The conventional wisdom is that the year 2009 will be a tough one. We’ll all have to cut back on spending, get our debts under control, skip the annual family vacation, and clip coupons, but by 2010, we’ll have a “return to normalcy.” Unfortunately, this just isn’t in the cards. The era of Permanent Prosperity has turned out to be not-so permanent, and in ’09, the bills are finally coming due. Sure, we’d like to hunker down and pay them, but the president, the Congress, and most importantly, the Federal Reserve, aren’t going to let us. As bad as 2008 was, we’ll one day look back on it as The Last Good Year.
The Political-Media-Banking Complex
Even though they’re the ones who will be taking us off the deep end, we can’t blame Obama and the Democrats for our sorry state of affairs. Clearly, the Bush administration bears the bulk of the responsibility, and the Reagan and Nixon-Ford administrations played their parts as well. In fact, it’s the hole that Nixon began digging for us with the closing of the gold window in 1971 that will ultimately burry the U.S. dollar.
Under the gold standard, every $35 represented an ounce of gold in the Federal Reserve’s coffers. Of course the Fed played tricks with accounting and created far more paper dollars than it had ounces of gold backing them, but there was at least some limit to the extravagance of their monetary machinations. All this changed on August 15, 1971 when President Nixon unilaterally reneged on America’s promise to redeem Federal Reserve Notes (a.k.a. U.S. dollars) in gold. Since then, the Fed’s ability to create money out of thin air has been entirely limitless.
The Fed’s rampant inflation has become so commonplace that the vast majority of financial journalists don’t even take notice of it. The federal government is deeply in debt, so where does it get the money to fund all of these bailouts? Few bother to even consider the question, and those that do assume the bailouts will be paid for with tax revenue. Pundits who are a little more on the ball might understand that the bailouts and “stimulus” won’t be paid for with taxes, but by issuing new government debt, but even this misses the point. That debt is largely “monetized” by the Fed, which is just a fancy way of saying the Fed creates new money out of thin air to pay the government’s bills. So how much money has the Fed created in this manner in the past three months? The answer is quite shocking.
How Money is Measured
M0 is the measure of the nation’s monetary base. It includes all physical currency such as notes and coins, as well as accounts at the central bank that can be exchanged for physical currency. This is the strictest of monetary measures, and the one least susceptible to rapid increases. M1, by contrast, adds bank reserves and checking accounts to the money supply, while M2 also tags on savings accounts, money market accounts, and CDs under $100,000. M3, which the Fed stopped tracking because the increases were too large to explain, is the most liberal measure of money supply, as it includes all CDs as well as institutional money market accounts, Eurodollars, and repo agreements.
The important takeaway from the monetary lesson above is that M0 is the most conservative measure of the money supply available and is completely indisputable: it is the physical currency in circulation or in the coffers of the Fed. It exists in reality, not electronically. And here’s the scary reality: for the period ending December 3, the Fed had increased the M0 money supply by as much in thirty days as it had in the previous eighty-three years! The amount of money in circulation was 74% higher on December 3, 2008 than it was on September 3, 2008. And here’s where it gets even scarier: each one of those $268 billion new dollars in print can turn into ten new dollars via the process of fractional-reserve lending.
This is not a conspiracy theory, but the cold hard facts. Many ancient civilizations met their doom by holding on to superstitions the likes of which we think our society is somehow above. But the truth of the matter is that all but a tiny fraction of Americans hold fast to the most absurdly false religion imaginable: the notion that prosperity can be created at the printing press. In 2009, this myth will be shattered once and for all.
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:
- 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.
- 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.
- 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:
- 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;
- no significant uncertainty exists regarding the amount of the consideration that will be derived from the real estate sales; and
- 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:
- 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.
- 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:
- An article in the Hindu Business Line by Dolphy D’Souza of E&Y [link].
- 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.