Revenue from customers is a significant income for businesses all over the world. Accounting for the same requires proper understanding of the accounting principles and standards governing revenue recognition. In India, Ind AS 115, ‘Revenue from Contracts with Customers’, as applicable from 01.04.2018, states rules and practices that reflect true revenue arising from customers to a business. This articles attempts to understand those provisions and imbibe them in situation arising on practical application.
Scope of Ind AS 115
The following transactions have been excluded from the scope of the standard
|
Transaction Type |
Reason |
|
Leases |
Ind AS 116 |
|
Insurance Contracts |
Ind AS 104 |
|
Financial Instruments and other contractual obligation |
Ind AS 109 and 110 |
|
Consolidated and Separate Financial Statements |
Ind AS 111 and 28 |
|
Investments in Joint Ventures and Associates |
|
|
Non- monetary exchanges among entities in same line of business |
|
Applicability of Standard
This standard is applicable only when the counterparty is a customer. This standard defines customer as “a party that has entered into a contract with an entity to obtain goods or services for a consideration. The goods and services should be the output of the entity’s ordinary course of business”. For instance, developing an asset in collaboration by two parties is not covered under this standard.
Five Step Model for Revenue Recognition
Ind AS 115 focuses on “transfer of control” method of recognizing revenue in the financial statements as opposed to “transfer of significant risks or rewards” given by earlier standards. Control of an asset refers to the ability of the customer to direct the use and obtain majorly all the benefits arising from the asset. For this, the standard specifies five steps that help in determining nature, amount and timing of the revenue to be recognized in the financial statements.
Identify the Contract with the Customer
Following five elements must be present for identifying a contract:
- The contract has been approved by the parties (oral or written)
- The entity can identify the rights regarding the goods and services to be transferred
- The entity can identify the payment terms for the goods and services
- The contract has commercial substance
- Collectability Assessment is undertaken and it is probable that the entity will collect substantially all of the consideration to which it is entitled.
If any one of the elements is missing, the Step 1 stays incomplete and revenue cannot be recognized. Any amount received during the pendency of fulfilling this criteria, shall be recognized as a liability in the books of accounts. However, if the contract is terminated and the fees received is non- refundable, in that case the liability can be recognized as revenue
Identifying Performance Obligations
Revenue recognition happens at individual performance obligation level in a contract. They mean:
- Distinct goods or services
- A series of distinct goods or services that have same pattern of transfer to the customer like hotel management services which may include housekeeping, security etc.
Meaning of distinct goods or services
The performance obligations may not be explicitly stated in the contract. An implicit obligation arises due to entity’s customary practice, published policies or specific statements and they create a valid expectation of goods or services to be received by the customer.
Example: Arvind industries (AI) sells tally software license to its clients. The contract includes that AI will provide software updates and technical support for next two years with the software package. The software remains functional without updates and technical support.
Here AI need to identify the performance obligation in order to recognize revenue. The software is provided/delivered before updates and technical support. So all three activities are differently identifiable. The performance obligation are:
- Software license
- Software updates
- Technical Support
Determining the Transaction Price
An entity shall consider its business practices and the contract terms to consider the transaction price of a contract. The effects of the following must be considered;
|
Type of Consideration |
Explanation |
|
Variable Consideration |
In addition to the term of the contracts the variability of a contract depends on following circumstances – That the customer will accept the less price based on business practices, published policies or specific statements – Entity’s intention when entering contract, to offer a price discount to customer The method for calculation of variable amount are: – The expected Value- Probability-weighted amount in a range of possibility – The Most likely amount- Single most likely amount in a range of possibility
An entity will also update refund liability and the contract liability at the end of each reporting period.
