Arvind Gattani
EXECUTIVE SUMMARY
Revenue recognition is one of the most important accounting policy that can have a direct impact on the financial performance of the company. Ind AS 115 lays down new requirements and rules in many aspects of revenue recognition, which are, either, new or significantly different than accounting principles under existing revenue recognition standards. The impact is not only about the timing and amount of revenue recognition, but also the significant and expanded presentation and disclosure requirements. Effectively Ind AS 115 has done away with the “transfer of risk and reward” approach for recognizing revenue and has introduced a new, five step, revenue recognition model. Read on to know more….
BACKGROUND
The Ministry of Corporate Affairs (MCA), on February 16, 2015 notified the Companies (Indian Accounting Standards) Rules, 2015. The notification lays down various standards commonly known as Ind AS along with applicability of those standards to various companies in a phased manner. The standards are broadly in line with International Financial Reporting Standards, commonly referred to as IFRS.
Ind AS 115,Revenue from Contracts with Customers (which is based on IFRS 15,Revenue from Contracts with Customers)was originally notified vide aforementioned notification. However, subsequent to the decision of International Accounting Standards Board (IASB) to defer the implementation of IFRS 15, the MCA vide Companies (Indian Accounting Standards) (Amendment) Rules, 2016 dated March 30, 2016 omitted Ind AS 115 and inserted Ind AS 11, Construction Contractsand Ind AS 18, Revenue.
To align with the revised effective date, January 1, 2018, of IFRS 15, the MCA, on March 28, 2018, notified (again) Ind AS 115,Revenue from Contracts with Customersas part of the Companies (Indian Accounting Standards) Amendment Rules, 2018. With the Ind AS 115 effective for accounting periods beginning on or after April 1, 2018, existing revenue recognition standards Ind AS 11 and Ind AS 18stands omitted and the Guidance Note on Accounting for Real Estate Transactions (for entities to whom Ind AS is applicable) issued by ICAI in May 2016 stands withdrawn.
OBJECTIVE
The core principle is that an entity shall recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services, besides reporting useful information about the nature, amount, timing and uncertainty of revenue and cash flows arising from a contract with a customer.
The standard specifies the accounting for an individual contract with a customer. However, as a practical expedient, an entity may apply this Standard to a portfolio of contracts (or performance obligations) with similar characteristics if the entity reasonably expects that the effects on the financial statements of applying this Standard to the portfolio would not differ materially from applying this Standard to the individual contracts (or performance obligations) within that portfolio.
SCOPE
The standard shall be applied to all contracts with customers, except the following:
a) lease contracts within the scope of Ind AS 17, Leases;
b) insurance contracts within the scope of Ind AS 104, Insurance Contracts;
c) financial instruments and other contractual rights or obligations within the scope of Ind AS 109, Financial Instruments, Ind AS 110, Consolidated Financial Statements, Ind AS 111, Joint Arrangements, Ind AS 27, Separate Financial Statementsand Ind AS 28, Investments in Associates and Joint Ventures; and
d) non-monetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers. For example, a contract between two oil companies that agree to an exchange of oil to fulfill demand from their customers in different specified locations on a timely basis.
The standard shall apply only if the counterparty to the contract is a customer.
A customer is a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.
FIVE STEP MODEL
The new revenue recognition model prescribed by Ind AS 115 consists of below five steps:
A. Identify the contract(s) with a customer;
B. Identify the separate performance obligations in the contract;
C. Determine the transaction price;
D. Allocate the transaction price to the separate performance obligations; and
E. Recognize revenue when (or as) each performance obligation is satisfied.
A. Identify the contract(s) with a customer
An entity shall recognize a contract with a customer that is within the scope of this Standard only when all of the following criteria are met:
a) the parties to the contract have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations;
b) the entity can identify each party’s rights regarding the goods or services to be transferred;
c) the entity can identify the payment terms for the goods or services to be transferred;
d) the contract has commercial substance; and
e) it is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Points to ponder while applying above recognition criteria
i. The Standard shall continue to be applied till the contract is in force and the parties to the contract have present enforceable rights and obligations.
ii. A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (or parties). A contract is wholly unperformed if both of the following criteria are met:
a) the entity has not yet transferred any promised goods or services to the customer; and
b) the entity has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services.
iii. Commercial substance exists, if the transaction is backed by a substantive business purpose and executed in an orderly manner.
iv. Once assessed at contract inception, an entity shall not reassess the recognition criteria unless there is an indication of a significant change in facts and circ*mstances.
Treatment of consideration received during pendency of recognition criteria
When a contract with a customer does not meet the recognition criteria and an entity receives consideration from the customer, the entity shall recognize the consideration received as revenueonly when either of the following events has occurred:
a) the entity has no remaining obligations to transfer goods or services to the customer and all, or substantially all, of the consideration promised by the customer has been received by the entity and is non-refundable; or
b) the contract has been terminated and the consideration received from the customer is non-refundable.
