The impact
of revenue is all pervasive and encompasses all entities. The standard brings
about a fundamental change in how entities will envision, recognise and measure
revenue. In this article the author briefly discusses the date of applicability
of Ind AS 115, the fundamental changes from current practice, key impacts for
certain industries and disclosure and other business implications. Given the
pervasive and fundamental impact of the standard, entities that have not
already started, should waste no time in preparing for Ind AS 115.
When does Ind AS 115
apply?
The Exposure Draft (ED)
issued by the ICAI states that the standard would apply from accounting periods
commencing on or after 1st April 2018.
However, it is not yet
notified by the Ministry of Corporate Affairs (MCA). In the past we have
observed instances where standards have been notified on the last day of the
financial year. Whilst there is no 100% guarantee that the standard would apply
from 1st April, 2018, companies should anticipate that it would be
notified by MCA before the end of the financial year, given the past
experience.
Whilst this is an unhappy
outcome, it may be noted that the ICAI had clarified the applicability date in
April 2017 and the ED was issued much earlier; providing enough opportunity to
prepare for implementation of the new standard. By the time this article is
published, it will be clear whether the standard has become applicable. It may
be noted that listed companies will have to churn out numbers under Ind AS 115
in the first quarter of 2018-19, and hence this is a highly onerous obligation,
than what may initially appear.
What are the fundamental
changes compared to the existing Ind AS 18 Revenue?
Ind AS 115 requires
perceiving revenue from the customer’s point of view; which is whether the
customer has received a stand-alone benefit from the goods or services it has
received. This is likely to impact accounting of connection, activation,
installation, admission, and similar revenue. This can be observed across
several industries, such as, telecom, power, cable television, education,
hospitality, etc. Consider for example, an electricity distribution
company installs an electric meter at the customer’s site. The meter certainly
benefits the customer, but it does not provide to the customer any independent
stand-alone benefit, because the meter is useless without the subsequent
transfer of power to the customer. Neither the customer can use the meter to
procure power from other distributors. Therefore, the customer has not received
any benefit from the meter on its own and consequently such connection income
is recognised overtime by the distribution company.
The other fundamental
change is that under Ind AS 115, an entity recognises revenue when control of
the underlying goods or services are transferred to the customer. This is
different from the current “risk and reward” model under Ind AS 18, where
revenue is recognised on transfer of risk and rewards to the customer. Consider
an entity transfers legal title and control of goods to a customer on free on
board (FOB) delivery terms. However, the entity reimburses the customer for any
damages or transit losses in accordance with its past practice. Under the Ind
AS 18, risk and reward model, some entities may have delayed recognition of
revenue till the time the customer has received and accepted the goods. This is
on the basis that the risk and rewards are transferred when the customer
receives and accepts the goods. Under the control model in Ind AS 115, revenue
will be recognised on shipment because control is transferred to customers at
shipment. As soon as the goods are boarded, the customer has legal title to the
goods, the customer can direct the goods wherever it wants and the customer can
decide how it wants to use those goods. In this situation, the entity will have
two performance obligations (1) sale of goods, and (2) reimbursing transit
losses. The total transaction price will be allocated between the goods and the
transit losses, and recognised when those respective performance obligations
are satisfied. However, in most situations, the performance obligation relating
to reimbursement of the transit losses may be insignificant, in which case it
may be ignored.
There are numerous other
changes that may not be fundamental, but still be very important. Take for
example, the discounting of retention monies. Currently under Ind AS 18 there
is debate on whether retention monies need to be discounted. This is because of
contradictory requirements in the standard. One view is that since revenue is
recognised at fair value, the retention monies need to be discounted to
determine the fair value of revenue. Ind AS 18 also states that “when the
arrangement effectively constitutes a financing transaction, the fair
value of the consideration is determined by discounting all future receipts
using an imputed rate of interest…………….The difference between the fair value
and the nominal amount of the consideration is recognised as interest revenue
in accordance with Ind AS 109.” This means that discounting is only required
when the arrangement contains a financing arrangement. Ind AS 18 was therefore
debatable.
On the other hand, Ind AS
115, is absolutely clear. Paragraph 62 states that “notwithstanding the
assessment in paragraph 61, a contract with a customer would not have a
significant financing component if any of the following factors exist: ………….(c)
the difference between the promised consideration and the cash selling price of
the good or service (as described in paragraph 61) arises for reasons other
than the provision of finance to either the customer or the entity, and the
difference between those amounts is proportional to the reason for the
difference. For example, the payment terms might provide the entity or the
customer with protection from the other party failing to adequately complete
some or all of its obligations under the contract.
Since retention monies are
held by customers as a measure of security to enforce contractual rights and
safeguard its interest, retention monies are not discounted under Ind AS 115.
