Real Estate Accounting

Real-estate accounting is a complicated business! It is difficult to comprehend and understand. Needless to say, real estate companies in India have been criticized by analysts for a lack of transparency in their property dealings and in how they account for projects.


As the industry struggles, investors are scrutinizing companies' accounting methods and transparency. The Institute of Chartered Accountants of India (ICAI) has, in the meantime, issued a Guidance note on Recognition of Revenue by Real Estate Developers. It has suggested that companies recognise revenues for real estate sales on the basis of the percentage of completion of the project at the time of reporting. In residential real estate projects, apartments/units are typically sold before they are constructed. A significant amount of money could also have been received even though construction might not have even commenced.

Under the percentage completion method, companies do not recognise revenues until a certain minimum cost threshold is reached, which can vary from 5-10% of total budgeted costs to as much as 25% being followed by some real estate companies. Some companies include the cost of land in estimating the progress achieved, whereas other companies do not take this cost into account in determining the percentage of work done or progress made. A change in these variables can have a significant impact on the revenues and profits reported by various real estate companies that follow the percentage completion method.

At a recent real estate seminar, I met the CFO of a large real estate company and we were discussing the intricacies of the interpretation and implementation of the percentage completion method. He gave me an interesting example. Suppose you have a project with a total size of 1,000,000 sq ft out of which 200,000 sq ft has been launched and about 50,000 sq ft has been sold. Assume that the land cost is Rs 500 sq ft, estimated construction cost is Rs 1500 sq ft and the actual cost incurred till date is Rs 200 sq ft (on the 200,000 sq ft). Now, suppose you had to compute the percentage completion, the logical way would be to compute the land cost of 200,000 sqf (Rs 100 million) add the cost incurred ( Rs 40 million) and divided it by the total estimated cost (Rs 100 million land plus Rs 300 million). This comes to approximately 35% (140/400). However, there is an another method. Since you have already paid for the 1 million sq ft of land, you can essentially include the entire land cost of 1 million (Rs 500 million) in the percentage completion computation. This means the ratio becomes (Rs 500 million + Rs 40 million)/ (Rs 500 million + Rs 300 million), ie 68% instead of 35%. Essentially, you can frontload the entire land cost on a smaller phase of the project to boost up the percentage completion ratio. This enables companies to book a higher revenue since revenue booking is directly dependent on the percentage completed. Such accounting policies are technically not incorrect and have been approved by the auditors of the company !

Lords of Finance

I have been reading the Lords of Finance for some time now and have completed approximately half of the 500 page book. I must admit that it is an extremely well written book on The Great Crash and Depression. It is a lively and fascinating "event by event" look at the slow motion lead up to The Great Crash, and the four men that could have prevented the Depression.  Liaquat Ahamed describes the four men as follows: ‘Four men in particular dominate this story: At the Bank of England was the neurotic and enigmatic Montagu Norman; at the Banque de France, Emile Moreau, xenophobic and suspicious; at the Reichsbank, the rigid and arrogant but also brilliant and cunning Hjalmar Schacht; and finally, at the Federal Reserve Bank of New York, Benjamin Strong, whose veneer of energy and drive masked a deeply wounded and overburdened man.’

One of the important point the book makes is how factors other than purely economic issues play a role in making economic decisions and how the consequences of those economic decisions then bounce back onto the wider political arena.

Ahamed's central thesis is that the critical decisions made by these four bankers not only caused the Great Depression but also created the conditions for World War II.

The book beautifully explains the complexities and the workings of the financial system at the macro level and throws light on some extremely interesting facts. Some of these are as below:

Gold Standard

The book intricately explains how the gold system used to work till the late twentieth century and the issues with it. The most fateful event of all the events during the early twentieth century was the decision to adhere to the gold standard. In retrospect, tying the amount of currency a country has in circulation to the amount of gold it has in its vaults appears arbitrary and nonsensical. However, it seemed like a good idea at the time, it provided a universal standard against which countries could stablize their currencies. It was a ruinous decision. As Liaquat Ahamed notes, all the gold mined in history up to 1914 "was barely enough to fill a modest two-story town house." There simply was not enough of it to fund a global conflict or to allow economic recovery afterward. 

Federal Reserve

The US was without a central bank until Woodrow Wilson signed the Federal Reserve Act on December 23,1913. The reason for not having a central bank, it was argued, was that it put too much power in the hands of one institution and was therefore undemocratic and un-American. However, in October 1907, the US was rocked by a severe financial crisis caused by the failure of unscrupulous characters to corner the market in the stock of a copper company, resulting in a severe run on the banks. Through some decisive action by JP Morgan, the panic was finally contained. It was only after this incident that an effort was made to create a central bank.

