Revenue Recognition in Real Estate Development – Methods | Accounting | Tax Implications

Revenue recognition in real estate development refers to the process of determining when and how revenue from real estate projects is recorded in financial statements. Due to the long-term nature of real estate projects, developers commonly use either the Completed Contract Method (CCM), where revenue is recognized upon project completion and transfer of ownership, or the Percentage of Completion Method (PCM), where revenue is recognized progressively based on the project's stage of completion. The choice of method impacts financial reporting and tax liability, and is guided by accounting standards and regulatory guidelines.

Table of Contents

1. Method of Accounting for Revenue Recognition for Real Estate Developer
2. Appropriate Method for Taxability of Real Estate Developers
3. Judicial Controversy Regarding Adoption of Completed Contract Method (CCM) or Percentage of Completion Method (PCM) by the Real Estate Developer

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The activity of development of real estate is in the nature of business activity and the income arising from such activity is to be treated as business income in the case of real estate developer. The real estate activity may consist of development of Township, Residential Complex, Commercial or Industrial Complex etc. Real Estate Projects are generally of large volume and take several years in completion. Since the activity relating to real estate project is spread over several years, it involves complex accounting and taxation issues regarding recognition of income in different years.

The Institute of Chartered Accountants of India (ICAI) has issued Accounting Standard-9 for income recognition. However, complex accounting issues relating to real estate development could not be convincingly addressed by general principles of income recognition as prescribed by Accounting Standard on Revenue Recognition (AS-9). Therefore, Guidance Note on Recognition of Revenue by Real Estate Developers was issued by ICAI, first in the year 2006, which has recently been revised comprehensively in the year 2012 and presently, this revised guidance note for accounting and income recognition of real estate transactions (Revised 2012) is applicable for real estate developers. Apart from the above, Accounting Standard-7 is applicable for real estate transactions prescribing accounting principles for preparation of financial statement by the contractors. The principles of accounting prescribed for construction contracts as per AS-7 are also relevant for real estate developers since the Guidance Note issued for real estate developers is based upon the principles propounded in AS-7 for construction contracts.

Under the Income-tax Act, 1961, there is no specific provision as such regarding taxability of income of the real estate developers and therefore, general provisions of computation of business income prescribed u/ss 28 to 44DB of the Income-tax Act shall be applicable along with other relevant provisions of the Act. Since, there is no specific provision under the Income-tax Act regarding taxability of income of real estate developers, the income recognized by the developers in the financial statement prepared in accordance with various Accounting Standards and Guidance Note issued by Institute of Chartered Accountants of India/Ministry of Corporate Affairs (ICAI/MCA) shall be relevant and form the basis for computation of taxable income under the Income-tax Act. Moreover, provisions of section 145 of the Income-tax Act regarding method of accounting regularly employed by the assessee are also relevant.

1. Method of Accounting for Revenue Recognition for Real Estate Developer

Primary issue in the case of real estate developers is to decide whether they are required to follow Completed Contract Method (CCM) or Percentage of Completion Method (PCM) for revenue recognition while preparing their Annual Financial Statement. Before we proceed further, let us understand the features and tax implications of both the methods.

1.1 Completed Contract Method (CCM)

As per general principle of revenue recognition as discussed under Accounting Standard-9, revenue relating to any sales transaction is recognized when significant risks and rewards of ownership of goods are transferred.

In the case of sale of immovable property, ownership of the property is transferred as per the Transfer of Property Act, 1882 when legal title of ownership is transferred. As per the Transfer of Property Act, 1882 legal title of the property is transferred by way of registration of sale deed or in accordance with the provision of section 53A of the Transfer of Property Act.

Under Completed Contract Method, revenue is recognized as per the above principle when ownership of property is transferred. In the case of real estate project, ownership of the property can be transferred only when property comes into existence and physical possession of the property is handed over. A real estate project generally takes several years to be completed. Therefore under the Completed Contract Method, no revenue is recognized during the years when project is under development and whole of the revenue is recognized in the year when the project is physically completed, possession is handed over and ownership is transferred.

1.1.1 Features of Completed Contract Method (CCM)

1. Revenue is recognized in the financial statements only on completion of the project.
2. There does not remain consistency in the income to be recognized in the financial statement of the real estate developer on year to year basis. In some year(s), there may be huge income recognized while in other years, there may not be any income reflected in profit and loss account.
3. Income is recognized in the profit and loss account on actual basis and not on estimated basis from year to year as is recognized in the case of Percentage of Completion Method (PCM).
4. Such inconsistency of profits/financial performance reflected in the financial statement may create hardship in getting the credit limits from the banks/financial institutions or raising public funds by way of other means.