Explain the five step model
in
Ind AS 115 and briefly
outline the impact on industry.
The model in the standard
is based on five steps, which are given below.
Step 1:
Identify the contract: A contract has to be enforceable and the transaction
price should be collectable on the day the contract is entered into. The
contract can be written or oral, but has to be enforceable. If the contract is
not enforceable revenue cannot be recognised.
Step 2:
Identify performance obligations: Within a contract there could be several
performance obligations. Performance obligations are basically distinct goods
and services within a contract from which the customer can benefit on its own.
Step 3: This
step requires determining the transaction price in the contract. Whilst in most
cases this would be fairly straight-forward, in certain contracts, it could be
complicated because of:
– Variable consideration (including application of the constraint)
– Significant financing component
– Consideration paid to a customer (for example, free mobile
offered to a customer that buys a telecom wireless package)
– Non-cash consideration
The standard deals in
detail on how to recognise, measure and disclose the above components.
Step 4: Allocate
the transaction price to the various performance obligations in the contract.
Step 5:
Recognise revenue when (or as) performance obligations are satisfied. This can
be at a point in time or over time.
The construct of the model
is very simple but when applied, can throw huge challenges and is very
different from current Ind AS 18. It may be noted, that there would be numerous
areas of differences and challenges for each industry. Below is a broad outline
of the impact of the standard and the interplay of the five steps on various
industries. It is a very brief summary of a few of the many issues, used only
for illustration purposes.
Real estate
Real estate entities offer
a 10:90 or similar schemes to customers. As per the scheme, the customer pays
10% of the contract value on signing the offer letter, followed by a 90%
payment when the unit is delivered to the customer. If real estate prices fall
significantly, the customer may simply decide not to take delivery, and allow
the 10% to be forfeited. In many jurisdictions, such contracts may not be
legally enforceable against the customer and when enforceable the legal system
could be a huge deterrent to recover the monies from the customer. If this is
the situation, there is no enforceable contract under Ind AS 115, and
consequently no revenue is recognised till such time the contract is enforceable
or the remaining 90% is received by the real estate entity.
Another hot topic for real
estate entities would be the method for recognition of revenue, i.e. whether
percentage of completion method (POCM) or completed contract method (CCM) would
apply when a building is constructed which has several units sold to different
customers. In this case, since the customer does not control the underlying
asset itself, as it is getting constructed, revenue is recognised only on
delivery of the real estate unit to the customer. This issue was discussed in
detail by IFRIC at a global level. IFRIC observed the following: although the
customer can resell or pledge its contractual right to the real estate unit
under construction, it is unable to sell the real estate unit itself without
holding legal title to the completed unit. Consequently, the real estate entity
is not eligible for overtime recognition of revenue. However, the standard
allows overtime recognition of revenue, in situations where the real estate entity
has the right to collect payments from the customer for work completed to date.
Such amounts should include cost and an appropriate margin. If the real estate
entity does not have such a right, in statute and contract, POCM recognition of
revenue is not allowed. In other words, revenue is recognised when the
completed unit is delivered to the customer. Real estate entities in India that
want to apply POCM should verify if the statute entitles them with such a
right. If such a right is provided in the statute, they should ensure that the
contract with the customer also provides such a right.
Pharmaceutical
Some Indian pharmaceutical
companies have sales in US, through a few large US distributors on a principal
to principal basis. However, the amount of revenue to be received from the US
distributors may be variable, as the contract may have a price capping
mechanism or provide an unlimited right of return to the US distributors. The
price capping mechanism ensures that if the entity sells the same products at a
lower price to other customers, the distributor would be entitled to a
proportionate refund.
The US distributors will
send a sales report containing quantity and value to the pharma company on a
quarterly basis. Under current standards, some pharmaceutical companies may not
recognise revenue on dispatch to the US distributor, but recognise revenue
based on reported sales at the end of each quarter; effectively treating the US
distributor as an agent. This is because the risks and rewards may not have
transferred to the US distributor who has an unlimited right of return and is
also entitled to the benefit from the price capping mechanism. Under Ind AS
115, the control of goods is transferred to the distributor on dispatch since
the US distributor has legal title and ownership of the goods.
The pharma company does not
have any rights to recover the products, except as a protective right in rare
situations. Consequently, the pharma company recognises revenue upfront when
the control of the goods is transferred to the distributor. Since revenue is
variable because of the price capping mechanism and the unlimited right of
return, the transaction price will need to be estimated in accordance with the
methodology prescribed in the standard.