At the end of each reporting period shall update the estimated transaction price based on the circumstances prevalent at end of reporting period.
|
|
Significant financial component in the contract |
All relevant facts and circumstances should be considered to assess financial components, including – Difference in consideration and cash selling price of goods/services – Expected length of time between transfer and payment of goods/service. And prevailing interest rate in the market
In below mentioned cases, significant financial component does not exist – Amount paid in advance and transfer is at discretion of the customer – Substantial consideration is variable and amount or timing of consideration varies on a future event which is not in control of customer or entity. – The difference between consideration and cash price arises due to reasons other than financial component
|
|
Non-Cash Consideration |
Measure non cash consideration at fair value. If can not measure fair value, then stand-alone selling price method to be used. |
|
Consideration payable to customer |
It is accounted as reduction from the transaction price unless the consideration is for distinct product/service. |
Allocation of Transaction Price
The objective of the entity should be to allocate the transaction price to each performance obligation in the contract. An entity shall allocate transaction price by using stand- alone selling price of the goods or services. The best evidence of a stand- alone selling price is the observable price when the entity sells similar goods or service to similar customers under similar circumstances. The Standard has prescribed some suitable methods for estimating the stand-alone selling price of goods or services. These methods are
|
Methods |
Explanation |
|
Adjusted Market Assessment Approach
|
An entity can evaluate the market and estimate the prices |
|
Expected Cost plus a Margin Approach |
An entity may forecast the expected cost and add some appropriate margin. |
|
Residual Approach |
Here stand alone price is calculated by referring to the total transaction price less the sum of the observable stand alone selling prices of other goods or services promised in the contract.
The residual method can only be used, if on of following condition is met: 1) The entity sells the same goods or service to different customers for a broad range of amount. 2) The entity has not yet established a price for that goods or service, and they are not previously sold on stand- alone basis. |
However, allocation of discounts and variable consideration are an exception to the above stand- alone rule. Discount may be allocated separately to the range of products or services rather than a performance obligation if that best depicts the revenue from the transfer of control.
Example: Vinod Machinery(VM) sells Printers for Rs. 40,000 and provides annual maintenance service of Rs. 4,000 per year, to its customers. Sine VM sells these goods and services separately, they are distinct and accounted for a separate performance obligation. A customer enters into a contact to purchase printer with maintenance service at Rs. 42,000. So How VM should allocate the transaction price of Rs. 42,000 to the performance obligations?
VM should allocate the transaction price based on their relative standalone selling prices.
Printer: Rs. 38,182 (42000 x (40000/44000))
Service: Rs. 38,19 (42000 x (4000/44000))
Therefore, the discount get allocated proportionately to two performance obligation.
Recognition of Revenue and presentation
Revenue is recognized on the satisfaction of each performance obligation. The entity has to determine at the beginning of the contract whether performance obligations are satisfies over a period of time or at a point in time. The following criteria are needed to be met for obligations to be satisfied over a period of time:
Criteria (a): Customer simultaneously receives and consumes benefits of entity’s performance (Payroll Processing Services)
or
Criteria (b): The entity’s performance creates or enhances the asset as controlled by the customer with the creation or enhancement (Construction Contract)
or
Criteria (c): The asset does not have an alternate use of the asset and it is legally enforceable for the customer to pay for the asset.
In case any of the above criteria is met, the control will considered to be transferred over time. Otherwise, control is transferred at a point in time.
When party to a contact has performed, the contract shall be presented as contract asset or liability.
A contract liability is an entity’s obligation to transfer good/service for which the entity has received the payment.
A Contract Asset is an entity’s right to consideration for goods/services transferred to customer.
Other important considerations
1. Contract Modifications
A contract is considered modified if there is a change in the scope, price or both to which both the parties have agreed upon. It is accounted as follows:
|
Situation |
Accounting |
|
Distinct goods or services are added to the contract and the consideration increases on stand- alone basis |
Separate contract |
|
Remaining goods or services are distinct from added goods or services |
Termination of old contract and creation of new contract |
|
Remaining goods or services not distinct |
Adjustment to be made on cumulative catch- up basis |
2. Contract Costs
|
Type of Costs |
Accounting |
|
Incremental costs i.e. that will not be incurred if contract is not obtained |
Capitalize |
|
Contract Fulfillment Costs |
If not dealt by other standards, then capitalized |
Any Contract cost capitalized, shall be amortized on a systematic basis that is consistent with the transfer of goods/services to which the asset relates
Disclosure
Qualitative and quantitative information about the following need to be disclosed
- Its contract with customers
- The significant judgments and changes, in applying this standard
- Any asset recognized from the cost to obtain or fulfill a contract
Conclusion
Revenue Recognition has become a mixture of various elements combining into one. The standard Ind AS 115 now prescribes detailed disclosures and provides specific guidelines on accounting of transactions. To understand and analyze the same, careful supervision over contract formation and its enforceability is required.
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