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Query No. 4
Subject:
Accounting treatment of income from property
development
to part finance a construction project.1
A. Facts of the Case
1. A company, which is a joint venture between the Government
of India and the Government of National Capital Territory of Delhi,
is engaged in the business of construction, operation and
maintenance of Mass Rapid Transit System (MRTS) in National
Capital Region. While some phases of the system have already
become operational, others are at various stages of construction.
The funding plan approved by the Government of India provides
for equity from both the governments and loan from Japan Bank
for International Cooperation (JBIC). In addition, the plan also
required the company to undertake property development and real
estate activities to part finance the construction of the project and
also to supplement operational revenues to enable repayment of
the loan taken from JBIC. The relevant extract of the Cabinet
decision is reproduced below:
“…The balance of project cost over and above the equity and
debt finance will be raised by … (name of the company) by
way of revenue from property development, which has been
estimated at 6% of the revised project cost at April, 1996
prices…”
2. According to the approved funding plan, the company was
required to generate about Rs.300 crore for Phase-I from property
development as part financing of MRTS project. It was also decided
that the requisite land for the project including for property
development would be given to the company at inter-departmental
rates.
3. As a sequel to the above, Memorandum and Articles of
Association of the company have a clause authorising the company
to carry on all the relevant activities required for commercial
development of the properties.
4. The company has been carrying on the property development
activities in a number of modes depending upon the location, size
and approved use of the parcel of land. At times, the company has
also been engaging developers for certain lands on ‘Build-Operate-
Transfer’ (‘BOT’) basis by handing over the site to them for a
period of 30 years or so. In addition to the land parcels, certain
commercial properties have been developed on the footprints of
the stations in the form of shops, kiosks, stalls, etc., from which
regular income is generated. According to the querist, income
from all the above activities, right from inception have been
considered as revenue profit, based on the terms and conditions
of the contracts with various lessees and the BOT developers,
under the overarching provisions of relevant Accounting Standards
and the accounting policies disclosed in the financial statements
of the company.
5. During the financial year 2005-06, the company has transferred
the leasehold rights of two parcels of land measuring 16.802 acres
and 2.972 acres for residential developments. These lands have
been leased for 99 years and 90 years respectively to two different
developers for total consideration of Rs.248.80 crore. This was the
first instance wherein land was given to the developers for a longer
period of 90 years and above, since these were residential
developments and lease for any period less than this would have
made the proposition ineffective.
6. The company treated the above said transactions of the lease
of land as sale in consonance with the accounting policy as
reproduced below:
“10.4 Income from lease of land for property development
pursuant to lease agreement for 60 years and above is
recognised as sale on handing over of land to developers
since it transfers substantially all the risks and rewards
incident to ownership of land.”
“3.7 Cost of land at the time of handing over to developers
pursuant to the lease agreement for 60 years and above
is accounted for as inventory.”
In addition to the above, in order to bring transparency and make
full disclosure, Notes to Accounts also contained the following
information:
“5.6 One of the objects of the company is to undertake
property development and real estate work for which
surplus land, if any, could be used. Due to impracticability
of segregation of such land, it is shown as ‘Fixed Assets’
till transaction is finalised as per accounting policy No.
3.7 & 10.4 of the company.”
“5.7 During the year, land costing Rs. 686.65 lakh was
identified for property development, which was
transferred from fixed assets to current assets.”
7. During the course of audit of the accounts for the year 2005-
06, the government audit party made an observation that since
this profit is meant for meeting project cost as per the approved
funding plan of the government, it should be treated as capital
reserve. The stand of the company was that the funding plan is
meant only for resource mobilisation. The accounting treatment of
any transaction is to be dealt with as per the accounting standards,
established norms and prevalent practices and as such the
treatment accorded, considering the income as revenue, is a correct
presentation. Property development is an authorised activity of the
company as stipulated in the Memorandum and Articles of
Association of the company. Full disclosure has also been made
in the financial statements.
8. For better appreciation, the querist has reproduced the query
of the government audit and the management’s reply as below:
Government audit party’s query:
“Profit and Loss Account
Income -Real Estate (Schedule 9) Rs.296.22 crore
This includes Rs.248.80 crore being the consideration for
transfer of leasehold rights of 16.802 acres of land at Khyber
Pass and 2.972 acres of land at Rithala (valuing Rs.6.87 crore)
to licensees for a period of 99 years and 90 years respectively.
