25 June, 2010:
As a part of an ongoing IASB-FASB project on revenue recognition, on 24th June 2010, the IASB issued exposure draft ED/2010/6 on Revenue Recognition in Contracts with Customers. The thrust of the standard is to spread the recognition of revenue in case of any sales/service contract which creates continuing performance obligation on the part of the entity. The ED is open for comments by October – it would be an important standard once implemented. The standard will affect booking of revenues by several entities, particularly, IT companies.
Several entities selling technology products or capital equipment make sales with pay-per-use or revenue sharing models. The accounting standard will define revenue recognition by such entities as well as the revenues of such entities are clearly affected by the performance of the sold goods. It is also a common practice among technology companies, software companies, telecom companies etc to enter into separate agreements for sales and services – a sale agreement, and a separate service level agreement, with the second agreement laying a performance obligation on the seller. Despite the presence of separate agreements, the ED requires aggregation of the two contracts to identify the performance obligation attaching to the sale contract. Hence, if two contracts are negotiated as a part of a common commercial transaction, they are to be combined for applying this standard – if the prices of the two contracts are interdependent, they will be treated as a consolidated contract.
Revenue matched with performance obligations:
The key principle of the ED is contained in Para 25 – that an entity will recognize revenue from a contract when it satisfies the performance obligation underlying the contract. Sale of a goods or service may have inherent promises of performance obligations. Such elements of the seller’s obligation are transferred immediately – for example, by passing on the control of goods. But then there may be continuous obligations as well – for example, a performance obligation. If there are such obligations, the revenue arising out of sale will be attributed to the different elements of the obligations of the seller. There are various methods for splitting the consideration, such as output methods, input methods, etc.
One of the commonest examples of performance obligations is the express or implied condition on sale of a product or service – condition of fitness. A car has to be fit to be run as a car, and any manufacturer/dealer selling a car gives an explicit or implied warranty. Does it imply that on such a sale, there should be recognized a performance obligation? The answer would be –no. The ED distinguishes between obligations that cover the fitness of goods at the time of sale (fitness cover) versus obligations that cover the fitness or performance of goods subsequent to the time of sale (insurance cover). It is only in the latter case that there is deemed to exist a performance obligation.
In case of sale of goods with pay-per-use style consideration, there is clearly a performance obligation, as the sale consideration is conditional upon performance. Though the standard does not contain express provisions for such sales, the consideration shall be probability-weighted based on the broad principles of the standard.
Establishing the transaction price:
Yet another significant feature of the ED is that it lays considerations for determination of the transaction price and may cause significant change from existing practices. Hence, para 42 provides that in determination of the transaction price, the entity takes into account the following:
- Collectibility: if the price is not payable immediately, the transaction price has to be weighted by the probability of the ultimate collection of the transaction price. This will be true in case of all credit sales where substantial time for payment is given. If, for instance, the probability of collection is 99%, the sale price will only be 99% of the face value – the balance 1% will be taken as income only when the collection becomes certain or is ultimately collected.
- Time value of money: In many cases, sellers give significant time for payment – for example, interest free credit for sale, or sale on instalments, without interest. In such cases, either where there is no interest, or interest is below-market, the transaction price will be the discounted value. The discount will be unwound only over a period of time.
- Non-cash consideration: if any non cash consideration is being given by the counterparty, the value of the same will be taken into consideration.
- Consideration payable to the customer: As the customer pays consideration, there might even be consideration payable by the vendor, which may have been netted.
Allocation of transaction price to performance obligations:
The ED provides guide to the methods for allocation the consideration to performance obligations over time. That is, the transaction price of a contract involving elements of performance obligations needs to be compared with the “stand-alone” price of the goods, that is, the price without the performance obligations. If the stand-alone price is not observable, the entity shall estimate it, using cost-plus-margin approach, or adjusted market approach.
Creating liability for onerous performance obligations:
If a contract involves an onerous performance obligation, the entity shall create a liability for such obligation. An obligation is onerous, if the probability-weighted cost of the obligation is higher than the consideration payable for it. The value of this liability shall be revisited on each balance sheet date.
Licensing and right to use:
IAS 19 deals with “transfer of right to use” – license contracts are often distinguished as there is no transfer of the right to use. There is only provision of a right. The ED makes provisions about licensing and right to use contracts too.
All non-exclusive rights to use contracts, commonly called licensing contracts, will give rise to a performance obligation. Software companies are clearly covered by this clause.
Sales with buyback
Many suppliers make a sale with an agreement to buyback at a stipulated price. The buyback price is normally lower than the sale price. This agreement is taken as composed of (a) a lease contract and (b) an agreement of buyback
The lease part will be dealt with as per IAS 17 – depending on whether the lease is financial or operating ( a distinction that is soon on its way out).
There are numerous other example of variety of complex sales transactions happening in the world of commerce today. Clearly, suppliers have come closer to the business models of customers and are increasingly participating in the customer’s business. The ED is trying to capture some of structured sale products, but there are lots that it does not. And in fact, with the pace at which practices in selling goods emerge, the standard will soon be found too old. Nevertheless, it is a welcome standard.
[Reported by: Vinod Kothari]