1.1.2 Tax Implications of Completed Contract Method (CCM)

1. Under Completed Contract Method, no taxable income is generated in the year(s) when project is under development.
2. Assessee may prefer to follow Completed Contract Method to defer the tax liability.
3. Due to deferment of taxable income, sometimes assessee may lose the benefit of set off of brought forward losses, as unabsorbed business losses brought forward from earlier year(s) may lapse.
4. There shall remain uncertainty till the completion of project regarding claiming of deduction under section 80-IB or under any other provisions of the Act.
5. Tax authorities do not appreciate the adoption of this method as it results into deferment of payment of tax liability.

1.2 Percentage of Completion Method (PCM)

In view of the peculiarity of the real estate project i.e. it takes several years in development and completion of project, it is more appropriate to follow Percentage of Completion Method (PCM) for revenue recognition.

Under Percentage of Completion Method, revenue is recognized as per the stage of completion of the project on year to year basis during the development of the project.

The underlying principle for adoption of Percentage of Completion Method for revenue recognition is that in case of real estate project, generally, significant risks and rewards of ownership of property are transferred to the buyer at the time of entering into binding sale agreement. Once sale agreement is entered, the developer effectively acts for the buyer in the capacity as contractor.

1.2.1 Features of Percentage of Completion Method

1. Revenue is recognized in the financial statement on year to year basis as per the stage of completion of the project at the end of each year.
2. There remains consistency of profit to be reflected in the profit and loss account every year.
3. Revenue is recognized in the financial statement even before property comes into existence and physical possession of property is handed over by the developer.
4. Income is recognized on estimated basis by estimating the total project revenue to be earned and total project expenses to be incurred in future.

1.2.2 Tax Implications of Percentage of Completion Method

1. Taxable income is resulted & offered to tax consistently on year to year basis.
2. Tax liability is discharged by the assessee on year to year basis and it is not accumulated to be paid in one go.
3. Tax authorities prefer this method as it results into early collection of tax.

2. Appropriate Method for Taxability of Real Estate Developers

Income-tax Act does not prescribe any specific method to be adopted to compute taxable income of real estate developer. There is no specific provision under the Income-tax Act in this regard and therefore, business income of the real estate developer is to be computed and assessed in accordance with the normal provisions of computation of business income prescribed under the Act. The tax authorities cannot impose and do not have power to insist to adopt any particular method for revenue recognition and computation of taxable income by the real estate developer.

Income under the head business or profession is computed by taking the profit or loss shown in the profit and loss account and then making adjustments to such profit or loss in accordance with the specific provisions given under the Income-tax Act. Profit and loss account is drawn and profit and loss for the year is computed in accordance with the Accounting Standards/Guidance Note prescribed by the Institute of Chartered Accountants of India (ICAI)/Ministry of Corporate Affairs (MCA). It is settled principle of law that in case there is any provision under the Income-tax Act which is in deviation to the Accounting Standards, the provision of Income-tax Act shall prevail. In the absence of any specific provision under the Income-tax Act, the profit computed in accordance with the Accounting Standards shall be considered for the purpose of computation of taxable income as has been held by different courts including the apex court consistently in several judicial decisions which have been discussed in the foregoing paragraphs of this chapter.

The accounting principles for recognition of revenue by the real estate developer have remained in evolving stage in India during last decade. There have been different methods of revenue recognition by the real estate developers prescribed at different times by the Institute of Chartered Accountants of India (ICAI) which have been discussed in detail in a separate chapter. Therefore, the manner of taxability of income for the real estate developer shall be applicable in accordance with method of revenue recognition prescribed and applicable as per the Accounting Standard/Guidance Note issued by the ICAI effective for the relevant period.

Presently, the accounting principles for revenue recognition by real estate developer are governed by the revised ‘Guidance note on Accounting for Real Estate Transactions (Revised 2012)’ issued by the ICAI applicable from the accounting year commencing on or after 01.04.2012. Detailed discussion analyzing the applicability of the Guidance Note to the real estate developer for revenue recognition in the financial statement has been made in a separate chapter.

Revenue recognition by the real estate developers during the development of the project on year to year basis as per the stage of completion of the project following Percentage of Completion Method (PCM) as prescribed in the Guidance Note is subject to several contingencies and fulfilment of various conditions. Revenue under the Guidance Note cannot, inter alia, be recognized unless the ultimate outcome of the project can be estimated reliably and there is no uncertainty prevailing regarding ultimate collection of revenue.

