Ind AS-115: Revenue from Contract with Customers

Topics contained

Scope & Objective

This Ind AS had been introduced so as to streamline the process of revenue recognition for revenue from contracts entered with customers by an entity operating in any sector/industry. However, there are certain exceptions to the type of contracts covered by this Ind AS:

-        Lease contracts;

-        Insurance contracts, except in case where entity is mainstream into insurance business;

-        Financial instruments;

-        Non-monetary exchange between entities in same line of business.

Recognition & Five-Step Model

Any revenue arising from contract executed with the customer, is to be recognized in books only when all below mentioned 5 questions are answered. This is the reason why the recognition criterions are altogether also referred as five-step model. We shall understand each of these questions one-by-one:

A contract is an agreement being executed between 2 or more parties, that creates enforceable rights and obligation in favour of all the parties involved therewith. Such an agreement could be written/oral/implied as per business practices. Further, Ind AS guidance emphasizes the fact that such contract must be enforceable, so as to make this five-step model effective. The contract be said to be enforceable only on fulfilment of all below mentioned conditions:

-        The parties have mutually approved the terms of contract and are committed to perform their respective contractual obligations;

-        Entity can identify each party’s rights for goods/services to be transferred;

-        Payment terms are clearly identifiable;

-        Contract has commercial substance- risk, timing or amount of future expected cashflow;

-        Probable that entity shall recover substantially all consideration as it is entitled in exchange of contracted goods/services.

Unless and until all these criterions are met with, no contract be said to be enforceable/existent and thus, all criteria are to be repetitively assessed till all of these conditions are fulfilled except in case when the goods/services are transferred without fulfilment of said conditions only after collecting specified amount as non-refundable. In such circumstances, non-refundable consideration be recorded as revenue only when either or of below condition is satisfied:

A.     Entity does not any pending obligation to transfer goods/services to the customer and that all/substantially all consideration as promised by customer has been received as to be non-refundable; or

B.     Contract is terminated and consideration is collected as to be non-refundable.

Contract usually lasts over pre-defined term, renewable at regular intervals however, there are some contracts which could be terminated by either or party at any given point of time, which might result in stringent penalty payable by the breaching party. Such penalty is the evidence signifying that the parties involved have enforceable rights and obligations.

Two or more contracts would be required to be accounted for as one single contract only when those all contracts are entered into at or nearly same point of time and with the same customer provided one of the below conditions exists:

-          Contracts are negotiated as one package with single commercial objective;

-          Amount of consideration payable for 1 contract depends on price/performance of another contract;

-          Goods/services promised under contract happen to be one obligation only.

The contract is said to have been modified when all below 3 conditions are met with:

-           Leads to change in scope/price/both;

-           Change is approved by all the parties involved;

-           Change is enforceable

Whereincase, contract is modified, the accounting shall be effected in either or of the below stated manner:

a.     Termination of old contract and creation-recognition of new contract- This be possible only when the scope of work promised gets widened due to addition of goods/services to be delivered, which are different from existing one’s along with resultant increase in contract price i.e. equivalent to individual selling price of added goods/services; or

b.     Make a cumulative catch-up adjustment to original contract- This could be done in 3 probable ways: 1.) Account for modification prospectively only if newly added goods/services are different and specifically identifiable as compared earlier contracted gods/services; 2.) Account for modification on cumulative catch-up basis only when newly added goods/services are not distinct from earlier contracted one’s, which is the specifically the case for construction contracts; 3.) In situation where, out of all goods/services newly added to contract some are alike to the one’s earlier contracted and rest are different, then for the one’s that alike to earlier one’s account for via cumulative catch-up adjustment and for rest that are different give a prospective accounting effect; or

c.      Combination above two.

Performance Obligation is referred to as a promise under contract to transfer to the customer: 1. Distinct goods/services; or 2. Series of distinct goods/services which are substantially same and have same pattern of transfer.

Goods/services be regarded as distinct only when:

- Customer can benefit from goods/services on standalone basis using resource readily available;

- Goods/services are separately identifiable from other promises under contract- only if there exists no specific integration between contracted goods/services or that no originally contracted goods/services got modified due to newly added goods/services. Also, none of the goods/service under contract are inter-dependent.

There could be multiple performance obligations involved in a single contract. Once the contract’s enforceability is verified, next immediate thing to be done is to identify each and every performance obligation involved therewith. Revenue recognition relies over multiple factors of which one is fulfilment of all performance obligations contained in contract.

An amount of consideration that entity expects to be entitled to in exchange for transferring promised goods/services to the customer but excluding amounts as collected on behalf of third parties, is referred to as transaction price.

All or any combination of below 4 elements would constitute transaction price and some times it be the single element of below all that be recognized as transaction price:

Variable Consideration

Significant financing component

Non-cash Consideration

Consideration payable to customer

In case promised consideration includes variable component along side fixed component, then amount of expected consideration is to be estimated by the entity. Such variability be determined as per contract norms.

Significant component is said to be existent disregard of fact that financing component is contained in contract or not.

Sometimes customers agree to pay off for the goods/services in form other than cash such as shares of common stock, equity instruments, advertising, equipment exchange or otherwise.

Consideration payable to customer shall include all cash amounts that an entity pays/expects to pay to the customer.

