Revenue Recognition

Companies at times offer a broad range
of products and services to its customers. These arrangements are
sometimes negotiated with the customer through a single contract which
contains multiple deliverables that are separately identifiable and have
stand-alone value to the customer, for example an automobile company
sells vehicles to a customer along with an optional extended warranty of
three years for a composite price. In accounting for revenue in case of
multiple deliverable arrangements the company should identify
‘separately identifiable components’ for which revenue is recognised at
varied points of time as per the contract. The consideration for these
separate elements should be allocated on a fair value basis using either
the ‘Fair value method’ or the ‘Relative fair value method’. Under the
fair value method, the revenue equivalent to the fair value of all
undelivered contract is deferred, and the difference between total
contract price and deferred revenue is recognised as revenue on
delivered components. Under the relative fair value method, the total
contract price is allocated to each contract deliverable in the ratio of
their fair values as a percentage to the aggregate fair values of all
individual contract deliverables.

Let us consider the concept of
multiple deliverable arrangements by way of an example — Example 1:
Multiple deliverables A company sells a vehicle along with a contract
for an optional three-year extended warranty bundled along with it for a
contract value of INR 570,000. The fair value of the extended warranty
services is INR 60,000. The fair value of the vehicle without the
extended warranty services is INR 540,000. The entire consideration is
required to be paid upfront.
 Relative fair value method

Step 1: The above contract can be broken into the following identifiable components:

Step 2: Allocation of revenue based on their relative fair values — Contract value: INR 570,000

It
may be noted here that the aggregate fair value of delivered components
is INR 600,000 while the aggregate contract price is INR 570,000. As
such, there is a discount of 5% (i.e., 30,000/ 600,000) on the overall
contract as compared to its market price. Under the relative fair value
method, this discount of 5% is applied to each deliverable for revenue
recognition purposes. As such, the consideration allocated to vehicle is
INR 513,000 (i.e., 95% of INR 540,000) and that allocated to extended
warranty is INR 57,000 (i.e., 95% of INR 60,000).

Fair value method

It
may be noted here that under the fair value method, the consideration
allocated to the undelivered component is its entire fair value and the
remaining contract price is allocated to the delivered component. As
such, the consideration allocated to the extended warranty (i.e.,
undelivered component) shall be INR 60,000 while the remaining
consideration of INR 510,000 (i.e., INR 570,000 — INR 60,000) shall be
allocated to the sale of vehicle.

Customer loyalty programmes:

A
range of businesses, such as supermarkets, retailers, airlines,
telecommunication operators, credit card providers and hotels offer
customer loyalty programmes, which comprise of loyalty points or ‘award
credits’. Such award credits or loyalty points may be linked to
individual purchases or groups of purchases, or to continued custom over
a specified period. The customer usually redeems these award credits
for free or discounted goods or services.

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 tenth
product bought from the entity (seller). As the customer purchases each
of the first ten 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.

 In accounting
for customer loyalty programmes the company estimates the fair value of
the award credits, generated through its loyalty programmes. The
consideration (for goods sold on which award credits are issued) is
allocated to the award credits based on either the fair value method or
the relative fair value method (as discussed above). Revenue is
recognised for the delivered goods based on the sale consideration
allocated to the goods sold while the sale consideration allocated to
the award credits are recognised when the award credits are redeemed.

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

Example
2: Customer loyalty programmes Company Q runs a loyalty scheme that
rewards customers’ spend at its stores. As per the scheme, customers are
granted 10 award credits for every INR 100 spent in Q’s store.
Customers can redeem their accumulated points towards a discount on the
price of a new product in Q’s stores. The loyalty points are valid for
three years.

During 2012, Q had sales of INR 1,000,000 and
accordingly granted 100,000 loyalty points to its customers. The
management expected only 80,000 loyalty points to be redeemed and that
the cost per point redeemed would be INR 0.8 per point. The management
has adopted fair value method for allocation of consideration to the
multiple deliverables i.e., initial sale of goods and award credits. Q
records the following entries in 2012 in relation to the loyalty points
granted in 2012:

Redemption of award credits in Year 1

During
2012, 30,000 points were redeemed, and at the end of the reporting
period, management still expected a total of 80,000 points to be
redeemed, i.e., a further 50,000 points will be redeemed over the next
two years.