Bank of England

The Bank of England in the nineteenth and early twentieth century was run like a club. Its membership was drawn from closed inner circle of city bankers and merchants. Those who became governors were required to take temporary leave of absence from their own businesses. To be the governor of Bank of England, was therefore not a mark of particular merit, but merely sign of the right pedigree, patience, longevity, and the luxury of having a sufficiently profitable business with partners willing to let one take four years’ leave. The director of the bank did not pretend to know very much about economics, central banking or monetary policy. An economist of the 1920s described them as resembling ship captains who not only refused to learn the principles of navigation but believed that these were unnecessary.

Germany Hyperinflation

In 1923, Germany experience the single greatest destruction of monetary value in the human history. It was experiencing an economic depression after the first world war.  Prices rose 40 fold in 1922 and the mark correspondingly fell from 190 to 7600 to the dollar. By August 1923, a dollar was worth 620,000 marks and by early November 1923, 630 billion. Basic necessities were priced in billions – a kilo of butter cost 250 billion. It was not only the extraordinary numbers but the dizzying speed at which prices were soaring. In the last 3 weeks of October 1923, prices rose 10,000 fold. In the time it took to drink a cup of coffee in one of Berlin’s cafes, the prices might have doubled !

The book has taught me more about financial markets than all my academic studies in B school. It is utterly surprising that most B schools do not have a compulsory course on the history of financial markets. They would rather concentrate on teaching bogus models that never ever work in the real world. My advise to all B school students and participants of financial markets – the book is a must read!

Rather than splendid personalities and events, the book's real advantage is timeliness. 

More on this later when I finish reading the book.

Guide to successful investments

Paul Kedrosky’s research had pointed out, it takes a VC to invest $50 million and be in the industry for seven years to make a good VC. Since the last 4 years, I have been working in a real estate private equity fund. I have been involved in deals worth more than USD 100 millions and although I have not completed 7 years in the investments business, I would like to believe that I am nearly there in becoming a good investor.

Here are my key learnings of the last few years:

Understanding the business: This sounds so obvious and simple and yet is the most difficult part to achieve. Often it does not require very sharp intellect but rigour, perseverance and patience of a good learner. The best guide in understanding the business is not research reports but by actually experiencing the business. The best real estate fund managers have been developers, some of the finest VC investors have been technology entrepreneurs themselves. The rationale is obvious; people who have been there and done that know the nuances of the business better than others and hence can evaluate a deal much more easily. If you do not have the business experience it is a good idea to actually ‘work’ in such a company before hand. So you can work at a developer’s office, a solar power generating company, a bio gas plant etc for 10-15 days to get a first hand knowledge of the challenges faced in such businesses (before evaluating real estate or a clean energy deal). This is difficult to achieve, but if possible, is one of the best ways to evaluate a deal.

Understanding the business model of the customers of the business in which you are investing: Following are some of the basic questions that should be asked:

- Can they afford the product that your company is making?

- What choices do they have?

- How easy/difficult is it for them to substitute your company?

- What is the dependency on your company and the overall industry?

Conversations with industry experts are often an easy and quick way to have insights. This also gives an idea about the competitive scenario prevailing in the market and the kind of challenges your investee company could face. For example, if investors had the patience of studying the financial statements of retailers in 2005, 2006, 2007, it would have clearly shown the huge losses and the big problems that the retailers were facing. One need not wait for a Lehman crisis to understand the troubles of investing in shopping malls.

Entrepreneur: It is a well accepted fact that the biggest factor in an investment decision is the entrepreneur himself. Everything else becomes secondary. I wont dwell too much on this; just 2 points:

- Spending time with the entrepreneur. It is very important to spend atleast 50-60 hours with the entrepreneur before putting money on him. This need not be in serious meetings in the office but could be for a drinking session or a lunch/dinner meeting with friends. The idea is to know him personally. It is surprising how much information one can get in casual settings rather than a Q & A session in the Board Room.

- Another important factor is to also know about the circle of influence of the entrepreneur. Who are the key people that he/she listens to? It is very important to touch base and connect with such people.

All said and done, at the end of the day, there is some amount of crystal ball gazing that takes place and there is no substitute for great insight. Happy Investing !