UNINSTALLED MATERIALS AND IMPACT ON REVENUE RECOGNITION

BACKGROUND

Contract Co (CoCo) enters
into a contract with a customer to refurbish a 40-storey building and install
new lifts for a total consideration of INR 1,62,000. The promised refurbishment
service, including the installation of the lifts, is a single performance
obligation satisfied over time. The refurbishment will be performed over a three-year
period. The total revenue is expected to be as follows:

TOTAL EXPECTED REVENUE

The contract costs incurred
over the three-year period are as follows:

CONTRACT COSTS OVER  THREE YEARS

At the end of Year 1,
included in the total costs of INR 99,000 are the costs incurred to purchase
the lifts worth INR 81,000. These lifts had been delivered at the site at the
end of Year 1 but had not yet been installed. The lifts were procured from a third-party
supplier and CoCo was not involved in either the designing or the manufacture
of the lifts. These lifts were installed at the end of Year 2. CoCo recognises
revenue over time, applying an input method based on costs incurred. Assume
that in arriving at the agreed transaction price, CoCo had applied the
following mark-up to its costs:

COST MARK-UP BY THE COMPANY

CoCo has determined that it
acts as a principal in accordance with Ind AS 115.B34-B38, because it obtains
control of the lifts before they are transferred to the customer.

QUERY 1

CoCo uses an input method
based on costs incurred. How should it determine the amount of revenue, profit
and gross margin to be recognised in its financial statements for Year 1, Year
2 and Year 3?

YEAR 1

The general principle of
over time revenue recognition in Ind AS 115 is that the pattern of revenue
recognition should reflect the entity’s performance in transferring control of
goods and services to the customer (see Ind AS 115.39). Paragraph B19 of Ind AS
115 notes that when an input method is used, an entity should exclude the
effects of any inputs that do not reflect the entity’s performance to date. It
specifically requires that revenue is only recognised to the extent of costs
incurred if:

(a) the goods are not
distinct; (b) the customer is expected to obtain control of the goods
significantly before receiving services relating to the goods; (c) the cost of
the transferred goods is significant relative to the total expected costs to
completely satisfy the performance obligation; and (d) the entity procures the
goods from a third party and is not significantly involved in designing and
manufacturing the same (but the entity is acting as a principal in accordance
with paragraphs B34-B38).

Therefore, CoCo excludes
the cost of the lifts from the cost-to-cost calculation in Year 1 because the
cost of the lifts is not proportionate to CoCo’s measure of progress towards
performing the refurbishment. Paragraph B19 is met because:

(i) The
lifts are not distinct. The refurbishment and installation of the lifts represents
one single performance obligation;

(ii) The
customer obtains control of the lifts when they arrive on its premises at the
end of Year 1, but installation of the lifts is only performed at the end of
Year 2;

(iii) The
costs of the lifts are significant relative to the total expected costs of the
refurbishment; and

(iv) The
lifts were procured from a third party and CoCo is not involved in designing or
manufacturing the lifts.

CoCo
therefore adjusts the measure of its progress towards completion and excludes
the uninstalled lifts from the costs incurred when determining the entity’s
performance to date:

DETERMINING THE ENTITY’S PERFORMANCE

CoCo then
calculates the percentage of performance completed to date:

INR 18,000
other costs (excluding lifts) / INR 54,000 total other costs (excluding lifts)
= 33.33% complete. CoCo recognises revenue to the extent of the adjusted costs
incurred and does not recognise a profit margin for the uninstalled lifts:

PROFIT MARGIN RECOGNISED

The above
accounting is clearly in accordance with Ind AS 115 and there are no
interpretation issues. However, the accounting in the following years is not
clear under Ind AS 115, which is the subject of this discussion.

YEARS 2 & 3

At the end
of Year 2 the lifts have been installed and an additional INR 18,000 of costs
has been incurred. Ind AS 115 does not contain specific guidance on the
accounting for the previously uninstalled materials that have now been
installed. Possible approaches for the accounting in the remaining years are:

View 1
– Continue to exclude the cost of the lifts from the cost-to-cost calculation
in the remaining periods of the contract;

View 2 –
Include the cost of the lifts in the cost-to-cost calculation once the lifts
have been installed and use a contract-wide profit margin;

View 3
– The cost-to-cost calculation would continue to exclude the cost of the lifts;
however, once the lifts have been installed, an applicable profit margin on the
lifts would be recognised as revenue;

View 4 – Since Ind  AS 115 is not specific in its requirements,
Views 1, 2 or 3 might be acceptable depending on the facts and circumstances.
It is necessary to consider whether the approach selected meets the overall
principle in Ind AS 115.39 that the amount of revenue should ‘depict an
entity’s performance in transferring control of goods or services promised to a
customer’. This principle once selected should be applied consistently.