In cases where the Guidance Note does not permit to recognize revenue during the development of project even after completion of particular stage of the project, revenue has to be recognized in such a case as per the general principles of revenue recognition as enumerated in AS 9 which effectively means recognizing revenue as per Completed Contract Method (CCM). In such situations, the tax authorities cannot be justified to make assessment of taxable income following the Percentage of Completion Method.

3. Judicial Controversy Regarding Adoption of Completed Contract Method (CCM) or Percentage of Completion Method (PCM) by the Real Estate Developer

There has been controversy regarding the adoption of the accounting method based upon which income is to be computed by the real estate developer from the real estate project. The Institute of Chartered Accountants of India has prescribed the adoption of CCM or PCM at different periods under AS 7 and AS 9 read with the Guidance Note for accounting applicable to the real estate transactions. There have been frequent changes made in the above guidelines by the Institute during last decade which have been discussed in detail in a separate chapter.

Since income under the head business in case of real estate developer is based on the accounting profit read with the provisions of section 145 of the Income-tax Act, 1961, the computation of taxable income has also been mired in judicial controversies. There have been divergent decisions of various courts rendered in this regard from time to time.

It has been observed that the judicial decisions have primarily followed the principles of consistency as given in section 145 of the Act. Frequent changes made in the accounting treatment have not been strictly approved by the courts in some cases.

Here is an attempt to give the significant cases rendered by the different courts from time to time classifying the cases relating to period prior to 01.04.2003 when option to adopt CCM or PCM was available with the assessee as per old Accounting Standard-7 and post 01.04.2003 when such option was not available as per revised Accounting Standard-7 and as per Guidance Note for real estate developers issued by the Institute of Chartered Accountants of India. The classification has been made based upon the year of dispute involved in the case and not on the basis of the year in which decision has been rendered.

3.1 Cases relating to year in dispute prior to 1st April, 2003 i.e. when old AS-7 was applicable

In the following cases courts have laid down the proposition that it is the option of the real estate developer assessees to choose either CCM or PCM for computation of income. Courts have approved adoption of CCM or PCM whichever method was being followed by the developers. These decisions are in line with the accounting principle prescribed in old AS-7 which also provided option to adopt either CCM or PCM by the real estate developer for accounting purpose relating to the year prior to 1.4.2003. However these decisions may not be applicable relating to the period after 1.4.2003 since accounting principle to be adopted by the developer has undergone a change as prescribed in the revised AS-7 and other guidelines issued by the Institute of Chartered Accountants of India in this regard.

(a) Option of the assessee to Choose CCM or PCM

(1) In the case of CIT, Meerut v. Hyundai Heavy Industries Co. Ltd. [2007] 210 CTR 178/291 ITR 482/161 Taxman 191 (SC), assessment years 1987-88 and 1988-89, it was held by the Supreme Court that

“Lastly, there is a concept in accounts which is called as the concept of Contract Accounts. Under that concept, two methods exist for ascertaining profit for contracts, namely, ‘Completed Contract Method’ and ‘Percentage of Completion Method’. To know the results of his operations, the contractor prepares what is called as Contract Account which is debited with various costs and which is credited with the revenue associated with a particular contract. However, the rules of recognition of cost and the revenue depend on the method of accounting. Two methods are prescribed in Accounting Standard-7 (AS-7). They are – ‘Completed Contract Method’ and ‘Percentage of Completion Method’.”

(2) In the case of CIT v. Bilahari Investment (P.) Ltd. [2008] 215 CTR (SC) 201/299 ITR 1/168 Taxman 95 (SC), A.Ys. 1991-92 to 1997-98, it was held by the court that

“Recognition/identification of income under the 1961 Act is attainable by several methods of accounting. It may be noted that the same result could be attained by any one of the accounting methods. The completed contract method is one such method. Similarly, the percentage of completion method is another such method.”

(3) In the case of MKB (Asia) (P.) Ltd. v. CIT [2007] 294 ITR 655/[2008] 167 Taxman 256 (Gauhati), A.Ys. 1992-93 to 1995-96, an assessee has the option to adopt any recognized method of accounting for his business and the income has to be computed in accordance with such regularly maintained accounting system. Assessee company engaged in the business of works contracts, regularly valuing its closing work-in-progress as per AS-7 as laid down by the Institute of Chartered Accountants of India, the IT authority had no option or jurisdiction to meddle with the matter.

