Wednesday, March 04, 2009

Revenues accrued and booked, but never realized

by Ravi Purohit

What happened

Lok Housing & Constructions made the following disclosure during the just concluded Dec'08 quarter:

The global economy in general and the real estate industry in particular is passing through recessionary scenario, which has resulted in to financial melt down of un-precedential scale. From time to time the Company had entered several agreements for sale of plots, properties, development rights and constructed units held by it as stock in trade. In accordance with the consistently followed accounting policy of the Company, sales revenue and profit thereon were recognised at the time of entering in to such agreements to sell. Due to the financial meltdown and Severe economic recession, some of the parties with whom the Company had entered in to agreement to sell have failed to meet their commitments and considering the overall interest of the Company, the agreement for sale entered in to in the past financial years and in respect of which revenues already recognized have been mutually terminated / cancelled. The Company has been legally advised that though the agreements for cancellation of sales have been entered in to during this quarter (being October to December 2008), but since cancellation of sales pertains to sales recognised earlier, the financial statements of the period during which sales and profits were recognised needs re-construction / amendment, on the doctrine of "Relation back". The Company shall amend the financial statements of earlier years and get the same approved in the next general body meeting. Accordingly no effect in respect of cancellation of sale agreements has been given in the financial statements of this quarter. During the quarter under review the Company has entered in to 53 agreements for cancellation of sales made in the earlier financial years, the sale value of which is Rs 282.14 crores and the resulting loss / reversal of profit recognized earlier being Rs 225.01 crores"

How big is this restatement, compared with the size of the firm?

It is huge. In the last three years (FY06, '07, & '08), Lok Housing Constructions reported cumulative revenues of Rs.578 crore and cumulative net profit of Rs.226.4 crore. The revenues were taken in the income statement based on the Company signing sales agreement with potential buyers (as mentioned in the explanation provided by the Company).

Now they say those contracts have been mutually terminated/cancelled, which means it will have to restate earlier numbers, ie. sales by Rs.282 crore (50% of total sales of the last three years) and net profit by Rs.225 crore (almost 100% of all profits earned during the last three years). Prior to FY2006, the company did not even make profits.

Using the CMIE standardised definition of PAT net of P&E, the profits ever made by the company are: Rs.14.55 crore ('06), Rs.79.07 crore ('07) and Rs.109.78 crore ('08). Compared with these more modest values, a restatement of Rs.226.4 crore is even more massive.

How did this happen?

In its accounting policies section of the Annual Report for FY07 and FY08, the Company states the following:

  1. The Company follows completed contract method of accounting in respect of its construction activity. Under this method profit in respect of units sold is recognized only when the work in respect of the relevant units are completed or substantially completed, which is determined on technical estimates.
  2. The construction and development cost for completion relating to the sold units, which are considered for profit are estimated on the basis of technical evaluation.
  3. Revenue recognition in respect of property sale transactions is on the basis of agreement to sale and are subject to execution of conveyance and compliance of applicable legal formalities.

The first and second statement is clearly not in sync with what the Company describes in its Note to Accounts for the Dec'08 quarter. Thus, it has to be the third point which states that it recognizes sales in respect of property sale transactions on the basis of "agreement to sale". However, according to Accounting Standard 9, the Company can book revenues only if the following two are fulfilled:

  • The seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and
  • No significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.

This means, revenues can be booked only upon delivery of the said property, which clearly was not the case for Lok Housing, else it would not have to restate sales and profits. So how is Lok Housing able to book revenues and profits and yet not deliver the property to the purchaser with whom it has an agreement to sale in place for more than 2-3 years?

Could it be because of the following Guidance note by the ICAI on Recognition of Revenue by Real Estate Developers?

Revenue in case of real estate sales should be recognized when all the following conditions are satisfied:

  1. The seller has transferred to the buyer all significant risks and rewards of ownership and the seller retains no effective control of the real estate to a degree usually associated with ownership;
  2. no significant uncertainty exists regarding the amount of the consideration that will be derived from the real estate sales; and
  3. it is not unreasonable to expect ultimate collection.

7. The determination of point of time when all significant risks and rewards of ownership are transferred depends on the facts and circumstances of each case considering the terms and conditions of the agreement. In case of real estate sales, all significant risks and rewards of ownership are normally considered to be transferred when legal title passes to the buyer (e.g., at the time of the registration, with the relevant authorities, of the real estate in the name of the buyer) or when the seller enters into an agreement for sale and gives possession of the real estate to the buyer under the agreement. All significant risks and rewards of ownership are also considered to be transferred, if the seller has entered into a legally enforceable agreement for sale with the buyer and all the following conditions are satisfied even though the legal title is not passed or the possession of the real estate is not given to the buyer:

  1. The significant risks related to real estate have been transferred to the buyer. In case of real estate, price risk is generally considered to be one of the most significant risks.
  2. The buyer has a legal right to sell or transfer his interest in the property, without any condition or subject to only such conditions which do not materially affect his right to benefits in the property.