The Government of India, Ministry of Urban Affairs &
Employment (Department of Urban Development), New Delhi,
while according investment approval of Delhi MRTS project
vide letter No. K-14011/59/88-UD-II dated 12.11.96 directed
that the estimated 6% of the project cost is to be met by way
of revenue from property development.
In view of the above, the profit on account of sale of the
aforesaid land, which is meant for meeting the project cost,
should have been treated as capital reserve.
Treating the same as revenue income of the year has resulted
in understatement of capital reserve and loss by Rs.241.93
crore (248.80 – 6.87 crore).”
Management’s reply:
“Audit in the Half Margin has drawn attention to the Notification
No.K-14011 /59/ 88-UD II dated 12.11.1996 of Ministry of
Urban Affairs & Employment as per which the balance of
project cost over and above the equity and debt finance will
be raised by the company by way of revenue from property
development.
The government while approving the project has stipulated
that a certain percentage of funds requirements will be raised
through revenue from property development. Thus, it was a
part of resource mobilisation plan so as to meet the cost of
project. How the transaction is to be treated in the books of
account is neither import of the funding plan nor intention of
the government. Accounting treatment to transaction needs
to be effected as per the requirements of Accounting Standards
norms, conventions, customs and relevant enactments. The
approved funding plan of the Government does not provide
any implied authority to override such accounting treatment.
As per accounting guidelines based on various statutory
requirements, capital reserve is created from the following
sources:
— Capital contributed for shares in excess of their par or
stated value;
— Gains on the revaluation of assets; and
— Any other gain or surplus of an exceptional nature that
has not been earned during the regular course of
business.
From the above it is very clear that income generated from
property development activity of the company which is
authorised by its Memorandum and Articles of Association as
one of the objectives of the company can no way be canalised
for creation of capital reserve. For ready reference, the relevant
clause No. 72(3) of the Memorandum of Association is
reproduced below:
“To realise the proceeds of any developed or under-developed
properties of the company by transferring, selling, mortgaging,
letting out on hire, leasing out, licensing, granting concession
or otherwise deal in and/or dispose of all or any portion of
immovable properties including advertising rights for properties
immovable as well as movable, as may be thought desirable
and to accept as consideration cash and consideration other
than cash and to take back or re-acquire any property so
disposed of by re-purchasing or leasing the same or obtaining
a license for such price and on such terms and conditions as
may be agreed upon.”
It may please be noted that the approved financing plan has
mentioned about generation of some percentage of total fund
requirement from the property development leaving it to the
company to best commercially exploit this source of resource
mobilisation. Out of the many options available with the
company to optimise revenue generation, decision is taken
taking into consideration enumerable factors like location, land
use, approvals from the various statutory authorities, etc. The
company, on a case to case basis, decides to lease it for 6-
12-30 years or more than 60 years. Whatever option is chosen,
the income generated remains as a part of the business
activities of the company for which Memorandum of Association
authorises it. As a sequel, appropriate accounting policies
have been disclosed for all such options in the balance sheet.
It may not be possible to consider income generated from
one option as an income from property development in
consonance with various accounting standards and norms
and income generated from the other options to be treated as
capital reserve on the consideration of approved financing
plan.
We shall also draw your kind attention to the ICAI’s
Compendium of Opinions- Vol. No. XX, Query No.22, on
Accounting for the Development and Leasing of Industrial
Estate. A Government company engaged in the business of
developing an industrial estate, leased out industrial plot for a
period of 60 years and 99 years. Query was raised as to how
the company should take income of the lump sum premium
received.
The opinion expressed by the Expert Advisory Committee of
the ICAI was that the lease of land be treated as sale and
thus the whole lease premium should be recognised as
revenue in the profit and loss account in the year it becomes
due on performance of the act giving rise to revenue and the
related cost of acquisition of land and development expenditure
thereon should be expensed in the same period.
It is also pertinent to note here that approval of funding plan
warranting raising of revenue from property development does
not impact any reduction in the cost of the project to the
company. It is only a plan aimed at raising funds from a
source to meet the overall cost of the project.
In view of the above submission, Audit is requested to drop
the Provisional Comment.”