(4) In the case of CIT v. Doom Dooma India Ltd. [1993] 200 ITR 496 (Gauhati), A.Y. 1979-80, it was held that the assessee had the option to adopt one or the other method of accounting and the taxing authority can object only if it is of the opinion that the method employed is such that the income cannot be properly deduced therefrom. The Tribunal has taken the view that the assessee adopted the same system of accounting for valuing the opening stock and closing stock and that there is no basis for taking the view that the income cannot be properly deduced from the method employed by the assessee. This view is consistent with law. However, it is not open to assessee to adopt one method for valuing opening stock and a different method for valuing closing stock so as to suppress the income in the previous years.

(b) Adoption of Completed Contract Method (CCM) approved by the Courts

Relating to the period prior to 1.4.2003, i.e. A.Y. 2003-04 when as per the AS 7, option was available with the assessee, courts have approved the adoption of CCM on the basis of principle of consistency as enshrined in section 145 of the Act & attempt of the Revenue to introduce PCM or the like method was disapproved in the following judicial decisions-

(1) In the case of CIT v. Realest Builders & Services Ltd. [2008] 307 ITR 202/170 Taxman 218 (SC) A.Y. 1994-95; Contention of the assessee was that income did not accrue to it till the date of conveyance since there was no transfer of right, title and interest upto the date of execution of conveyance and, therefore, there was no accrual of income at the time of execution of the tripartite agreement when the assessee received consideration. As per section 145, it is open to the Department to insist on change in the method of accounting followed by the assessee if it results in under-estimation of profits/net income. If the AO comes to the conclusion that there is under-estimation of profits, he must give relevant facts and figures in that regard and demonstrate that the method of accounting adopted by the assessee results in under-estimation of profit. There was neither allegation nor such exercise was undertaken in this case. Therefore, it has to be accepted that the income from the sale of plots accrued to the assessee only on the date of conveyance and not at the time of execution of tripartite agreement when the assessee receive consideration.

(2) CIT v. Triveni Engg. & Industries Ltd. [2011] 196 Taxman 94/336 ITR 374/[2010] 8 taxmann.com 146 (Delhi), A.Y. 2000-01 in the present case, the assessee had followed consistently mercantile method of accounting. In respect of project related activities, the assessee had consistently and regularly followed the completed contract method in terms of Accounting Standard (AS 7) issued by the ICAI. This method had been accepted by the revenue all along. Even in this year, this method was not rejected from which it would be evident that the Assessing Officer was satisfied with the correctness and completeness of the accounts of the assessee and further with the method of accounting regularly employed as being scientific and rationale. In such circumstances, argued the learned counsel for the assessee that it is not open to the Assessing Officer to deviate from the regularly and consistently followed method of accounting followed by the assessee and accepted by the revenue. He argued that the Courts have highlighted the primacy of the method of accounting and held that the consistent and regular method of accounting is supreme unless the Assessing Officer finds that accounts of the assessee are not correct or complete or that the method of accounting is not regularly followed/not in accordance with the notified accounting standards.

(3) In the case of CIT v. Guttoffnungashutto Sterkrado [1992] 197 ITR 66/64 Taxman 303 (Ori.), A.Ys 1968-69, 1969-70, it was observed that no defect in the accounts maintained by the assessee was pointed out by the Assessing Officer and on the contrary the profits of the assessee can be correctly determined from the method of accounting adopted by it. Therefore, the ‘complete contract’ basis was the correct mode for determination of the assessee’s income and its income can be correctly determined from the method of accounting adopted by it.

(4) In the case of CIT v. V. S. Dempo & Co. Pvt. Ltd. [1996] 131 CTR 203 (Bom.), A.Ys. 1967-68, 1969-70, 1970-71, 1971-72, assessee regularly following completed contract method for determining its income from contract business. Similar system was also accepted by Revenue in the case of other assessees having same line of business. Tribunal holding that method of accounting followed by assessee was correct and resort to s. 145(1) was not called for, was found justified.

(5) In the case of Dy. CIT v. Otis Elevators Co. India Ltd. [2006] 99 ITD 73 (Mum.), A.Ys. 1989-90 to 1993-94, 1995-96 & 1996-97, it was held that Contract completion method of accounting regularly employed by assessee for decades, not depicting any distorted picture of profits and which confirmed to Accounting Standards employed in India and also abroad, could not be rejected.