At the end of the reporting period, the balance of
the deferred revenue is INR 40,000 [(50,000/ 80,000) x 64,000].
Therefore, the difference in the deferred revenue balance is recognised
as revenue for the year.

Redemption in year 2: change in estimates

At the end of the year, the balance of deferred revenue for 20,000 loyalty points shall be INR 15,059 [(20,000/85,000) x 64,000] which shall represent the closing balance in deferred revenue account. The differential amount in deferred rev-enue account of INR 24,941 (i.e., 64,000 – 24,000 – 15,059) shall be transferred to revenue. Q records the following entry in 2013 in relation to the loyalty points granted in 2012:

The remaining balance in deferred revenue account of INR 15,059 shall be recognised as revenue in the year 2014.

Transfer of assets from customers:

Ind AS 18 provides guidance on transfer of property, plant and equipment (or cash for its acquisition) for entities that receive such assets from their customers in return for ongoing supply of goods or services. As such, the principles contained hereunder do not apply to gratuitous transfers of assets i.e., transfer of assets without consideration. Further, the guidance also cannot be applied to transfers that are in the nature of government grants or those covered under the service concession arrangements.

If it is concluded that the company has obtained control over the asset transferred by the customer, the company should recognise (debit) the transferred asset as its own asset (though it may not have the ownership). The corresponding impact of the transfer should 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.

The accounting for transfer of assets from customers involves an analysis whether the control over the transferred asset is obtained by the company and if the control is transferred the asset will be recognised in the company’s balance sheet. The company is required to determine the obligations assumed by the company in lieu of the transfer of control over the transferred asset and 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 where as to the extent that the obligations are fulfilled at the inception of the contract, revenue shall be recognised upfront. The assets transferred by the customer shall be depreciated over the useful life of the asset.

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

Example 3: Transfer of assets from customers

Company M enters into an agreement with Company N to outsource some of its manufacturing process. As part of the arrangement, Company M will transfer its machinery to Company N.

Based on a report submitted by independent valuer, the fair value of assets transferred is INR 100,000. Initially, Company N must use the equipment to provide the service required by the outsourcing agreement. Company N is responsible for maintaining the equipment and replacing it when it decides to do so. The useful life of the equipment is 5 years. The outsourcing agreement requires service to be provided for 5 years for a fixed price of INR 30,000 per year, which is lower than the price that Company N would have charged if the equipment had not been transferred. In such case the fixed price would have been INR 50,000 per annum.

Pursuant to a detailed analysis, Company N determines that the control over the equipment is transferred in its favour. Hence, Company N would have to initially recognise the asset at its fair value in accordance with Ind AS 16. Further, Company N would also have to recognise the revenue over the period of the services performed i.e., over 5 years. (Refer Table 1)

Example 4: Sale on extended credit terms

Company K sells equipment to Company L for a total consideration of INR 1,000,000. The payment for this sale is deferred over a period of five years with regular payments of INR 200,000 each year to be made by Company L to Company K. No interest is charged by Company K to Company L and the normal credit terms of Company K are four months from the date of sale. The current cash price for the goods sold is INR 758,157. Considering the current cash price and the five annual payments of INR 200,000, the effective interest rate on the transaction works out to 10% p.a.

The sale by Company K to Company L is on deferred payment basis and beyond its normal credit terms. The total consideration under the terms of the arrangement is INR 1,000,000. However, revenue should be recognised at the current cash price i.e., the price at which the goods will be sold without such extended credit terms. The difference between the current cash price and the total consideration should be recognised as finance income over the extended credit period.

Accordingly, the revenue on the date of the transaction shall be recognised at its current cash price of INR 758,157. The difference INR 241,843 (i.e., INR 1,000,000 – INR 758,157) will be recognised as finance income over the period of the contract using the effective interest rate method.

The recognition of finance income based on effective interest rate of 10% is computed as shown in Table 2

Revenue recognition principles prescribed under Ind AS 18 and discussed in this article vary significantly from the currently applicable AS 9 – Revenue Recognition. The application of these principles will require significant judgment in several aspects while preparing an entity’s financial statement.