The entity shall recognize the consideration received as a liabilityuntil one of the above events occur or until the recognition criteria is subsequently met.
B. Identify the separate performance obligations in the contract
Performance obligation is an identified obligation(s), satisfaction of which is must for recognizing revenue. Unlike current Ind AS, revenue recognition under Ind AS 115 does not happen at the transaction / contract level but at the individual performance obligation level.
Therefore, at contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either:
a) a good or service (or a bundle of goods or services) that is distinct; or
b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
A good or service that is promised to a customer is distinct if both of the following criteria are met:
a) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (i.e. the good or service is capable of being distinct); and
b) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (i.e. the good or service is distinct within the context of the contract).
A series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met:
a) each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria to be a performance obligation satisfied over time; (As described in Point E, of the five step model) and
b) same method would be used to measure the entity’s progress towards complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer. (As described in Point E, of the five step model)
Performance obligations need not be restricted to the goods or services that are explicitly stated in the contract. It may also arise from promises that are implied by an entity’s customary business practices, published policies or specific statements if, at the time of entering into the contract, those promises create a valid expectation that the entity will transfer a good or service to the customer.
C. Determine the transaction price
An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price excludes amounts collected on behalf of third parties (for example, sales taxes, goods and services tax etc.). The consideration promised in a contract may include fixed amounts, variable amounts, or both.
When determining the transaction price, an entity shall consider the effects of all of the following:
a) variable consideration;
b) the existence of a significant financing component in the contract;
c) non-cash consideration; and
d) consideration payable to a customer.
Variable Consideration
> If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.
> Variable consideration can be explicit in a contract or implied by an entity’s past business practices. Instances that causes consideration to be variable includes i) rate difference, ii) quantity discounts, iii) performance bonuses, iv) incentives / commission, v) claims, vi) liquidated damages, etc.
> An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:
a) The expected value – it is the sum of probability-weighted amounts in a range of possible consideration amounts. This method is suitable if an entity has a large number of contracts with similar characteristics.
b) The most likely amount – it is the single most likely amount in a range of possible consideration amounts. This method is suitable if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not).
> An entity shall apply one method consistently throughout the contract when estimating the effect of an uncertainty on an amount of variable consideration to which the entity will be entitled.
> At the end of each reporting period, an entity shall update the estimated transaction price (including updating its assessment of whether an estimate of variable consideration is constrained) to represent faithfully the circ*mstances present at the end of the reporting period and the changes in circ*mstances during the reporting period.
The existence of a significant financing component in the contract
> Transactions often include terms in the nature of financing, either the customer or the entity, which requires separate accounting, considering time value of money. When the credit period offered to customer is higher than normal industry practice, the entity is effectively providing finance to the customer. Conversely, in case of advance payment by the customer, the entity has effectively received finance.
> The standard requires that in determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if there is significant benefit to either party.
> However, as a practical expedient, an entity need not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less.
> An entity shall present the effects of financing (interest revenue or interest expense) separately from revenue from contracts with customers in the Statement of Profit and Loss.
Non-cash consideration
> Consideration may be in the form of goods, services or other non-cash consideration (e.g., property, plant and equipment or a financial instrument). In case of contracts involving consideration in a form other than cash, such non-cash consideration shall be measured at fair value.
> An entity will likely apply the requirements of Ind AS 113, Fair Value Measurementwhen measuring the fair value of any non-cash consideration.
> If an entity cannot reasonably estimate the fair value of the non-cash consideration, the entity shall measure the consideration indirectly by reference to the stand-alone selling price of the goods or services promised to the customer (or class of customer) in exchange for the consideration.
Consideration payable to a customer
> Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer). Consideration payable to a customer also includes credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity.
> An entity needs to determine whether consideration payable to a customer represents a reduction of the transaction price, a payment for a distinct good or service, or a combination of the two.
The accounting of consideration paid or payable to customer is summarized through below question:-
D. Allocate the transaction price to the separate performance obligations
As stated earlier, Ind AS 115 prescribes revenue recognition at each performance obligation level, as against at the transaction / contract level. Therefore the transaction price in an arrangement is required to be allocated to each separate performance obligation such that the allocated amount depicts the amount of consideration to which the entity expects to be entitled, at each performance obligation level, in exchange for transferring the promised goods or services to the customer.
Allocation based on stand-alone selling prices
> The stand-alone selling price is the price at which an entity would sell a promised good or service separately to a customer. The best evidence of a stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circ*mstances and to similar customers.