8. When the seller has transferred to the buyer all significant risks and rewards of ownership, it would be appropriate to recognize revenue at that stage subject to fulfillment of other conditions specified in paragraph 6 above, provided the seller has no further substantial acts to complete under the contract. However, in case the seller is obliged to perform any substantial acts after the transfer of all significant risks and rewards of ownership, revenue should be recognized on proportionate basis as the acts are performed, i.e., by applying the percentage of completion method in the manner explained in Accounting Standard (AS) 7, Construction Contracts. An example is a building or other facility on which construction has not been completed though all significant risks and rewards of ownership have been transferred pursuant to the fulfillment of conditions stated in paragraph 7 above. Another example is of a land which is yet to be developed though the seller has transferred all significant risks and rewards of ownership of the land to the buyer through an agreement for sale as per paragraph 7 above."

I think this means that having once sold the rights to the buyer, the seller is merely a contractor and can therefore start booking revenues based on the work completed, i.e. even if a building is still under construction, the builder can start booking revenues and profits on it.

I am no expert on the accounting standards that are practiced by real estate companies in India, and after looking at the Notes to Accounting Policies in the Annual Report and in the most recent quarterly result for Lok Housing, my doubts have only increased. However, there have been some insightful articles in the press in recent times, which touch upon this topic:

  1. An article in the Hindu Business Line by Dolphy D'Souza of E&Y [link].
  2. An article in the Business Standard [link]

An unsatisfactory situation

This raises two questions:

  • How can a Company be allowed to book sales and profits for transactions never completed and allowed to carry it for 2-3 years? Surprisingly, there are no provisions for bad debts in any of the years during 2006-08, the maximum sundry debtors (outstanding for more than six months that the Company reported by Rs.147 crore in FY08, half of what was due to Lok Housing and that they belonged to previous years?
  • Even if our Accounting Standards do allow companies to book sales and profits without delivering the underlying consideration because there is an 'agreement to sale' in place, why is Lok Housing mutually terminating/cancelling these contracts and not going to the Court of Law and make those involved pay for the agreements entered into? How can a company benignly view cancellation of the agreements that are supposed to have earned it all the profits it reported in the last three years?

Disclosure: I have no shares of any Indian real estate company, and never have. I may never even invest in them in future too, unless there is more transparency in the way they operate, report their financials and the way the entire real estate market in India operates.

What can we do better?

I think the government would do well to:

  • Make it compulsory for all the local municipalities (such as the BMC) across India to provide all information pertaining to real estate projects (the clearances/objections, blue prints of plans applied for by developers and thereafter approved by the municipal authorities, and other related and important documents), on the Internet.
  • Ask every builder to a) Create a website, b) Make the entire plan as approved by the local authorities, the various clearances (CC, OC, etc.), and the flats/offices (including the ones currently on sale/already sold) available on the site with daily updates.
  • Clarify guidelines on financial reporting, or else more episodes like Lok Housing will come about, particularly given the softness in real estate prices.

9 comments:

  1. I agree with your article, however the cost of the agreement is huge- lost approx 5 lacs in this company....you are right about the financials.....I simply don't know if we any company's financials at all be trustworthy.......

    ReplyDelete
  2. Alok: If you see the write-back numbers provided by the Company, it makes for an interesting read.

    It says: Sales reversals to the extent of Rs.282 crore and net profit reversal of Rs.225 crore. The difference between the two, I presume would be the amount paid by the buyer with whom the agreement was signed, which upon cancellation of the agreement ideally should be retained by Lok Housing.

    Net profit as a percentage of sales comes to 20 per cent.

    This means that the Company signed Sale Agreements with an upfront payment amounting to only 20% of the total consideration.

    Real estate companies undertake such agreements (with low upfront payments) when there is home loan and the disbursing agency involved...since for a home loan to be sanctioned, there needs to be an agreement for sale in place.

    But, the time lag of over a couple of years between the two events(i.e. signing of the agreement for sale and involvement of a home loan company)seems unlikely to me.

    Clearly, in Lok Housing's case, the cost of agreement wasn't as big as one would have liked it to be...and whats even more disturbing is that the Company is does not seem to be taking any kind of legal recourse to get the buyers to honor the agreements!

