Let's face it, accountants are not the most fascinating people. The merest whisper that you are an accountant at a party and you suddenly find yourself alone in the crowd. So number crunchers labouring in property companies in the region must be hugging themselves with joy. Next year is likely to be an interesting year for property accounting in the Middle East because of something that happened in the summer of last year.
Most companies have so far been following International Financial Reporting Standards (IFRS), booking revenue from off- plan property sales based on the percentage completion method. So what, you make ask? Suppose a company sold a villa off-plan for Dh5 million (US$1.3m) in 2007 with an estimated cost of Dh2m, a profit of Dh3m and an estimated completion date of 2010. Provided there was a signed contract with the buyer and a down payment of, say, 20 per cent, the company could recognise a portion of the villa revenue and profits before it was complete, so long as work was progressing at the site. It also meant that the company's profit-and- loss statement (P and L) would be orderly, with profits every year until the completion and villa handover next year.
In the absence of any definitive guidance from the International Accounting Standards Board (IASB) and considering that certain parts of IFRS on revenue recognition were decidedly confusing, the developers took the view that it was appropriate to follow the percentage completion method. This was certainly not illegal or fraudulent and this policy was disclosed in their financial statements. The confusion centred on whether the company was selling a product, the completed villa, or a construction service as a contractor engaged by the buyer. Revenue from products is normally recognised at delivery. Revenue from services is normally recognised on a percentage- of-completion basis as construction progresses.
The boffins at the IASB, after years of umming and ahhing, finally settled the matter in July last year by issuing International Financial Reporting Interpretations Committee 15 (IFRIC 15). This missive declared that an off-plan property sale was the sale of a product and, hence, developers should recognise revenue and profits on off-plan sales only on delivery. It comes into effect for all financial statements prepared on or after the end of this year.
So what gives? Frankly, a lot. The effect of IFRIC 15 on balance sheets is not dissimilar to setting off a small thermonuclear device. It has most companies in a knot because there are a number of potential cringe-inducing effects on developer financials. Six of them, actually. First, property P and L may soon take on a reddish hue. Why? Well, most property projects take three years to five years to complete. In the meantime, apart from spending heaps of money on contractors and consultants, companies have to pay salaries and run their operations. These costs have to be charged to the P and L immediately on payment, unlike payments to contractors, which are deferred and charged to P and L in the year of completion.
If the company does not have income from some other projects last year and this, those P & Ls will turn a deep rouge and continue to be that colour until completion. The longer the project cycle, the more the pain. Second, these days lots of developers have announced delays in projects, triggered by a combination of a lack of cash and a lacklustre off-plan market. Delays mean that delivery dates get pushed further along and hence will be tougher on the P and L, so profits will take a hit for longer than expected.
Third, future net profits may be erratic. Though the percentage completion model at least ensured smooth earnings over the years, now it is all going to appear as one lump sum on completion, especially when you have projects of varying sizes and completion times. Investors are not typically thrilled with yo-yoing profits, preferring a curve moving continually upwards. Fourth, as anyone familiar with share valuation knows, property share valuations based on earnings are likely to be as predictable as a spring day in London because of erratic profits.
Fifth, the boffins decided that the new rule will be applied retrospectively. Companies will have to go back and restate revenues and net profits as though they had followed IFRIC 15 from the beginning. Therefore, the P and Ls for last year and 2007 may not look that spectacular any more. Sixth and last is transparency. Analysts tracking property companies have always been a highly frustrated bunch as most financials in the region have given a new meaning to the word "opaque". Still, the percentage completion method did give a clue as to what happened during the past year. Financials will become murkier, not clearer, with the new measures.
Some firms have already started accounting for IFRIC 15 in their interim financials for this year. Those that may be the hardest hit are those highly dependent on huge off-plan sales and without any significant recurring income from rentals such as from shopping malls or leased villas and apartments. On the flip side (and there is always one), the bean counters should be ecstatic. For one, they can stop doing all the complex percentage calculations. The big kicker is that they could suddenly be the centre of attention, helped by the fact that their work may soon explode into public view.
Binod Shankar is a UAE-based CFA Charterholder. He is a writer and consultant and runs Genesis, a financial training company.