Following be indicators of existence of variable consideration:

Customer has expectation from entity’s customary practices, for discount/rebate, etc.;

Existing facts and circumstances exist, which indicate entity’s intention to allow the customer certain price concession;

Entity is to consider all relevant facts & circumstances to determine whether contract contains financing component or not including below key points:

Difference, if any between promised consideration and cash selling price;

Combined effect of a. Time-gap between the date when entity fulfils all performance obligations under contract and the date when customer pays-off for all, b. prevailing interest rate in market

Existence of such component be determined by entity as below:

Initially entity is to measure non-cash consideration/component at fair value;

And if at all same cannot be reasonably estimated, then it shall measure same indirectly by referring to stand-alone selling price of goods/services as promised.

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Methods to estimate consideration amount:

Expected value= Sum of probability weighted amounts in a range of possible consideration amounts;

Most likely amount= Amount/result with high probability, out of 2 available outcomes;

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While allocating transaction price, main target of entity should be that the transaction price be allocated to each and every performance obligation identified under contract. Also, that the allocation of transaction price must be in proportion to standalone selling price identified/estimated for each and every performance obligation, except for allocation of discounts and variable components provided the standalone selling price is available individually for each of the POs.

Standalone selling price could be assessed using observable price of goods/services, whereincase entity is selling all such goods/services separately in similar circumstances to similar customers. There are several methods available for evaluating the same such as:

1.     Adjusted market assessment approach: Helpful in circumstances when promised goods/services belongs to regular market domain of entity and thus it can easily estimate a price, the customer be willing to pay for same otherwise.

2.     Expected cost plus margin approach: This method is more useful when promised goods/services under contract does not belong to regular market domain of an entity. In such circumstances entity shall estimate cost of satisfying said PO and then add up an appropriate margin to the same to evaluate the price.

3.     Residual approach: This method is particularly useful when, entity could reliably estimate standalone selling price for only a few POs out of all promised POs under a contract. In such circumstances, entity shall take total transaction price and reduce from it the sum total of identifiable standalone selling price, and difference be taken as standalone selling price of remaining POs.

Allocation of discount component:

The discount be allocated to each and every PO in proportion to standalone selling price of those POs. However, before allocating discount to each and every PO, we need to understand that whether same is to be allocated to each of them or only a few out of all. In case if all of the below criterions are fulfilled then the discount be allocated to only a few POs as identified out of all:

-        Entity regularly sells each of those goods/services under contract on standalone basis;

-        Entity also regularly sells on standalone basis a bundle of some of those goods/services at discount to standalone selling price of all those goods/services;

-        Discount as referred above being attributable to each such bundle is almost same as discount offered in overall contract.

Allocation of Variable Consideration:

Variable component of consideration be attributable to either entire contract i.e. each and every PO therewith or to the specific PO therewith. However, when it comes to allocation therewith, entity shall allocate such component to all such goods/services that form part of single PO and that too only if both below conditions are fulfilled:

a.     Terms of variable payment are pertaining to entity’s effort to fulfil a PO;

b.     That the variable payment to that particular PO only.

This is how the transaction price be allocated to various performance obligations involved in the contract.

As referred under earlier also, revenue be recognized by the entity only when all the performance obligations under contract, are discharged upto the fullest i.e. to say goods/asset/services are transferred to the customer. Transfer becomes effective only when full control of asset is passed on to the customer.

Control is the ability to direct the use of and obtain the remaining benefits from an asset. It further includes the ability to prevent others from directing use of or obtaining benefits from an asset. There could be either one-time transfer of control or the transfer could be executed over a period of time. Transfer be regarded as to be transferred over a period of time in case any of the below mentioned criteria is fulfilled:

-        Customer receives and consumes the benefits provided by the entity simultaneously; or

-        Entity’s performance creates/enhances an asset that is being controlled by customer alongside; or

-        Entity’s performance does not create an asset with alternative use to entity and that entity has enforceable right to payment for performance completed till date.

If in case control is transferred as referred above over period of time, then entity shall recognize revenue also over period of time in proportion to completion of contract.

Cost Evaluation

Contract cost comprises of 2 elements: a. Contract acquisition cost; and b. Contract fulfilment cost.

Contract acquisition cost: Entities may incur various costs to obtain or acquire a contract with a customer. Incremental costs particularly constitute of such costs that would not have been incurred had there been no contract obtained. Once entity determines the cost specifically incurred in regards to certain contract with customer, it should then check if such costs meet the capitalization criteria or else. Based on such analysis, the cost that is expected to be recovered shall be capitalized and rest all be expensed off.

Contract fulfilment cost: Any such cost as is being incurred post obtaining any contract, so as to execute the same be referred as contract fulfilment cost. If such cost is covered by any other Ind AS, same be accounted for accordingly and if not, then entity shall also recognize an asset for such cost, provided all below conditions are fulfilled:

-        Cost directly pertains to a contract or anticipated contract that entity can specifically identify such as direct labour, direct material, etc.,

-        Such cost generates/enhances resources of the entity that be used to satisfy PO in futures,

-        Entity expects to recover such costs.

Disclosure

Entity presents a contract in its balance sheet as a contract liability, contract asset or a receivable, depending on relation between entity’s performance and customer’s payment at reporting date. Revenue from contract with customers be recognized separately from its other sources of revenue. Also, it should further recognize impairment losses if any on receivables or contract assets.

LAW@GLANCE

Topics contained

Scope & Objective

Recognition & Five-Step Model

Cost Evaluation

Disclosure