    ReplyDelete
  3. Off course, it is duty of municipals
    corporations but it may be difficult to maintain all kind of information related to properties and other issues.


    harry

    ReplyDelete
  4. Correction: In my reply to Alok's comment, in one of the paragraphs I mentioned the following:

    "Net profit as a percentage of sales comes to 20 per cent"

    what I actually meant was:

    "net profit reversals as a percentage to sales reversals comes to 80 per cent".

    Btwn, the Company would do well to explain to its shareholders (or i am hoping some one would ask them):

    - whether the projects/agreements that were reversed were the only profitable ones it ever entered into? are all the remaining projects ventures loss-making, atleast thats what it looks like if one were to compare the profit reversals and the total profit earned!

    - further, i am still tryin to look for a listed real estate company that made 80% margins on sales? Unless, the sales reversals and profit reversals are unrelated?

    Lok Housing's financials and the reversal figures seem to be as enigmatic as Satyam's. Do we need another round of investigations?

    Well, one investigation is already under way - by the income tax department - which says that the Company has not paid any tax for assessment years 07-08 and 08-09. The company made a wonderful statement in its response:

    "The company argued that under the Income Tax Act, only the "real income" can be taxed and it cannot tax income that is still to be realised."

    The IT department too has made interesting comments:

    The department, represented by Beni Chatterjee, said the high share price was a result of high profits shown by the petitioner. It further stated, "The revised claim of the petitioner, reducing the profit of Rs 250 crore to almost nil, would be highly prejudicial to those shareholders who brought the shares of the petitioner from the promoter companies on the basis of audited accounts published by the petitioner."

    link to the article that covers this:

    http://tinyurl.com/bb78uv

    ReplyDelete
  5. Lok has got a project in Khar called Lok Nirman which is fully empty. I remember reading Invest The Happionaire Way - Yogesh Chabria and that time he had clearly predicted a real estate crash of 70%.

    I am waiting to read Yogesh's next book Cash The Crash, has anyone read it yet?

    Builders are in big trouble.

    ReplyDelete
  6. Your comments on Lok Housing are very compelling. As per the Interpretation issued by ICAI for Guidance of Realty Companies, Agreement for Sale creates binding conditions for revenue recognition. Subsequent events (cancellation) negating earlier estimation of revenue recognition shall have to be effected in the period in which such subsequent event occurs. Lok Housing intends to go back on this basic principal of revenue recognition. Having shown rosy picture during past years, they now intend to play a fast one on investors. Restatement of accounts can be permitted only in case of massive fraud or other such highly exceptional events. Restatement of accounts can not be a used as a handy tool to dupe investor.

    ReplyDelete
  7. Ajay,

    I fail to understand why investors and market participants ignore the differential between earnings and operating cash flow.

    Earnings(PAT) = operating cash flow + accruals. If the level of accruals relative to sales or total assets of the firm are seemingly high and inconsistent with peer group in the industry, this should raise an alarm or red flag and the scrip should be shorted mercilessly by the market partcipants.

    It is high time we see forensic accounting taken seriously by investors. ICAI and rating agencies have to educate the investors and we need a rating system to rank stocks based on earnings quality.

    ReplyDelete
  8. Ajay,

    what about developing an index for real estate like the Case-Shiller Index in the U.S. which tracks median housing prices in the major cities every month. ALso how about a futures contract on real estate indexes like the one introduced by the Chicago Mercantile Exchange?

    ReplyDelete
  9. Yogesh:

    Rising debtors as a proportion to sales should always raise a red flag when analyzing companies. But, it seems during bull markets investing public at large (incl. institutions of all shapes and sizes), simply ignore it.

    The case in point being IT companies of the yesteryear - DSQ Software, HFCL, Silverline, etc. And, now real estate companies.

    In 3 of the last 5 years (ending FY08), Lok housing had an average debtors O/S to sales ratio of close to or above 100%...that to my mind is simply crazy! And, yet when stock markets were booming, Lok Housing commanded a market cap of Rs.1600 crore! What's more they were even able to place shares to the Benett & Colemn group (some 7.6 lac shares @ 196 a piece).

    I agree with you that investors should take balance sheets & company accounts seriously...but history is replete with instances where investors (retail/ institutions/ govt. owned) prefer being circumspect ONLY during bad times. We live in a generation that prefers - 'cure' over 'prevention'.

    ICAI with its guidance note has only made things easy for companies like Lok Housing to do what they did!

    On the Case-Shiller index, I completely agree. We should have such an index. As of today there remains a complete lack of transparency with regards to real estate prices in India.

    ReplyDelete

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