View 1
– Continue to exclude the cost of the lifts from the cost-to-cost calculation
in the remaining periods of the contract;

Under this
approach, no profit margin would be recognised for the installed lift. The
profit margin derived from the lifts is instead shifted to the other services
in the contract as costs for those services are incurred.

COSTS INCURRED TO DATE

REVENUE FOR THREE YEARS

Arguments for View 1:

Under B19(b)
only one accounting treatment applies to goods that meet the conditions set out
in B19(b). B19(b) does not distinguish goods that have been installed from
those that have not yet been installed. As per para B19(b), a faithful
depiction of an entity’s performance might be to recognise revenue at an amount
equal to the cost of goods used to satisfy a performance obligation if the
entity expects at contract inception that certain conditions are met.

The Basis
for Conclusions to IFRS 15 notes that the aim of the adjustment is to reflect
the same profit or loss and margin as if the customer had supplied those goods
themselves for the entity to install or use in the construction activity.
Paragraph BC172 of IFRS 15 notes: For goods that meet the conditions in paragraph
B19(b) of IFRS 15, recognising revenue to the extent of the costs of those
goods ensures that the depiction of the entity’s profit (or margin) in the
contract is similar to the profit (or margin) that the entity would recognise
if the customer had supplied those goods themselves for the entity to install
or use in the construction activity [IFRS 15.BC172]. If the customer had
supplied the lifts itself, then CoCo would not have recognised any profit or
margin on the lifts.

Per
paragraph IE98 from Illustrative Example 19, the adjustment to cost-to-cost can
be read to be applied throughout the entire life of the contract, in
accordance with paragraph B19 of Ind AS 115, the entity adjusts its measure of
progress to exclude the costs to procure the elevators from the measure of
costs incurred and from the transaction price. The entity recognises
revenue for the transfer of the elevators in an amount equal to the costs to
procure the elevators (i.e., at a zero margin).

Arguments against View 1:

View 1 does not reflect the
reality of the transaction as an entity would typically charge a margin for
procurement (the extent of the margin would likely depend on whether the item
is generic or of a specialised nature – a higher margin is likely to be applied
for items that are specialised in nature or that are harder to source), and
would not recognise a profit margin on the item when it is installed. Rather,
the margin is being shifted to the other services in the contract as costs for those
services are incurred. However, such margins may not be material when the
entity is procuring a generic item and is not involved in its design.

View 1 would
result in a different cumulative amount of revenue being recognised using the
same input method at the end of Year 2 when there has been a significant delay
between delivery and installation compared to when there is no delay – even
though the same amount of work has been performed at the end of Year 2. This is
because B19(b)(ii) would not be met because the customer does not obtain
control of the goods significantly before receiving the services.

View 2
– Include the cost of the lifts in the cost-to-cost calculation once the lifts
have been installed.

Under this approach, once the lifts have been installed, the cost of the
lifts would be included in cost-to-cost calculations.

COST-TO COST CALCULATIONS

Arguments for View 2:

The
guidance in Illustrative Example 19 and the Basis for Conclusions to IFRS 15
focuses on the situation before the goods are installed, so the adjustment to
the cost-to-cost calculation only applies on goods that have been delivered but
not yet installed.

The
relevant extracts from the section for ‘Uninstalled materials’ in the Basis for
Conclusions are as follows:

BC171 of IFRS 15 states: The boards observed that if a customer
obtains control of the goods before they are installed by an entity… The boards
noted that recognising a contract-wide profit margin before the goods are
installed could overstate the measure of the entity’s performance and,
therefore, revenue would be overstated… [emphasis added].

BC172: The
boards noted that the adjustment to the cost-to-cost measure of progress for
uninstalled materials… (emphasis added).

BC174: …Although
the outcome of applying paragraph B19(b) of 1FRS 15 is that some goods or
services that are part of a single performance obligation attract a margin, while any uninstalled materials attract only a zero margin…

Arguments against View 2

When the
profit margin applicable to the procured item(s) is significantly different
from the profit margin attributable to other goods and services to be provided
in accordance with the contract, the application of a contract-wide profit
margin will overstate the amount of revenue and profit that is attributed to
the procured item(s). This is not consistent with the underlying principle in
Ind AS 115.39, which is that the amount of revenue recognised should ‘depict an
entity’s performance in transferring control of goods or services promised to a
customer’ (i.e., the satisfaction of an entity’s performance obligation).