9. Based on the above explanation, the point was eventually
dropped by the Office of the C&AG. However, the company was
advised to refer the issue to the Expert Advisory Committee of the
Institute of Chartered Accountants of India for advice.
B. Query
10. In view of the facts explained above, the querist has sought
the opinion of the Expert Advisory Committee on the following
issues:
(i) Whether in view of the specific object clause enshrined
in Memorandum of Association, the accounting treatment
effected by the company is in order.
(ii) Whether the amount generated from the above
transaction can be treated as capital profit and if so,
can it be transferred to capital reserve account without
routing it through the profit and loss account.
(iii) Whether the decision of the government mandating the
company to raise and use funds from property
development for supplementing project cost authorises
it to treat the income so generated directly to capital
reserve account.
(iv) Whether the amount so received can be adjusted in the
overall cost of the project by reducing the cost of assets
by that amount.
C. Points considered by the Committee
11. The Committee, while expressing its opinion, has considered
only the issues raised in paragraph 10 above with respect to the
leasing of two parcels of land and has not touched upon any other
issue arising from the Facts of the Case, such as, timing and
manner of reclassification of land as inventory, sources of creation
of capital reserve, etc. The Committee also notes that the opinion
on query no. 22 expressed by the Committee contained in the
Compendium of Opinions-Volume XX mentioned in paragraph 8
above does not deal with treatment of lease income used to finance
a construction project.
12. The Committee notes that there are two basic issues involved.
First issue is treatment of the lease transaction. Second issue is
treatment of the resulting profit and need for creation of capital
reserve.
13. So far as the first issue is concerned, the Committee notes
that the two parcels of land were given on lease for long periods,
one for 99 years and another for 90 years, to the developers of
residential properties. The Committee is of the view that in lease
agreements of such long periods, it is generally expected that
either the lease period would be extended or the title will pass to
the lessee at some agreed amount. Keeping in view the facts and
circumstances of the query and prevalent commercial practices in
India in this regard, in substance, the lease of the two parcels of
land amounts to passing of the significant risks and rewards of
ownership in the land to the lessee. Thus, it would be in the nature
of sale of the two parcels of land and should be accounted for
accordingly. In this regard, the Committee also takes note of the
requirement of Schedule VI to the Companies Act, 1956 of showing
leaseholds as an asset of the lessee. This requirement, according
to the Committee, is a recognition of the principle of ‘substance
over form’. The cost of the land should be recognised as expense
in the same period in which revenue from the lease of the two
parcels of land is recognised keeping in view the matching principle.
14. As regards the second issue, the nature of the resulting profit
is to be examined. In this connection, the Committee notes the
following paragraphs from the Guidance Note on Treatment of
Expenditure During Construction Period2, issued by the Institute of
Chartered Accountants of India:
“8.1 It is possible that a new project may earn some income
from miscellaneous sources during its construction or preproduction
period. Such income may be earned by way of ….
or from sale of products manufactured during the period of
test runs and experimental production. Such items of income
should be disclosed separately either in the profit and loss
account, where this account is prepared during construction
period, or in the account/statement prepared in lieu of the
profit and loss account, i.e., Development Account/Incidental
Expenditure During Construction Period Account/Statement
on Incidental Expenditure During Construction (Refer to para
14.7). The treatment of such incomes for arriving at the amount
of expenditure to be capitalised/ deferred, has been dealt with
in para 15.2.”
“15.2 From the total of the aforesaid items of indirect
expenditure would be deducted the income, if any, earned
during the period of construction, provided it can be identified
with the project.”
15. The Committee is of the view that only income which arises
incidentally during the execution of a project would go on to reduce
the project cost. The fact that an income is used to finance a
project cost does not determine its accounting treatment. The
treatment of such income is governed by the applicable accounting
principles. Thus, in the present case, merely because a part of the
project cost is financed by revenue from real estate transactions,
the project cost is not reduced. The Committee is of the view that
income from the lease of the two parcels of land is not incidental
to the MRTS project since it does not arise in the course of the
execution of the project. Hence, this income would not go on to
reduce the project cost.
