Subscribe to BCA Journal Know More

December 2008

Gaps in GAAP – Multiple Element Contract

By Dolphy D’Souza, Chartered Accountant
Reading Time 6 mins
Accounting Standards

Recently the ICAI issued an Exposure Draft of Monograph on
‘Revenue Recognition for Arrangements with Multiple Deliverables’ inviting
comments. The author is pleased to respond to the Exposure Draft.

Overall, the author does not agree with the issuance of the
proposed Monograph for the following summary reasons :

    1. After having made a public announcement of convergence with International Financial Reporting Standards (IFRS) effective April 1, 2011, the Institute of Chartered Accountants of India (ICAI) or any of its committees should not take any action which may go against the spirit of the said announcement.

    2. As hereinafter discussed, certain requirements of the Monograph may not be in compliance with IFRS.

IAS 18 contains guidance with regard to multiple element
contracts, which provides that ‘Recognition criteria are usually applied
separately to each transaction. However, in certain circumstances, it is
necessary to apply the recognition criteria to the separately identifiable
components of a single transaction in order to reflect the substance of the
transaction. For example, when the selling price of a product includes an
identifiable amount for subsequent servicing, that amount is deferred and
recognised as revenue over the period during which the service is performed.’
International Financial Reporting Interpretations Committee (IFRIC), at its
November 2006 meeting, has considered that the multiple element issue was wide
and complicated, needing a full scope debate and amendment of IAS 18, rather
than an interpretation, and therefore decided not to take this item onto its
agenda. Therefore, issuance of the proposed Monograph in India is not
recommended since it may conflict with the outcome of the said project.

The Monograph is an adaptation of ‘EITF 00-21 : Revenue
Arrangements with Multiple Deliverables’
under US GAAP. Since US GAAP
follows rule-based approach as compared to principle-based approach under IFRS,
application of the Monograph based on US GAAP requirements will significantly
reduce scope of judgment by the preparers and limit flexibility available under
IFRS. In addition, some of these requirements may be contrary to IFRS. The
following are a few examples in this regard :

(i) As per the Monograph, if there is objective and reliable evidence of fair value, i.e., Specific Objective Evidence (SOE) for all units of accounting in an arrangement, the arrangement consideration should be allocated to the separate units of accounting based on their relative fair values (the relative fair value method). In cases, where there is objective reliable evidence for undelivered elements only, then the residual method is used to allocate the arrangement consideration.

This implies that if there is no objective evidence of fair value, for either delivered or undelivered element, then no revenue can be recognised until all elements are delivered. Take for instance, a company selling version V1 of a product, plus an entitlement to receive updated version V2, due to be released in the next one year. As there is no SOE of fair value of V2, since it has not been sold separately, as it has not yet been released, under the Monograph, sales cannot be recognised on despatch of V1.

Paragraph 13 of IAS 18 and paragraph 11 of the Appendix to IAS 18 provide guidance on the accounting treatment of multiple elements under IFRS. Paragraph 13 states that “in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction”. As per paragraph 11 of the Appendix to IAS 18, “when the selling price includes an identifiable amount for subsequent servicing, that amount is deferred and recognised as revenue over the period during which the service is performed. The amount deferred is that which will cover the expected costs of the services under the agreement, together with a reasonable profit on those services”.

While IAS 18 does not provide any specific guidance on how that allocation should be determined, it does not require SOE of fair values; rather, cost of services plus reasonable profit may be an indicator of fair value. An entity may also estimate fair value based on a statistical approach or market practice. We believe that in cases where revenue recognition has been deferred under the Monograph due to a lack of SOE of fair value, it would be unreasonable to conclude that no fair value can be established under IFRS, just because SOE of fair value is not available.

(ii) As it is evident from (i) above, the Monograph gives precedence to the relative fair value method over the residual method; whereas there is no such preference under IFRS. As part of issuance of IFRIC 13, IFRIC has examined this issue and noted that IAS 18 does not specify which of these methods should be applied, or in what circumstances. The IFRIC decided that the interpretation should not be more prescriptive than IAS 18(refer Basis for Conclusions paragraph BC 14 to IFRIC 13). Under IFRS, therefore either method or other methods such as cost methods or management estimates would be acceptable.

(iii) The Monograph requires that under the residual method, the amount of consideration allocated to the delivered item(s) equals the total arrangement consideration less the aggregate fair value of the undelivered item(s). The residual method therefore has the effect of allocating all discounts to the delivered element, rather than apportioning the discount among all elements. For example, a company sells one product for INR 10 million with one year’s post-sale services (PSS) and a renewal rate of PSS has been fixed at INR 2 million (20%) at the end of the first year (giving a fair value of INR 2 million for the PSS element). Under the residual method, the company will be able to recognise INR 8 million when the licence is delivered (total contract price of 10 million less 2 million being fair value of the undelivered element).

Under IFRS,while the above may be an acceptable method of recognising revenue on delivered element; one could question the allocation of entire discount to the delivered element. Under IFRS one may allocate the discount to both the delivered and undelivered element, for example, in proportion of the fair value of the undelivered elements and of the residual amount determined for the delivered element. In the example above, this would have the consequence of allocating the discount both on the delivered licence element and on the undelivered PSS element, for example, 84% of it allocated to the delivered licence element and 16% allocated to the PSS. Thus, applying the residual method and then apportioning the discount among delivered and undelivered elements would result in recognition of INR 8.4 million of revenue on delivery of the product software, whereas the residual method alone would restrict the amount of revenue recognised upon delivery of the licence to INR 8 million.

For the above reasons, the author does not believe that the Research Committee should pursue this Monograph till the time further guidance is provided by the IASB. Any such action by the Committee may put a question mark over ICAI’s commitment to converge with IFRS.

You May Also Like