INTRODUCTION:

Revenue recognition is the important & pervasive aspect of financial reporting. Accounting Standard which covers this aspect needs to be very clear and descriptive to cover every major possible situations and peculiarities of contracts with customers. Existing standard of revenue i.e. AS 9 (also IND AS 18 for IND AS applicability companies) uses risk and reward transfer as a key point for recognition of revenue. Its guidance is very narrow as compared to IND AS 115. It does not deal with complex type of business models whose revenue recognition and contracts with customers are of unique nature. Also Institute of chartered accountants of india (ICAI) had issued different guidance note for revenue recognition of real estate sector.

IND AS 115 has more pervasive approach for defining point of revenue recognition. Hence its scope covers majority of business models and transactions. It also overwrites the earlier issued IND AS 18. Also ICAI has withdrawn the guidance note issued for real estate sector IND AS compliant companies after introduction of IND AS 115.

OBJECTIVE:

Objective of this blog is to summarise revenue recognition under existing standard & as per IND AS 115 Revenue from contract with customers.

Brief of existing Revenue standards:

Basic principle of revenue recognition is that Revenue must be recognized when the risk & reward is transferred and also various other aspects.

In case of sale of goods – Date when process of delivery of the goods to the customer is completed or when title is transferred.

In case of sale of service – When service is performed.

In case of allowing use of asset/resource – On accrual / time basis.

Revenue recognition under IND AS 115:

IND AS 115 gives detailed stepwise guidance on revenue recognition which gives more clarity & gives broader view as compared to existing standard.

IND AS 115 shifts the focus from risk & reward transfer to control transfer.

Steps in revenue recognition:

  • Identify contract with customer.
  • Identify performance obligations.
  • Determine transaction price.
  • Allocate transaction price to performance obligations.
  • Recognise revenue when or as entity satisfies the performance obligation.

Step 1 – Identify contract with customer

Criteria to be met for contract to be accounted –

Parties have approved contract (writing, orally or by customary business practices). Rights and payment terms regarding goods / services to be transferred can be identified. Contract has commercial substance. Probable that consideration will be received. (Customer’s ability & intentions to be checked).

Step 2 – Identify performance obligations.

At inception, entity shall identify as a performance obligation each promise to transfer customer goods or services that are distinct.

For E.g. – When entity promises to supply goods/services along with 3 years free maintenance service then supply of goods and supply of 3 years maintenance services are two separate performance obligations.

Performance obligation is not only limited to goods or services, it also includes customary business practices, published policies or specific statements.

Consumer durables industries will be having more than 1 performance obligations attached to the contract.

**Step 3 – Determine transaction price.

Transaction price is the amount of consideration which entity expects in exchange of transferring goods/services to customer as per contract, excluding amount collected on behalf of third party (e.g. Sales tax).

Transaction price is affected by nature, timing and amount of consideration promised by the customer.

Variable consideration : In case of variable consideration, 2 methods i.e. expected value method or single most likely amount method is used to identify the transaction price.

When sample size is high then expected value method is used in which probability is used to identify transaction price and when sample size is limited individual most likely method is used for identification of variable consideration.

Variable consideration is recognized when it is highly probable that subsequent change in estimate would not result in a significant revenue reversal.

Significant financing element : Timing of payments provide significant benefit of financing which can be implicit or explicit.

In such case transaction price is adjusted to reflect cash selling price and finance component is shown separately. Present value method is used in such bifurcation.

Non Cash Consideration : Fair value concept is used in this case. If not reliably measurable then standalone selling price of goods or services is used.

Step 4 – Allocate transaction price to performance obligations.

After deciding each performance obligations & transaction price, revenue shall be recognized by allocating transaction price to performance obligations.

Allocation should be based on stand-alone selling prices. The stand-alone selling price is the price at which an entity would sell a promised goods or service separately to a customer.

If standalone selling prices are not observable then it should be estimated based on following approaches:

  • Adjusted market assessment approach.
  • Expected cost plus margin approach.
  • Residual approach.

For e.g. – Say entity is selling TV with 3 year’s maintenance contract at Rs. 100,000. Here 2 performance obligations are involved i.e. sale of TV and provision of maintenance services for 3 years. Standalone selling price of each performance obligation shall be allocated & revenue shall be recognized based on it.

Say, standalone price of TV without maintenance service is Rs. 85,000. This means standalone selling price of 3 year’s maintenance service as per residual approach is Rs. 15,000.

In first year end (assuming TV sold on 1st day of year), revenue related to performance obligation of sale of TV shall be recognized i.e.Rs. 85,000 even though customer has paid Rs. 100,000. Now balance performance obligation of providing maintenance service will be fulfilled in 3 years & hence revenue booking will be deferred. In 1st year end only Rs. 5000 (Rs. 15,000/3 years) will be recognized & balance will be recognized at the end of 2nd & 3rd year. Here present value concept will also be used to unwind the financing element involved in revenue deferred to 2nd & 3rd year as explained in step 3 above.

Step 5 – Recognise revenue when or as entity satisfies the performance obligation.

Revenue shall be recognized the revenue allocated to the performance obligation when performance obligation is satisfied.

Satisfaction occurs when control of promised goods / services is transferred.

Timing of satisfaction of performance obligation can be over the time or at a point in time.

Over the Time recognition of revenue:

  • If customer simultaneously receives & consumes the benefits provided by entity’s performance. (For e.g. recurring service contracts like cleaning service, hotel industry, restaurants etc.)
  • Entity’s work creates or enhances the asset controlled by the customer.(Asset being created or enhanced could be tangible or intangible) (For e.g. – Construction activities, work in progress assets)
  • Entity’s performance does not create an asset with alternative use & entity has enforceable right to payment for performance completed to date.(For e.g. – Built to unique specification with payment linked to stages of completion.)

It means to fall in the recognition over time criteria, entity needs to connect it’s revenue model in any one of the above situation or else revenue recognition will automatically be done at a point in time i.e. on transfer of control.

Real estate industry & IND AS 115:-

Industries like real estate, are right now in dilemma over interpretation of this standard as it is very critical for revenue model of real estate entities to fit in any of the above 3 criteria or else they will have to shift from POCM (percentage of completion method) model to project completion model of revenue recognition & that is the reason why most of them have made some representation to ministry for some clarity over this.

However, listed entities have mentioned in their FY 2017-18 financial statement about impact of the IND AS 115 which was not effective for FY 17-18. Many of these real estate entities have mentioned that IND AS 115 is not having material impact on their revenue recognition model & they will continue with existing POCM model or revenue recognition as per legal opinions.

At a Point in Time recognition of revenue: If above mentioned criteria for recognizing revenue over time is not met then it is recognized at a point in time.

Point in time of recognition is transfer of control indicator of which are as follows:

  • Entity has present right to payment of assets.
  • Customer has legal title.
  • Physical possession is transferred.
  • Customer has significant risk & reward of ownership.
  • Customer has accepted the assets.

Industries which will be having more impact:

  • Consumer durables. (Because it mostly provides after sale services leading to more than 1 performance obligations in contract).
  • Service industry
  • Real estate sector

Conclusion:

The above summary of IND AS 115 shows that how it is provides detailed explanation for revenue recognition with broader view as compared to earlier standard .Entity will have to redesign its processes related to contract management & revenue booking. Also it will have to make changes in systems according to this IND AS 115 for identification of performance obligations, its respective standalone prices & allocation of this prices to individual performance obligation & ultimate revenue recognition once the performance obligations are satisfied over the time or at a point in time.

Please feel free to write to us on hemant@apmh.in / info@apmh.in for any queries on the above blog.