As noted
in the analysis for Year 1 above, Ind AS 115.B19(b) includes guidance for
uninstalled material at the point at which control has passed to the customer.
This guidance is noted as being an example of ‘faithful depiction’ of an
entity’s performance. Consequently, when there are significantly different
profit margins attributable to procured item(s), it is necessary to adjust the
amount of revenue that is attributable to those procured item(s).

View 3
– Once the lifts have been installed, an applicable profit margin is recognised
for the lifts separately from the rest of the project:

APPLICABLE PROFIT MARGIN

Arguments for View 3:

Same
arguments as for View 2, but it also addresses the downside of View 2 of
overstating profit margin once the materials are installed. Proponents of View
3 argue that this would most faithfully depict the economics of the transaction.

Arguments against View 3:

Mark-ups /
profit margins could be subject to management manipulation.

The
approach seems to have been considered but rejected by the boards as noted in
paragraph BC171 of IFRS 15. Alternatively, requiring an entity to estimate a
profit margin that is different from the contract-wide profit margin could be
complex and could effectively create a performance obligation for goods that
are not distinct (thus bypassing the requirements for identifying performance
obligations) [IFRS 15.BC171].

QUERY 2 –
assuming either View 2 or View 3 is followed for Question 1:

Where the
profit margins attributable to different components of a contract that is
accounted for as a single performance obligation are significantly different,
is it appropriate to use an input method as a measure of progress?

View 1

Yes. Although
different profit margins might arise from different parts of a contract, the
fact that the seller has a single performance obligation means that Ind AS 115
does not require those different components to be separately identified.
Proponents of this view note that IFRS 15.BC171 would appear to support this
approach: ‘Alternatively, requiring an entity to estimate a profit margin that
is different from the contract-wide profit margin could be complex and could
effectively create a performance obligation for goods that are not distinct
(thus bypassing the requirements for identifying performance obligations).’ It
is also noted that Example 19, which has different components that would
typically be expected to have different profit margins, is based on the vendor
using an input method to measure progress towards contract completion.

View 2

No. Ind AS
115.39 includes the objective that is required to be followed when measuring
progress where a performance obligation is satisfied over time, which is: ‘…The
objective when measuring progress is to depict an entity’s performance in
transferring control of goods or services promised to a customer (i.e., the
satisfaction of an entity’s performance obligation.’ Proponents of View 2
consider that, in the fact pattern set out above, the use of an input method,
with a single overall profit margin being allocated to costs incurred, would
result in an overstatement of performance for the transfer of the lifts and an
understatement of performance for the transfer of other services.

Supporters of View 2 also question whether the lifts are in fact part of
a single performance obligation. If the seller can procure the lifts
separately, then the customer could also procure the lifts, meaning that the
procurement of the lifts could be viewed as being a separate performance
obligation.

This
conclusion would also appear to be supported by IFRS 15.BC172, in that: ‘…For
goods that meet the conditions in paragraph B19(b) of IFRS15, recognising
revenue to the extent of the costs of those goods ensures that the depiction of
the entity’s profit (or margin) in the contract is similar to the profit (or
margin) that the entity would recognise if the customer had supplied those
goods themselves for the entity to install or use in the construction
activity.’

View 3

Ind AS115 is not specific in its requirements. Consequently, either View
1 or View 2 are acceptable as an accounting policy choice, to be applied
consistently to similar transactions.

AUTHOR’S VIEW AND
CONCLUSION

On Question
1,View 1 and View 2 are the two acceptable views, though on balance View 1 is
more preferred. View 3 and View 4 are not acceptable. View 1 practically makes
sense because it sticks with one approach throughout the period. This approach
is also consistent with Ind AS 115.B19 and meets the spirit of the requirement
in the Standard. View 2 may be accepted because Ind AS 115.B19 only applies to
uninstalled materials and once they are installed, then an entity goes back to
the general model for measuring progress.

On the
second question, View 1 is more appropriate. There is generally a better
alignment in margin using the input method, but not a guarantee of having a
consistent margin throughout in all cases.

The key
question is whether the use of the input method would be a faithful depiction
of the entity’s performance – and the response is in the affirmative. In any case, the standard
does not provide an option of applying input method, using different margins
for different components.