The Famous Five
The volume and breadth of differences between Indian GAAP and Ind AS is enormous. Further, its impact will vary by industry and for each company. Ind AS will cover every area comprising reported revenues, expenses, assets, liabilities and equity. Before we get into the details of the specific differences, we think companies should be familiar with the Famous Five. In our view, companies will have to devote substantial amount of their time especially in these areas while preparing for Ind AS adoption.
We have focused on the Famous Five concepts below.
Revenue Recognition – AS 115
Consolidation – AS 110
Business Acquisition – AS 103
Financials Instruments – AS 109
Taxes – AS 12
Let us Focus on AS 115, Revenue from contracts with Customers: Let us try to understand:
What has changed Revenue recognition? Is it for good or bad?
How does it affect my financials and its outlook?
Revenue recognition
Revenue is one of the most important financial statement measures for both preparers and users of the financial statements. It is therefore an accounting topic heavily scrutinized by investors and regulators. Today, Accounting Standard (AS) 9 on Revenue Recognition does not provide comprehensive guidance for certain aspects resulting in diversity in practices under Indian GAAP. Adoption of Ind AS 115, Revenue from Contract with Customers, provides comprehensive principles for recognising revenue, which will affect mostly all entities that apply Ind AS. Companies will be required to closely analyse their business practices within the revenue cycle to identify and evaluate potential GAAP differences.
Transfer of control
Under Ind AS 115, revenue is recognised when a customer obtains control of a good or service, while under Indian GAAP, revenue is recognised when there is a transfer of risk and rewards. A customer obtains control when it has the ability to direct the use of and obtain the benefits from the good or service. Transfer of control is neither same as transfer of risks and rewards nor similar to the culmination of an earnings process as understood today. Entities will be required to apply the new guidance to determine whether revenue should be recognised ‘over time’ or ‘at a point in time’. So as the first step, a company will have to first determine whether control is transferred over time. If the answer to this question is negative, only then revenue will be recognised at a point in time, or else it will be recognised over time.
The difference between transfer of control vis-a-vis transfer of risk and reward can sometimes be subtle and at other times be stark requiring a detailed understanding of the accounting standard and customer contractual arrangements.
The five-step control model
The core principle of Ind AS 115 is that an entity will recognize revenue to depict the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services. This core principle is described in a five-step model framework:
Step 1: Identify the contract(s) with the customer
Step 2: Identify the separate performance obligations in the contract Step 3: Determine the transaction price
Step 4: Allocate the transaction price to separate performance obligations
Step 5: Recognise revenue when (or as) each performance obligation is satisfied.
Application of this guidance will depend on the facts and circumstances present in a contract with a customer and will require the exercise of judgment.
Performance obligation
Understanding what a customer expects to receive as a final product is necessary to assess whether goods or services should be combined and accounted as a single performance obligation or separate elements. Some contracts contain a promise to deliver multiple goods or services, but the customer is not purchasing the individual items. Rather, the customer is purchasing the final good or service, which is the aggregate of those individual items. The judgment, based on proper application of the principles envisaged in Ind AS 115, will determine whether a contract involves a single or multiple performance obligations.
Until now there has been limited guidance in this area of multiple elements or performance obligations under Indian GAAP. Under Ind AS, companies will have to necessarily determine whether there are multiple promises in a contract and whether those promises are distinct. The consideration will then be
allocated to multiple components and revenue recognised when those distinct goods or services are delivered, i.e. when control is transferred.
It is also to be noted that separate performance obligations may be identified based on promises in a contract which may be explicit or implicit including based on past customary business practices. Also, upon transition to Ind AS, certain previously identified multiple elements may no longer be considered as separate promises under the new standard. In our experience, this area can be quite complex. Companies should carefully understand the impact of this, as potentially upon transition some revenue may never be reported and some could be reported twice.
Variable consideration
Entities may agree to provide goods or services for consideration that varies upon certain future events, which may or may not occur. Examples include volume and cash discounts, refund rights, rebates, performance bonuses/incentives, penalties, sales returns, etc. Sometimes this is also driven by past practice of an entity or a particular industry for example a history of giving discounts or concessions after the goods/services are sold. Variable consideration is a wide term and includes all types of positive and negative adjustments to the revenue.