(6) In the case of Abode Construction Ltd. v. ITO [2005] 2 SOT 27/95 TTJ 35 (Mum.), Assessment Year 1994-95, it was held that since the assessee was consistently following Project Completion Method which was accepted by revenue in the past and subsequent years and there were no adverse comments by auditors who had audited books of account of assessee, therefore, Assessing Officer had no power to rewrite books of account and to estimate income on mere doubt or suspicion. Thus, addition made by AO was set aside.

(7) In the case of Asstt. CIT v. Rajesh Builders [2004] 3 SOT 917 (Mum.), A.Ys. 1986-87, 1990-91, it was held that the assessee was following CCM approach of method of accounting. AO made an addition of 8% of the WIP to the profit of the assessee who has started constructing building the complex in the previous year on the ground that revenue could not wait indefinitely for the collection of its revenue. On appeal to CIT(A) addition made by AO was deleted. Tribunal approved the order of CIT(A).

(8) In the case of Nandi Housing (P.) Ltd. v. Dy. CIT [2004] 2 SOT 395 (Bang.), A.Y 1997-98, it was held that as per section 145 of the Income-tax Act it is the choice of the assessee to follow any of the two recognized method of accounting and once the choice is made by the assessee of a system that is recognized by ICAI or by assessees of same class, assessee cannot be taken away from that class just for the purpose of bringing some income to tax by arbitrarily making addition to disclosed income.

(9) In the case of H.M. Construction v. Jt. CIT [2003] 84 ITD 429 (Bang.), A.Ys 1995-96 to 1997-98, the assessee-builder followed project completion method for construction project. Tribunal held that alternate method suggested by CIT for adopting 8 per cent of contract receipts irrespective of level of construction and allocating the same over the period on the basis of contract receipts was contrary to the well recognised method of accounting principles, and was unscientific and crude. Assessee’s method of accounting was prudent inasmuch as income was accounted for only on the completion of its obligation. Method of accounting employed by the assessee and initially accepted by the AO in the course of original assessment was not erroneous so as to be prejudicial to the interest of Revenue. Therefore, CIT erred in invoking the revisionary powers under section 263. The CCM was approved.

(10) In the case of Mutual Construction (P.) Ltd. v. Dy. CIT [1999] 107 Taxman 247 (Pune) (Mag.), A.Y 1992-93 As regards non-furnishing of profit and loss account along with return and capitalising of the expenses separately, the project completion method is one of the recognised methods as per Accounting Standard-7 issued by the Institute of Chartered Accountants of India. But in the instant case, the assessee was not claiming any expenditure by way of deduction out of the profits of the year because there were no transactions of sales. In the absence of any business transaction, no profit accrued to the assessee and, therefore, ‘Nil’ return was filed. In these circumstances, the question of assessing of any income did not arise. No tax was due from the assessee on this account. Therefore, it could not be said that the order of the Assessing Officer was prejudicial to the interest of the revenue. Since the assessee was not claiming any deduction in respect of expenses, it was not necessary for it to prepare any profit and loss account. Therefore, the order of the Commissioner on these two issues was quashed.

(11) In the case of D. K. Enterprises v. ITO [1991] 39 ITD 394 (Bom.), A.Y 1987-88, Assessee, a builder firm following the method of reporting profits as and when a project was completed i.e. Project Completion Method. Same method followed consistently. No justification to reject this system.

(12) In the case of CIT v. Moghul Builders & Planners [2002] 173 CTR 43/[2001] 252 ITR 488/118 Taxman 898 (AP), it has been held that profits and gains arising out of construction and sale of flats by the assessee-builder had to be computed on the basis of handing over the possession of flats to the respective buyers. Tribunal has not committed any error, factual or legal, in applying the ratio of the judgment in Madgul Udyog v. CIT [1990] 184 ITR 484/[1991] 54 Taxman 34 (Cal.): TC 40R.339—No referable question of law arises—Madgul Udyog v. CIT [1990] 184 ITR 484/[1991] 54 Taxman 34 (Cal.): TC 40R.339 applied

It has been held in the case of CIT v. Unique Builders & Developers 160 DTR (Raj.) 313 that Assessing authority could not change the method regularly adopted by the assessee from ‘project completion method’ to ‘percentage completion method’ on irrelevant considerations.

(c) Adoption of Completion Contract Method (CCM) not Approved by the Courts and direction given to follow Percentage Completion Method (PCM)

In the following cases, which are relating to the period prior to 1st April, 2003 when as per old Accounting Standard-7 applicable during such period option was available to the assessee to follow either CCM or PCM, still Courts held that Real estate developers should have followed Percentage of Completion Method (PCM) only.