Software Company
Many Indian software
companies applied the US GAAP accounting for Indian GAAP as well. Under US
GAAP, a software company needs to separately account for elements in a software
licensing arrangement only if Vendor Specific Objective Evidence (VSOE) of fair
value exists for the undelivered elements. An entity that does not have VSOE
for the undelivered elements generally must combine multiple elements in a
single unit of account and recognise revenue as the delivery of the last
element takes place. VSOE is not required under Ind AS 115. The standard
prescribes a methodology for determining and allocating the transaction price
to various elements, which uses VSOE but in its absence prescribes other
methods of determining the allocation of the transaction price to the various
elements.
Telecom
Telecom companies may offer
a free handset to customers along with a wireless telecom package (voice and
data). Currently, some telecom companies recognise the telecom package overtime
and the cost of the free handset is recognised as a sales promotion cost. Under
Ind AS 115, the total consideration will be split between the telecom package
and the handset, and recognised as those performance obligations are satisfied.
This would give a completely different revenue, cost and margin pattern
compared to current practice.
Engineering and
Construction
The standard contains a
detail set of requirements on how to account for contract modifications. For
example, an unpriced change order is common in construction contracts; wherein
the scope of work is changed by the customer but the price for the change is
not agreed. The standard would require that the revenue and cost estimates on
the contract are immediately updated, consequently percentage of completion
margins would change. The problem is that revenue from the change in scope is
variable and the standard requires caution in estimating the variable revenue,
whereas costs are fully estimated. Consequently, the initially estimated POCM
margins may decline.
Consumer products and other
industries
An entity may have sold
goods, but on request from the customer, would have held those goods in its
storage facility. This is often referred to as bill and hold sales and is
common across all industries. For example, some pharmaceutical companies may
have a stock pile program for vaccinations based on government directives or a
consumer goods company may hold goods sold at its storage location on request,
as the distributor may be short of storage space. Contrary to current practice,
under Ind AS 115, in many cases bill and hold sales may not qualify for revenue
recognition because the underlying goods are fungible. For example, the stock
pile program may not qualify for revenue recognition, if they are subject to rotation,
i.e., the entity can sell some from the pile to another customer and replace it
with fresh supplies. These arrangements do not meet the criterion for
recognition of revenue on bill and hold sales, though they may have fulfilled
the criterion under Ind AS 18.
Another common topic
relevant for a consumer goods and other companies is warranties. If the
warranties are sold separately, or warranty entails a service in addition to
assurance (such as an extended warranty period), they are accounted for as a
separate performance obligation, rather than as a cost accrual.
Currently, the entire
revenue is recognized upfront and estimated cost for warranty is provided.
Under Ind AS 115, revenue will be allocated between the goods and the warranty.
Revenue and cost of goods is recognised as soon as the goods are sold. Revenue
and cost on warranties is recognised overtime as the warranty service is
provided.
This will result in a
different revenue, cost and margin profile compared to current practice under
Ind AS 18. It may be noted, that if the warranties are assurance type
warranties, and not sold separately or contain extended terms, the accounting
under Ind AS 18 and Ind AS 115 is the same.
Which are the disclosure
requirements that are onerous?
There are numerous
disclosure requirements. Entities should not underestimate the disclosure
requirements. Here we discuss two key disclosure requirements.
1. Entities will be
required to provide disaggregated revenue information in the financial
statements. The standard requires such disclosure on the basis of major product
lines, geography, type of market or customer (government, non-government, etc.),
contract duration, sales channel, etc., whichever is the most
appropriate and relevant for the entity. The standard provides guidance on how
this disclosure is made, and suggests that existing information provided to the
CEO, board, analysts, etc. may be used, and one need not reinvent the wheel.
2. For contracts or orders
that require more than one year to execute, the standard requires disclosure of
(a) transaction price allocated to the unsatisfied or partially satisfied
performance obligations, and (b) time bands by which the obligations will be
fulfilled and revenue recognised. For the said purpose, quantitative or
qualitative measures can be used.
What are the business
implications of Ind AS 115?
Certainly when top line and
margins change compared to current accounting, it will have numerous
implications, such as on income-tax, bonuses that are dependent on
revenue/margins, revenue sharing arrangements, contract terms and conditions,
internal control over financial reporting, etc. For example, companies
may change the sales arrangement with their distributors, to provide them
control at the point of shipment, so that revenue can be recognised at
shipment, rather than when the customer accepts the goods.
Certain business implications may
not be immediately obvious. Some companies may accept onerous contracts, to
recover some portion of the fixed costs/capacity. The IFRIC is currently
discussing whether when providing for onerous contract full cost provision or
only incremental cost needs to be provided for. Now if full cost absorption is required,
more onerous losses get recognised earlier. This may be a deterrent for
companies to accept a contract that is onerous.
