Practical insights into accounting for certain revenue arrangements

The structure of loyalty programmes offered by sellers varies, but in general they can be classified into one of the following schemes:

• Award credits earned can be redeemed only for goods and services provided by the issuing entity.
• Award credits earned can be redeemed for goods and services provided either by the issuing entity or by other entities that participate in the loyalty programme.

For a programme to be accounted as a customer loyalty programme, it needs to contain two essential features:

• the entity (seller) grants award credits to a customer as part of a sales transaction; and
• subject to meeting any other conditions, the customer can redeem the award credits for free or discounted goods or services in the future.

For instance, a customer receives a complimentary product with every fifth product bought from the entity (seller). As the customer purchases each of the first five products, they are earning the right to receive a free good in the future, i.e., each sales transaction earns the customer credits that go towards free goods in the future.

However, it may be noted that not all types of programmes that provide free or discounted goods are accounted as customer loyalty programmes. For instance, say a purchase of membership of a club entitles a member to purchase certain goods or services at a discounted price. In such case, the substance of such membership needs to be evaluated closely. It may seem that the purchase of membership may not be a separate transaction and the amount received by the club may be against purchase of those discounts themselves.

Accounting for customer loyalty programmes
Deferral of revenue
Under Ind AS, the award credits (i.e., air miles, credit card points, etc.) under customer loyalty programmes are not recognised as sales promotion or any other expense. Instead, they are recognised as a separate component within a multiple element revenue arrangement. As such, the revenue under the sales arrangement is allocated to one or more elements, including the award credit. At the inception of the arrangement, the revenue attributable to the award credit is deferred and is recognised as and when the award credits are redeemed by the customer. The revenue attributed to the award credits takes into account the expected levels of redemption.

Allocation of revenue to award credits
Ind AS requires that the consideration received or receivable from the customer is allocated between the current sales transaction and the award credits by reference to fair values. The Ind ASs do not prescribe a particular allocation method. However, the following two methods provided under IFRS may also be applied under Ind ASs:

• relative fair values; or
• fair value of the award credits (residual or fair value method).

Using the residual method, the undelivered components are measured at fair value, and the remainder of the consideration is allocated to the delivered component. For example, assume a transaction consists of two components, X and Y; at the reporting date only component X has been delivered. If the fair value of component Y is 50 and the total consideration is 120, then revenue of 70 would be allocated to component X and 50 to Y.

In estimating fair value, the entity (seller) takes into account:

• the amount of the discounts or incentives that would otherwise be offered to customers who have not earned award credits from an initial sale; and
• the proportion of award credits expected not to be redeemed, i.e., expected forfeitures.

Accounting for revenue related to award credit The revenue attributable to the award credit (that was deferred at inception) shall be recognised as such in the income statement as and when the awards are redeemed.

Any subsequent change in the estimates of awards expected to be redeemed are trued up for differences between the number of awards expected to be redeemed and the actual number of awards redeemed; the amount of revenue deferred at the time of the original sale is not recalculated.

Steps involved in accounting for customer loyalty programmes
Having discussed the principles of revenue recognition relating to the customer loyalty programmes, the following are the broad steps involved in accounting for the same:
1. Understand the various customer loyalty programmes in effect.

Let us understand the above principles with the help of an example:

Company X runs a loyalty scheme rewarding a customer’s spend at its stores. Under this scheme, customers are granted 10 loyalty points (or award credits) for every 100 spent in X’s store. Customers can redeem their points for a discount in the price of a new product in X’s stores. The loyalty points are valid for five years and 50 points entitle a customer to a discount of 50 on the retail price of the product in X’s store.

During 2011, X has sales of 500,000 and grants 50,000 loyalty points to its customers. Based on the expectation that only 40,000 loyalty points will be redeemed, management estimates the fair value of each loyalty point granted to be 0.80. During 2011, 15,000 points were redeemed in exchange for new products, and at the end of the reporting period management still expected a total of 40,000 points to be redeemed, i.e., a further 25,000 points will be redeemed.

X records the following entries in 2011 in relation to the loyalty points granted in 2011:

(Being revenue recognised in relation to sale of goods and deferred
revenue for loyalty points)

At the end of the reporting period, the balance of the deferred revenue is 25,000 [(25,000/40,000) x 40,000]. Therefore, the difference in the deferred revenue balance is recognised as revenue for the year.

(Being revenue recognised in relation to 15,000 loyalty points
redeemed in 2011)

During 2012, 17,500 points are redeemed, and at the end of the year management expects a total of 42,500 points to be redeemed, i.e., an increase of 2,500 over the original estimate. The fair value of each award credit does not change, but the redemption rate is revised based on the new total expected redemptions. At the end of the year, the balance of deferred revenue for 10,000 loyalty points (i.e., 42,500 — 15,000 — 17,500) is 9,412 [(10,000/42,500) x 40,000]. X records the following entry in 2012 in relation to the loyalty points granted in 2011:

(Being revenue
recognised in relation to loyalty points redeemed in 2012)

It is important to note that in determining whether an asset exists, the right of ownership is not essential. Therefore, if the customer continues to control the transferred item, the asset definition would not be met despite a transfer of ownership. Hence, the Company must analyse if it has obtained the control of the transferred asset to recognise the same in its books.