> In order to allocate the transaction price to each performance obligation on a relative stand-alone selling price basis, an entity shall determine the stand-alone selling price at contract inception of the distinct good or service underlying each performance obligation in the contract and allocate the transaction price in proportion to those stand-alone selling prices.
> In many situations, stand-alone selling prices will not be readily observable. In those cases, the entity must estimate the stand-alone selling price using suitable methods, which includes, but are not limited to, i) Adjusted market assessment approach, ii) Expected cost plus a margin approach, and iii) Residual approach.
> Residual approach estimates the stand-alone selling price of a good or service in a contract as a residual value after subtracting aggregate of the observable stand-alone selling prices of other goods or services promised in the contract from total transaction price.
Exceptions to above allocation principle
Above allocation principle may not result in a faithful depiction of the amount of consideration at each separate performance obligation level, under circ*mstances of variable consideration or varying discounts. Allocation under such circ*mstances are dealt with as under:
Allocation of a discount
> A customer receives a discount for purchasing a bundle of goods or services if the sum of the stand-alone selling prices of those promised goods or services in the contract exceeds the promised consideration in a contract.
> Under the relative stand-alone selling price allocation method, this discount will be allocated proportionately to all of the separate performance obligations. However, if an entity determines that a discount in a contract is not related to all of the promised goods or services in the contract, the entity allocates the contract’s entire discount only to the goods or services to which it relates, if all of the following criteria are met:
a) the entity regularly sells each distinct good or service (or each bundle of distinct goods or services) in the contract on a stand-alone basis;
b) the entity also regularly sells on a stand-alone basis a bundle (or bundles) of some of those distinct goods or services at a discount to the stand-alone selling prices of the goods or services in each bundle; and
c) the discount attributable to each bundle of goods or services described in (b) above is substantially the same as the discount in the contract and an analysis of the goods or services in each bundle provides observable evidence of the performance obligation (or performance obligations) to which the entire discount in the contract belongs.
Allocation of variable consideration
The idea is to allocate a variable amount (and subsequent changes to that amount) entirely to a distinct good or service that forms part of a single performance obligation if both of the following criteria are met:
a) the terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service); and
b) allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective when considering all of the performance obligations and payment terms in the contract.
Changes in transaction price
> After contract inception, the transaction price can change for various reasons, including the resolution of uncertain events or other changes in circ*mstances that change the amount of consideration to which an entity expects to be entitled in exchange for the promised goods or services.
> An entity shall allocate, to the performance obligations in the contract, any subsequent changes in the transaction price on the same basis as at contract inception. Amounts allocated to a satisfied performance obligation shall be recognized as revenue, or as a reduction of revenue, in the period in which the transaction price changes.
E. Recognize revenue when (or as) each performance obligation is satisfied.
> Under Ind AS 115, an entity recognizes revenue when it satisfies an identified performance obligation by transferring a promised good or service to a customer. A good or service is considered to be transferred when the customer obtains control.
> An entity shall determine at contract inception whether it satisfies the performance obligation over time or satisfies the performance obligation at a point in time. If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.
Is any of the below criteria met?
√ Customer simultaneously receives and consumes the benefits as the entity performs
√ Entity creates or enhances an asset and customer controls it during this process
√ Created asset has no alternative use to the entity and the entity had enforceable right to payment for performance up to date
Measuring progress
> An entity shall apply a single method of measuring progress for each performance obligation satisfied over time and the entity shall apply that method consistently to similar performance obligations and in similar circ*mstances.
> Appropriate methods of measuring progress include output methods and input methods. In determining the appropriate method, entity shall consider the nature of the good or service that the entity promised to transfer to the customer.
Output methods
> Output methods recognize revenue on the basis of direct measurement of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract. Examples of output methods include surveys of work performed, units produced, units delivered, and contract milestones.
> Since the output methods directly measure performance, they are generally considered as the most faithful depiction of an entity’s performance and can be the most faithful representation of progress.
Input methods
> Input methods recognize revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation relative to the total expected inputs to the satisfaction of that performance obligation. Examples of input methods include costs incurred, time elapsed or machine hours used, resources consumed or labour hours expended.
> If the entity’s efforts or inputs are expended evenly throughout the performance period, it may be appropriate for the entity to recognize revenue on a straight-line basis.
KEY DIFFERENCES BETWEEN THE CURRENT IND AS AND IND AS 115
As stated earlier, the requirements and rules of Ind AS 115 are fundamentally different from those under the current Ind AS. Particularly, Ind AS 115 prescribes a completely new revenue recognition model. It also provides comprehensive application guidance on various aspects not addressed in the current Ind ASs. Some of the key differences are summarized as under:
| Current Ind ASs | Ind AS 115 | |
| Scope: | ||
| Ind AS 18 deals with revenue arising from sale of goods, rendering of services and interest, dividend and royalties. Ind AS 11 deals with revenue arising from construction contracts. | Ind AS 115 is applicable to contracts with customers to provide goods or services in the ordinary course of business. However, it does not apply to:
| |
| Definition of customer: | ||
| Not defined | The ‘customer’ is defined as ‘a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.’ | |
| Revenue recognition approach: | ||
| Separate requirements exist for recognition of revenue from sale of goods, rendering of services and construction contracts. It focuses on transfer of significant risks and rewards approach for revenue recognition. | Ind AS 115 prescribes five steps model to account for revenue:
It focuses on transfer of control approach for revenue recognition. | |
| Disclosures: | ||
| Ind AS 11 / Ind AS 18 contains very limited disclosure requirements. | Ind AS 115 require extensive qualitative and quantitate disclosures pertaining to contract with customer. For example, Ind AS 115 requires companies to provide disaggregated revenue information in the financial statements that depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors. | |
| Other aspects: | ||
| Ind AS 11 / Ind AS 18 provides limited guidance on specific topic. | Ind AS 115 provides detailed application guidance on topics such as:
| |
TRANSITIONAL PROVISIONS
Ind AS 115 permits entities to apply one of the following transitional methods:
| Approach | Application |
| Full retrospective | The financial statements are presented as if Ind AS 115 had always been applied in accordance with Ind AS 8, Accounting policies, changes in accounting estimates and errors. Comparatives are restated with cumulative effect of transition recorded in opening balance of retained earnings (or other appropriate component of equity) as at the beginning of earliest period presented. |
| Modified retrospective (Cumulative catch up) | Entities will recognize the cumulative effect of initially applying Ind AS 115 as an adjustment to the opening balance of retained earnings (or other appropriate component of equity) at the date of initial application. Comparatives are not restated and are presented using existing revenue recognition standards (Ind AS 11 and Ind AS 18). While the modified retrospective approach allows an entity to avoid restating comparative numbers, entities adopting this approach must disclose the amount by which each financial statement line item is affected in the current reporting period by the application of Ind AS 115 as compared to Ind AS 11 and Ind AS 18 and qualitative explanation of the reasons for significant changes. |
> Irrespective of the transition approach selected, the ‘date of initial application’ is the start of the reporting period in which an entity first applies Ind AS 115 (i.e. April 1, 2018 for entities with financial year ending March 31, 2019).
> To ease the potential burden of applying Ind AS 115 on a fully retrospective basis, the standard provides following practical expedients:
a) For completed contracts, an entity need not restate contracts that (i) begin and end within the same annual reporting period, or (ii) are completed contracts at the beginning of the earliest period presented.
b) For completed contracts that have variable consideration, an entity may use the transaction price at the date the contract was completed rather than estimating variable consideration amounts in the comparative reporting periods.
c) For contracts that were modified before the beginning of the earliest period presented, an entity need not retrospectively restate the contract for those modifications. Rather, an entity will reflect aggregate effect of all of the modifications that occur before the beginning of the earliest period presented when: (i) identifying the satisfied and unsatisfied performance obligations, (ii) determining the transaction price, and (iii) allocating the transaction price to the satisfied and unsatisfied performance obligations.
> An entity applying Ind AS 115 retrospectively using the modified retrospective approachmay use only the practical expedient mentioned at point (c), above, related to contract modifications. This practical expedient may be used either: a) For all contract modifications that occur before the beginning of the earliest period presented, or b) For all contract modifications that occur before the date of initial application.
> While entities may choose one or more practical expedients, they must be applied consistently to all contracts where relevant.
> In addition, the entity should disclose a) the expedients that have been used; and b) to the extent reasonably possible, a qualitative assessment of the estimated effect of applying each of those expedients.
Key Transition Consideration
Transition options can significantly impact the revenue reported in the financial statements since the standard allows its application from different dates and therefore to different population of contracts. Entities need to carefully consider the potential impacts of the transition options on their financial statements before arriving a conclusion as to particular transitional approach. A practical expedient shall be selected only after thorough assessment has been carried out.
SUMMARY
Implementation of new revenue recognition standard is a welcome move considering convergence of revenue recognition policy with that globally accepted IFRS 15. However Ind AS 115 differs considerably as compared to existing accounting principles for revenue recognition. The differences could result in changes in the identification of performance obligations, timing of revenue recognition, measurement of transaction price and disclosures. Transition to new revenue recognition standard is not only an accounting change but is like to have significant impact on the entity’s data, systems and processes. Transition to new revenue recognition regime is expected to have significant impact across sectors especially in retail and consumer products, engineering and constructions, real estate, software and cloud entities, telecom etc.Though the standard has prescribed various practical expedients, companies would face lot of challenges to present their quarterly as well as annual results considering the extensive accounting changes and limited time to transition.
