefore, based on the above discussion, in our view, the exceptions aforesaid have no application to real estate agreements generally executed. According to us, if an agreement does not have a clause which permits the flat purchaser to terminate the agreement at will and the purchaser can terminate the agreement or withdraw only if the real estate entity fails to hand over the unit as per the date specified in the agreement, the agreement is non determinable under Section 14(d) (till the date specified by the real estate entity to hand over the unit). Thus, if there has been no failure in the performance of the real estate entity, the purchaser cannot in terms of the Agreement terminate the same.
The Ind AS 115 while making certain modifications in the accounting system for revenue recognition; still keeps the provision for percentage of completion method as an option to real estate entities. Thus, recognition of revenue as the construction progresses is possible considering the prevalent long-established legal system, facts and circumstances of individual contract.
We are of the view that with the recent amendment of the Specific Relief Act, 1963, the real estate entity will have an enforceable right to demand/retain payment for performance completed where there is a breach by the customer and the real estate entity seeks confirmation of the agreement and performance of payment obligations provided that the agreement supports the same.
Therefore, in view of the relevant provisions of this Standard and the Act and Amendment Act, the performance obligations of real estate entities do not create an asset for alternative use and the entity may have enforceable right to payment for performance completed to date depending on the Customer Documents entered into by the entity. Thus real estate entities need to pay utmost attention while documenting/ drafting the Customer Documents in order to ensure that it can recognize revenue at a point in time.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.