16. The Committee notes the following paragraph from Accounting
Standard 5, ‘Net Profit or Loss for the Period, Prior Period Items
and Changes in Accounting Policies’, issued by the Institute of
Chartered Accountants of India:
“5. All items of income and expense which are
recognised in a period should be included in the
determination of net profit or loss for the period unless
an Accounting Standard requires or permits otherwise.”
17. The Committee further notes the following paragraphs from
the ‘Guidance Note on Terms Used in Financial Statements”:
“14.04 Reserve
The portion of earnings, receipts or other surplus of an
enterprise (whether capital or revenue) appropriated by the
management for a general or a specific purpose other than a
provision for depreciation or diminution in the value of assets or for a known liability. The reserves are primarily of two
types: capital reserves and revenue reserves.”
“3.10 Capital Reserve
A reserve of a corporate enterprise which is not available
for distribution as dividend.”
“3.08 Capital Profit
Excess of the proceeds realised from the sale, transfer,
or exchange of the whole or a part of a capital asset over its cost. When the result of this computation is negative, it is
referred to as capital loss.”
“3.04 Capital Assets
Assets, including investments, not held for sale,
conversion or consumption in the ordinary course of business.”
18. The Committee also notes that Clause 7(1)(c) of Part III of
Schedule VI to the Companies Act,1956 reads as below:
“(c) the expression “capital reserve” shall not include any
amount regarded as free for distribution through the
profit and loss account; and the expression “revenue
reserve” shall mean any reserve other than a capital
reserve;”
19. The Committee notes that at the time of sale-type lease, the
parcels of land were current assets and not capital assets. The
lease transactions were also authorised by the Memorandum of
Association of the company and the Cabinet decision. Hence, on
the basis of paragraphs 15 to 18 above, the Committee is of the
following view:
(i) the resulting profit is a revenue profit earned during the
ordinary course of business,
(ii) it should be included in the statement of profit and loss
for the year, and
(iii) if the funding plan/Cabinet decision/terms of transfer of
land to the company or Articles of Association of the
company specifies the use of such profits for financing
the MRTP project, thereby prohibiting declaration of
dividend out of such profits, the said profits should be
transferred to ‘Capital Reserve’ as an appropriation of
the profits of the company.
20. The Committee further notes paragraphs 12 and 13 of AS 5,
which state as follows:
“12. When items of income and expense within profit or
loss from ordinary activities are of such size, nature or
incidence that their disclosure is relevant to explain the
performance of the enterprise for the period, the nature
and amount of such items should be disclosed separately.
13. Although the items of income and expense described in
paragraph 12 are not extraordinary items, the nature and
amount of such items may be relevant to users of financial
statements in understanding the financial position and
performance of an enterprise and in making projections about
financial position and performance. Disclosure of such
information is sometimes made in the notes to the financial
statements.”
From the above, the Committee is of the view that since the lease
transactions under consideration are of the nature described in the
paragraphs 12 and 13 of AS 5 reproduced above, keeping in view
the ordinary activities of the business, i.e., construction, operation
and maintenance of MRTS, the same should be separately
disclosed in the statement of profit and loss of the company in
accordance with the requirements of these paragraphs.
D. Opinion
21. On the basis of the above, the Committee is of the following
opinion on the issues raised in paragraph 10 above:
(i) The accounting treatment effected by the company is in
order as explained in paragraphs 13 to 19 above. The
company should, however, disclose the revenue from
such activities separately in the statement of profit and
loss as stated in paragraph 20 above.
(ii) The amount generated from the above transaction
cannot be treated as capital profit. The profit earned
from the transaction is a revenue profit to be included in
the profit and loss account. However, if such profits can
be used only for the purposes of the capital project and
the use of such profits for other purposes is prohibited,
thereby prohibiting declaration of dividend out of the
said profit, the profits should be transferred to ‘capital
reserve’ as an appropriation of the profits of the
company.
(iii) Mere decision of the Government mandating the
company to raise and use funds from property
development for supplementing project cost does not
require the company to take the income so generated
directly to capital reserve account.
(iv) No, the amount so received cannot be adjusted in the
overall cost of the project by reducing the cost of assets
by that amount as explained in paragraph 15 above.
1 Opinion finalised by the Committee on 23.3.2007.
2 The Guidance Note has since been withdrawn pursuant to the decision of the
Council at its 280th meeting held on August 7-9, 2008.
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