Revenue recognition is the important & pervasive aspect of financial reporting. Accounting Standard which covers this aspect needs to be very clear and descriptive to cover every major possible situation and peculiarities of contracts with customers.
OVERVEIW:
Revenue recognition is the important & pervasive aspect of financial reporting. Accounting Standard which covers this aspect needs to be very clear and descriptive to cover every major possible situation and peculiarities of contracts with customers. Existing standard of revenue i.e. AS 9 (also IND AS 18 for IND AS applicability companies) uses risk and reward transfer as a key point for recognition of revenue. Its guidance is very narrow as compared to IND AS 115. It does not deal with the complex types of business models whose revenue recognition and contracts with customers are of a unique nature. Also, Institute of Chartered Accountants of India (ICAI) had issued different guidance notes for revenue recognition of the real estate sector. IND AS 115 has a more pervasive approach for defining a point of revenue recognition. Hence its scope covers the majority of business models and transactions. It also overwrites the earlier issued IND AS 18. Also, ICAI has withdrawn the guidance note issued for real estate sector IND AS compliant companies after the introduction of IND AS 115.
OBJECTIVE: The objective of this blog is to summarise revenue recognition under the existing standard & as per IND AS 115 Revenue from contract with customers.
Brief of existing Revenue standards: The basic principle of revenue recognition is that Revenue must be recognized when the risk & reward is transferred and also various other aspects.
In case of sale of goods – Date when the process of delivery of the goods to the customer is completed or when the title is transferred.
In case of sale of service – When service is performed. In case of allowing the use of asset/resource – On accrual/time basis. Revenue recognition under IND AS 115: IND AS 115 gives detailed stepwise guidance on revenue recognition which gives more clarity & gives a broader view as compared to existing standards. IND AS 115 shifts the focus from risk & reward transfer to control transfer.
Steps in revenue recognition:
Step 1 – Identify contract with customer Criteria to be met for the contract to be accounted – Parties have approved contracts (writing, orally or by customary business practices). Rights and payment terms regarding goods/services to be transferred can be identified. The contract has commercial substance. Probable that consideration will be received. (Customer’s ability & intentions to be checked).
Step 2 – Identify performance obligations. At inception, an entity shall identify as a performance obligation each promise to transfer customer goods or services that are distinct. For E.g. – When an entity promises to supply goods/services along with 3 years free maintenance service then the supply of goods and supply of 3 years maintenance services are two separate performance obligations. Performance obligation is not only limited to goods or services, but it also includes customary business practices, published policies or specific statements. Consumer durables industries will be having more than 1 performance obligations attached to the contract.
Step 3 – Determine transaction price. The transaction price is the amount of consideration which entity expects in exchange for transferring goods/services to the customer as per contract, excluding the amount collected on behalf of the third party (e.g. Sales tax). The transaction price is affected by nature, timing and amount of consideration promised by the customer. Variable consideration : In case of variable consideration, 2 methods i.e. expected value method or single most likely amount method is used to identify the transaction price. When the sample size is high than expected value method is used in which probability is used to identify transaction price and when the sample size is limited individual most likely method is used for identification of variable consideration. Variable consideration is recognized when it is highly probable that subsequent change in the estimate would not result in a significant revenue reversal. Significant financing element : Timing of payments provides a significant benefit of financing which can be implicit or explicit. In such case, transaction price is adjusted to reflect cash selling price and finance component is shown separately. Present value method is used in such bifurcation. Non Cash Consideration : A fair value concept is used in this case. If not reliably measurable then the standalone selling price of goods or services is used.
Step 4 - Allocate transaction price to performance obligations. After deciding each performance obligation & transaction price, revenue shall be recognized by allocating the transaction price to performance obligations. The allocation should be based on stand-alone selling prices. The stand-alone selling price is the price at which an entity would sell a promised goods or service separately to a customer. If standalone selling prices are not observable then it should be estimated based on the following approaches:
For e.g. – Say entity is selling a TV with 3 year’s maintenance contract at Rs. 100,000. Here 2 performance obligations are involved i.e. the sale of TV and the provision of maintenance services for 3 years. The standalone selling price of each performance obligation shall be allocated & revenue shall be recognized based on it. Say, the standalone price of TV without maintenance service is Rs. 85,000. This means the standalone selling price of 3-year maintenance service as per the residual approach is Rs. 15,000. In the first year-end (assuming TV sold on 1st day of year), revenue related to performance obligation of sale of TV shall be recognized i.e.Rs. 85,000 even though the customer has paid Rs. 100,000. Now balance performance obligation of providing maintenance service will be fulfilled in 3 years & hence revenue booking will be deferred. In 1st year-end only Rs. 5000 (Rs. 15,000/3 years) will be recognized & balance will be recognized at the end of 2nd & 3rd year. Here present value concept will also be used to unwind the financing element involved in revenue deferred to the 2nd & 3rd year as explained in step 3 above.
Step 5 - Recognise revenue when or as the entity satisfies the performance obligation. Revenue shall be recognized the revenue allocated to the performance obligation when the performance obligation is satisfied. Satisfaction occurs when control of promised goods/services is transferred. The timing of satisfaction of performance obligation can be over the time or at a point in time.
Over the Time recognition of revenue:
It means to fall in the recognition over time criteria, entity needs to connect it’s revenue model in any one of the above situations or else revenue recognition will automatically be done at a point in time i.e. on the transfer of control. Real estate industry & IND AS 115:- Industries like real estate, are right now in dilemma over interpretation of this standard as it is very critical for revenue model of real estate entities to fit in any of the above 3 criteria or else they will have to shift from POCM (percentage of completion method) model to project completion model of revenue recognition & that is the reason why most of them have made some representation to ministry for some clarity over this. However, listed entities have mentioned in their FY 2017-18 financial statement about the impact of the IND AS 115 which was not effective for FY 17-18. Many of these real estate entities have mentioned that IND AS 115 is not having material impact on their revenue recognition model & they will continue with the existing POCM model or revenue recognition as per legal opinions. At a Point in Time recognition of revenue: If the above-mentioned criteria for recognizing revenue over time is not met then it is recognized at a point in time. The point in time of recognition is the transfer of control indicator of which are as follows:
Industries that will be having more impact:
Conclusion: The above summary of IND AS 115 shows how it provides a detailed explanation for revenue recognition with a broader view as compared to earlier standard. Entity will have to redesign its processes related to contract management & revenue booking. Also, it will have to make changes in systems according to this IND AS 115 for identification of performance obligations, its respective standalone prices & allocation of these prices to individual performance obligation & ultimate revenue recognition once the performance obligations are satisfied over the time or at a point in time. Please feel free to write to us on info@cahjmehta.com for any further queries on the above blog.