Under the current accounting practice, it is not uncommon to defer the revenue until the contingency is resolved. However under Ind AS, if the consideration is variable, then a company will need to estimate this variability at the inception of the contract subject to certain constraints,that is there should not be a significant revenue reversal in the future, which will be reassessed at each reporting period. Some of these concepts are new for us, as entities will have to estimate not only downward but also upward adjustments to revenue, something we are not used to. Also, this could result in earlier recognition of revenue as compared to current practice. This could affect entities in industries where variable consideration is presently not recorded until all contingencies are resolved. There is a narrow exception for intellectual property (IP) licenses where the variable consideration is a sales-or usage-based royalty, which will continue to be recognised based on sales or usage.
Another significant area of difference from the current practice will be presentation of revenue.
Upon adoption of Ind AS 115, generally all positive and negative adjustments to variable consideration discussed above will be presented as an adjustment to revenue as opposed to costs presently done for certain areas.
Allocation of transaction price based on relative Standalone selling price
Entities that sell multiple goods or services in a single arrangement (for example, sale of equipment with two year maintenance services contract) may be following different accounting practices under the current Indian GAAP. Under Ind AS 115, these entities must first evaluate whether the sale of equipment and services are two separate performance obligations, and if yes, then allocate the consideration to each of the distinct goods or services based on their relative standalone selling price. This allocation is
based on the price an entity will charge a customer on a standalone basis for each good or service sold separately. In this regard, management will follow a hierarchy to estimate the selling price. Entities will first consider observable data to determine the standalone-selling price. An entity will need to estimate the standalone selling price if such data does not exist (cost plus profit margin is an acceptable approach). Some entities may also need to determine the standalone selling price of goods or services that previously did not required this assessment.
Allocation of the transaction price to multiple performance obligations can be a matter involving significant estimate and judgment. Accordingly, a careful analysis of this aspect is required as a part of the transition to Ind AS.
Licenses
Entities that license their IP to customers will need to determine whether the license transfers to the customer ‘over time’ or ‘at a point in time’. A license that is transferred over time allows a customer access to the entity’s IP as it exists throughout the license period–such revenue is recognised over time. License provides right to access IP if all of the following criteria are met:
- The licensor performs activities that significantly affect the I P.
- The rights expose the customer to the effects of these activities.
- The activities are not a separate good or service.
Licenses transferred at a point in time allow the customer the right to use the entity’s IP as it exists when the license is granted. The customer must be able to direct the use and obtain substantially all of the remaining benefits from the licensed IP to recognise revenue when the license is granted. The standard includes several examples to assist entities making this assessment. In certain circumstances, this could result in change from current practice.
Time value of money
Some contracts provide the customer or the entity with a significant financing benefit (explicitly or implicitly). This is because performance by an entity and payment by its customer might occur at significantly different times. In such situations, under Ind AS, the entity will have to adjust the transaction price for the time value of money if the contract includes a significant financing component. The standard provides certain exceptions to applying this guidance and a practical expedient which allows entities to ignore time value of money if the time between transfer of goods or services and payment is less than one year.
Presently, under Indian GAAP, such financing benefit is not identified and separated. This aspect will impact entities which have significant advance or deferred payment arrangements.
Contract costs
Entities sometimes incur costs (such as sales commissions or mobilisation activities) to obtain or fulfill a customer contract. Contract costs that meet certain criteria will be capitalised as anasset and get amortised as revenue is recognised upon adoption of Ind AS. Such capitalised costs will require a periodic review for recoverability and impairment, if applicable. If the contract period is a year or less, then as a practical expedient, such capitalisation may not be required.
Presently, under Indian GAAP, such costs are generally expensed as incurred. This will result in more cost deferral for long-term type of arrangements.
Presentation
Ind AS includes more guidance on gross versus net presentation(including items such as excise duty, other charges, etc). Some of this could change the presentation of revenue upon adoption of Ind AS.
Disclosures
Extensive disclosures are required to provide greater insight into both, revenue that has been recognised and revenue that is expected to be recognised in the future from existing customer contracts. Quantitative and qualitative information will have to be provided about the significant judgments and changes in those judgments made while recording revenue.
This article is contributed by Partners of SBS and Company LLP – Chartered Accountant Company You can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it.