Control would imply right to utilise the transferred asset the way Company deems fit. For example, the Company can exchange that asset for other assets, employ it to produce goods or services, charge a price for others to use it, use it to settle liabilities, hold it, or distribute it to owners.

As part of the arrangement for transfer of asset from the customer, the arrangement may require that the Company must use the transferred item of property, plant and equipment to provide one or more service to the customer. However, if the Company has the ability to decide how the transferred item of property, plant and equipment is operated and maintained and when it is replaced, it can be concluded that the Company controls the transferred item of property, plant and equipment.

If based on the above principles, it is concluded that the company has obtained control over the asset transferred by the customer, the company shall recognise (debit) the transferred asset as its own asset (though it may not have the ownership). The corresponding impact of the transfer shall be recognised as either revenue or deferred revenue, depending upon the obligations assumed by the company in lieu of the transferred asset.

Timing of revenue recognition
In determining the timing of revenue recognition, the entity (recipient) considers:

•    what performance obligations it has as a result of receiving the customer contribution;

•     whether these performance obligations should be separated for revenue recognition purposes; and

•     when revenue related to each separately identifiable performance obligation should be recognised.

Comprehensive guidance on how to determine the entity’s performance obligations is not provided under the appendix C. In practice it may be difficult to determine whether the entity only has to connect the customer to a network, or it has to provide ongoing access to a supply of goods and services, or both.

All relevant facts and circumstances should be evaluated when determining whether additional performance obligations arise from the transfer including:

•     whether or not the customer providing the contribution is charged the same fee for the supply of goods or services as is charged to other customers that are not required to make such customer contributions;

•     whether customers have the ability to change the supplier of goods or services at their discretion; and

•    whether a successor customer needs to pay a connection fee when the customer that made the customer contribution discontinues the service, and if so, the amount of such connection fee relative to the fair value of the asset contributed.

In our view, in determining whether a rate charged to a customer includes a discount, the entity should compare rates for ongoing services charged to customers that make a contribution with the rates charged to customers that do not.

If it is determined that some or all of the revenue arising from the customer contribution relates to the ongoing supply of goods or services, then the revenue is recognised as those services are delivered. Typically, such revenue is recognised over the term specified in the agreement with the customer. If, however, no such term is specified, then the period of revenue recognition is limited to the useful life of the transferred asset.

Instead of property, plant and equipment, an entity may receive cash that must be used to construct or acquire an item of property, plant and equipment in order to connect the customer to a network and/or provide the customer with ongoing access to a supply of goods or services. The accounting for such cash contributions depends on whether the item of property, plant and equipment to be acquired or constructed is recognised as an asset of the entity on acquisition/completion.

•     If the asset is not recognised by the entity, then the cash contribution is accounted for as proceeds for providing the asset to the customer under Ind AS 11 or Ind AS 18, as applicable.

•     If the asset is recognised by the entity, then the asset is recognised and measured as it is constructed or acquired in accordance with Ind AS 16; the cash contribution is recognised as revenue following the guidance as stated above.

Steps involved in accounting for transfer of assets from customers
Having discussed the principles of revenue recognition relating to the transfer of assets from customers, the following are the broad steps involved in accounting for the same:
(1)    Analyse all the relevant agreements to identify arrangements covered within this guidance.

(2)    Assess whether the control over the transferred asset is obtain by the company. If the control is transferred to the company, the asset will be recognised in the Company’s balance sheet.

(3)    Determine the obligations assumed by Company in lieu of the transfer of control over the transferred asset.

(4)    If the above-mentioned obligations are in the nature of ongoing services, then revenue attributable to those obligations is deferred and recognised as the underlying services are rendered and obligations fulfilled.

(5)    To the extent the above-mentioned obligations are fulfilled at the inception of the contract, recognise appropriate revenue upfront.

(6)    Depreciate the acquired asset over its useful life.

Let us understand the above principles with the help of an example:

Company X has entered into an agreement with Company Y to outsource some of its manufacturing process. As part of the arrangement, Company X will transfer the ownership of its machinery to Company Y.

Based on a report submitted by independent valuer, the fair value of assets transferred is Rs. 90,000. Initially, Company Y must use the equipment to provide the service required by the outsourcing agreement. Company Y is responsible for maintaining the equipment and replacing it when it decides to do so. The useful life of the equipment is 3 years. The outsourcing agreement requires service to be provided for 3 years for a fixed price of Rs.10,000 per year which is lower than the price that Company Y would have charged if the equipment had not been transferred. In such case the fixed price would have been Rs.40,000 per annum.

Pursuant to a detailed analysis, Company Y determines that the control over the equipment is transferred in its favour. Hence, Company Y would have to initially recognise the asset at its fair value in accordance with Ind AS 16. Further, Company Y would also have to recognise the revenue over the period of the services performed i.e., over 3 years.

Company Y shall recognise the following journal entries to recognise the transactions under the arrangement: