An Insight into Practical Application Experience of Implementing Ind AS 115 by EY India

An insight into practical application experience of implementing Ind AS 115

Contents Preface..........................................................................................................................3 Major challenges faced by companies on implementation of Ind AS 115................................................................................................................4 1. Evaluation of whether certain contracts are scoped in Ind AS 115..........................5 2. Identification of performance obligation...............................................................6 3. Satisfaction of performance obligation.................................................................6 4. Application of PoCM............................................................................................7 5. Contract costs.....................................................................................................8 6. Timing of revenue recognition..............................................................................9 7. Expected credit loss (ECL) on unbilled receivables.................................................9 8. Determination of transaction price.....................................................................10 9. Warranty...........................................................................................................11 10. Contract modification......................................................................................11 Way forward................................................................................................................12 2

| An insight into practical application experience of implementing Ind AS 115

Preface 0n 28 May 2014, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) jointly issued a largely converged new revenue standard, Revenue from Contracts with Customers (numbered as IFRS 15 and ASC 606, respectively) that supersedes virtually all revenue recognition requirements in legacy International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles adopted by the U.S. Securities and Exchange Commission (US GAAP). The standard provides accounting requirements that apply to all revenues arising from contracts with customers (unless the contracts are in the scope of other IFRSs or US GAAP requirements, such as International Accounting Standard (IAS) 17 Leases). Internationally, this standard is applicable for reporting periods beginning on or after 1 January 2018.

In the Indian scenario, the Ministry of Corporate Affairs (MCA) notified Ind AS 115 (corresponding to IFRS 15) on 28 March 2018, which came into effect from 1 April 2018 . Ind AS 115 replaces Ind AS 11 (Construction Contracts) and Ind AS 18 (Revenue). It is a single source of revenue guidance for entities across industries. The new standard is a significant change in approach, is principle-based and provides more application guidance than the current Ind AS. Despite getting notified in March, the new revenue standard’s implementation was successful due to the enthusiasm and commitment shown by the corporates along with the backing of the regulators and professionals.

EY survey (Refer IFRS developments Issue 126 of May 2017) of annual financial statements for the year 2016 of 207 Fortune 500 IFRS preparers revealed that 33% companies qualitatively disclosed aspects of the standard that could have a significant effect on the financial statements. The top 10 most commonly mentioned topics in qualitative disclosures that entities believe will have an effect are:

Identifying performance obligations

45% 39%

Expected change in timing of revenue recognition Contract cost requirements

33% 28%

Changes in presentation Variable consideration requirements

26%

Disclosure requirements

25%

Principal vs agent considerations Allocating the transaction price

22% 14%

Licensing application guidance

12%

Identifying the contract/contract modiďŹ cations

12%

Other topics mentioned included customer options for additional goods or services, non-refundable upfront fees, and measures of progress over time.

Now that listed Indian companies have implemented Ind AS 115, we bring out the areas which impacted Indian corporates, practical challenges faced by these companies while implementing the new revenue standard and areas of focus for corporates going forward.

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Major challenges faced by companies on implementation of Ind AS 115

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| An insight into practical application experience of implementing Ind AS 115

Ind AS 115 creates a single source of revenue requirements for all entities in all industries. The new revenue standard is a significant change from legacy revenue standard. It affects all entities that enter into contracts to provide goods or services to their customers, unless the contracts are in the scope of other Ind AS requirements, such as the leasing standard. Hence, the key apprehensions of all stakeholders about the implementation of Ind AS 115 was whether it will significantly impact the revenue of companies. However, from the results published by the Indian listed companies, it seems that the impact was not pervasive but restricted to a few sectors only, with real estate sector being the most affected one. One of the reasons for companies not having felt the impact might be due to the election of modified retrospective approach of transition to Ind AS 115, wherein the said standard is applied only to contracts that are not completed contracts as at 1 April 2018 – the proportion of such contracts may not be significant for these companies. Hence, the impact felt in this quarter may not be an accurate reflection of the actual impact of the standard. To understand the real challenges faced by these companies, we bring an insight into the practical experience of implementing Ind AS 115:

1. Evaluation of whether certain contracts are scoped in Ind AS 115 Ind AS 18 did not consider barter of similar items as revenue generating activity. However Ind AS 115 does not consider any non-monetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers as revenue generating transaction. The new revenue recognition standard does not provide an elaborate guidance on the meaning of “non-monetary exchanges” and “same line of business”.

In absence of any specific guidance, Indian companies were required to exercise significant judgement to decide whether Ind AS 115 applies to barter transactions entered by them. We witnessed diversity in interpretation of these requirements and observed different views been adopted by the companies.

Following are some examples of contracts where companies faced interpretation challenges: a) Area sharing contracts entered by real estate developers with landowner b) Capacity swap/indefeasible right of use (IRU) arrangements for minutes/bandwidth by various telecom companies c) Contracts to sell broadcasting rights in return for advertisement spots in media companies In many of the above arrangements, contracts of buying and selling were entered into with same counterparty, invoices were raised for gross amount and settlement was either done on net or on gross basis. The critical question that arose was whether these nature of transactions should be considered as “non-monetary exchanges” especially if the invoices are raised separately for gross amount and cash was exchanged on either gross or net basis?

In the absence of a specific definition of “same line of business”, divergent views were observed. For example, some real estate players considered landowners not in the same line of business and considered the contracts with them as covered within the scope of Ind AS 115.

No specific disclosures are mandated in quarterly results by regulators and standard setters. We did not observe any specific disclosures in quarterly financial results of sectors like real estate, telecom or media companies on the scoping-related judgements and estimates. However, companies may need to provide elaborate disclosures about estimates and judgements with respect to material barter arrangements in the annual financial statements for some of the matters discussed above.

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2. Identification of performance obligation Ind AS 115 requires an entity to identify separate performance obligations in a contract, i.e., the promised goods and services, and then allocate the transaction price to them. Unlike legacy standard on revenue, which did not define elements/deliverables, the new standard provides guidance on the types of items that may be goods or services promised in the contract. It specifies a two-step model for identification of the performance obligation, i.e., (a) Distinct on its own (b) Distinct in context of the contract. Evaluation of whether a particular obligation is a separate performance obligation depends not only on whether the specific obligation has a stand-alone value but also on the amount of significant integration, customization and inter-dependency on other obligations.

This is one area which impacted many companies and even resulted in changing the accounting policies that were followed by a few companies under the erstwhile Ind AS 18. For example, we noticed an Indian natural gas distribution company deferred its connection, service and fitting income over a period of time from at a point in time, presumably because it did not fit the criteria of a separate performance obligation.

A project and product company has identified construction of Reverse Osmosis (RO) plant, sewage water treatment plant and biogas plant under the same contract as three different performance obligations affecting the timing of revenue recognition. Under Ind AS 18, it was treated as one performance obligation.

A large build-operate-transfer road asset company identified operation services and maintenance services as separate performance obligations.

An engineering company identified various different performance obligations like sale of product, sale of spares, commissioning, supervision and maintenance. Consequently, it also changed its accounting policy to recognizing revenue over a period of time.

An Indian multinational pharmaceutical company had to reverse the income recognized in earlier periods in relation to “out-licensing agreements” as it did not meet the separate performance obligation criteria.

Assessment of performance obligation using the two-step model in Ind AS 115 is fundamental to revenue recognition. It requires companies to establish a process to ensure that principles of two-step model are applied appropriately on an on-going basis. This will be extremely challenging in sectors like engineering, construction and technology where each contract is unique. Companies need to institute strong internal controls to ensure that performance obligations are identified appropriately and principles are applied consistently across the organization.

3. Satisfaction of performance obligation Ind AS 115 gives out a detailed guidance on when a performance obligation is satisfied – “at a point in time” or “over a period of time”. The guidance is equally applicable to goods, services and construction contracts. Paragraph 35 of the standard lists down three criteria, any one of it, if fulfilled, would mean that the control is being transferred over a period of time – a) The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs; b) The entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as an asset is created or enhanced; or c) The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

Companies have majorly faced issues in the application of the third criterion wherein the agreement between the parties is not clear about the enforceable right to payment for performance completed 6

| An insight into practical application experience of implementing Ind AS 115

to date. Further, the enforceability is a matter of law of the land for example – The Sale of Goods Act, 1930, Indian Contract Act, 1872, legal precedents, etc. Significant judgment is required to conclude on enforceability of payments in most of these cases.

Some of the automotive component manufacturers that were recognizing revenue from tooling based on its recovery through sale of products have now changed their accounting policy to recognize the revenue from tooling over the period of manufacture of those tools. This was possible as these tools did not have an alternative use to the entity and the entity had the right to payment as per the management’s judgement.

Similarly, real estate companies have experienced a significant impact due to this change. Companies from real estate sector have largely failed to satisfy the enforceability of right to payment condition to recognize revenue over a period of time, i.e., percentage of completion method (PoCM). The judgement on enforceability involved study of Real Estate (Regulation and Development) Act, 2016, relevant state rules of real estate regulatory authority, legal precedents, etc. Hence, companies have had to change its revenue recognition policy to “at a point in time”, leading to a net decrease in the net worth as on 31 March 2018 of more than INR5,000 crore in one of the company.

Majority of engineering and construction companies required extensive evaluation of their contract terms especially termination clauses and whether they are entitled to recover cost incurred with reasonable margin for the work done by them on an ongoing basis. In many contracts, terms were not explicit and required companies to exercise judgement after involving their legal experts. Many companies are relooking at the contract terms to ensure that the contract terms are explicit so that they face no hurdles for revenue recognition on PoCM basis.

4. Application of PoCM When an entity has determined that a performance obligation is satisfied over a period of time, the standard requires the entity to select a single revenue recognition method for the relevant performance obligation that faithfully depicts the entity’s performance in transferring the control of the goods or services. The standard provides two methods for recognizing the revenue on contracts involving the transfer of goods and services over a period of time: input methods and output methods. It seems that most companies are comfortable with input method, i.e., the cost incurred method for measuring the progress.

One of the significant changes from erstwhile revenue standard is the requirement relating to uninstalled material, i.e., when goods are delivered to a customer site, but the entity has not yet integrated the goods into the overall project (e.g., the materials are “uninstalled”). In such circumstances (e.g., when control of the individual goods has transferred to the customer, but the integration service has not yet occurred), an entity is required to recognize revenue at an amount equal to the cost of the goods used to satisfy the performance obligation (i.e., a zero margin). Margin adjustment is required under Ind AS 115 only for a significant bought-out items where company is not involved in designing the product.

This issue is all pervasive for sectors like engineering and construction, technology sectors, wherein supply of bought out items are a significant component of the overall contract. For e.g., a) Supply of transformers in turnkey projects to electrify cluster of villages b) Supply of turbines in contracts to construct power plant Critical judgement which companies need to decide is what constitutes “significant bought-out items”. There are no bright lines given in the standard. Hence companies need to frame thresholds to identify significant bought-out items to ensure that no margin is recognized on such items while applying PoCM. These may require changing systems and processes if PoCM is done through Enterprise Resource Planning software (ERPs).

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Real estate companies following PoCM method of revenue recognition are also facing challenges in deciding on when to start recognizing revenue in the absence of bright lines (that were provided by erstwhile “Guidance Note on Accounting for Real Estate Transactions” (for entities to whom Ind AS is applicable)). Furthermore, whether cost of land would be a part of the cost incurred or would it be allocated in proportion to the construction cost incurred is another challenge these entities are facing.

However, most of the real estate entities have largely considered satisfaction of performance obligation at a point in time thereby not having an impact of the above issue.

A multinational construction engineering company changed its manner of application of PoCM from an output method (milestone-based method) to input method (cost-incurred method) on implementation of Ind AS 115.

5. Contract costs Ind AS 115 specifies the accounting treatment for costs that entity incurs to obtain and fulfil a contract to provide goods and services to customers.

The incremental costs of obtaining a contract with a customer are recognized as an asset if the entity expects to recover them. Incremental costs are those that an entity would not have incurred if the contract had not been obtained. Some common examples are: a) Commissions that are related to sales from contracts signed during the period may represent incremental costs and hence require capitalization. b) Site preparation cost in case of construction and engineering companies. c) Specific training costs required to be incurred by outsourcing companies.

In many cases, there was no impact since contract costs of obtaining and fulfilling were not material.

However, we observed some material impact in a few sectors – for example •

•

•

•

An Indian information technology company had an impact of more than INR200 crore on the net worth as on 31 March 2018 primarily due to certain contract costs not meeting the criteria for recognition as costs to fulfil a contract.

A major auto component company considered designing activity costs as contract fulfilment costs and hence deferred the cost over the period of the contract.

A multinational technology company considered bonus paid to sales team for contract acquisition as contract costs.

A real estate company considered sales commission paid to brokers as contract acquisition cost and amortized it over the life of the contract.

This is a significant change in the practice for entities that previously expensed the costs of obtaining a contract and will be required to capitalize them under the new standard. The new revenue standard will also require a change in the practice for entities that have historically amortized sales commissions over the non-cancellable term of the initial contract or expensed them off. Under Ind AS 115, entities will be required to evaluate whether the period of benefit is longer than the terms of the initial contract. It will be important for entities to document the judgements they make when determining the appropriate amortization period and disclose the same in their financial statements.

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| An insight into practical application experience of implementing Ind AS 115

6. Timing of revenue recognition The key difference between Ind AS 18 and Ind AS 115 is timing of revenue recognition. Ind AS 18 requires revenue on transfer of significant risks and rewards of goods and services. Ind AS 115 mandates revenue recognition of transfer of control. It lays down following criterion to evaluate the transfer of control: •

The entity has a present right to payment for the asset if a customer is presently obliged to pay for an asset

•

The customer has legal title to the asset

•

The entity has transferred physical possession of the asset

•

The customer has the significant risks and rewards of ownership of the asset

•

The customer has accepted the asset

Shift in the recognition criterion from “transfer of risks and rewards” to “transfer of control” required a detailed evaluation in many cases across sectors. For example: a) A significant judgement was required to assess at what point does transfer of control of goods happen in cases where terms of contract provides an unlimited right of return to their customers – e.g., sales made by consumer product companies to their retail counterparts. A large retail company disclosed reduction of revenue due to sales and return arrangements in quarter ended 30 June 2018. b) Sales made on cost-insurance-freight (CIF) basis – whether transfer of control happens when goods are loaded on to ship or when goods reach the ultimate destination. A large steel company assessed that control of goods gets passed on free-on-board (FOB) basis. c) Sale and repurchase agreement – sale of raw material to contract manufacturer with back to back arrangement to purchase the finished goods. This is very common in pharma, steel and consumerproduct industries. Ind AS 115 clearly states that a company cannot recognize revenue on sale of goods if it has a repurchase obligation to take back the same goods or an asset that is substantially the same as the asset that was originally sold, or another asset of which the asset that was originally sold is a component. Many companies having contract manufacturing arrangements required a detailed assessment of whether an arrangement with contract manufacturer was on principal basis or was a job work contract.

7. Expected credit loss (ECL) on unbilled receivables Ind AS 115 requires an entity to assess a contract asset (including unbilled receivables) for impairment as per Ind AS 109 Financial Instruments using ECL method. ECL is measured in a way that reflects: a) An unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes; b) The time value of money; and c) Reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions Under the erstwhile standard, there was diversity in practice. Some companies used to provide for impairment on unbilled receivables along with other financial assets. Ind AS 115 has clarified beyond doubt that all contract assets need to be tested for impairment using principles of Ind AS 109.

Engineering companies have experienced a significant impact due to the recognition of impairment loss on

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unbilled receivables. One of the large engineering companies have done incremental provisions exceeding INR50 crore in their opening retained earnings for the quarter ended 30 June 2018.

8. Determination of transaction price a) Variable consideration If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer. An amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items.

If an entity determines at contract inception that a contract includes a price concession (i.e., variable consideration), any change in the estimate of the amount the entity expects to collect, absent an identifiable credit event, will be accounted for as a change in the transaction price.

Common examples of variable consideration includes liquidated damages and incentives. Most liquidated damages, penalties and similar payments are accounted for as variable consideration and reduced from revenue. Companies, especially engineering companies, that were earlier accounting for penalties/liquidated damages as cost, are evidencing a change in accounting policies. This is also relevant for real estate entities, where the percentage of work completed would change when such penalties are reduced from revenue instead of considering it as costs.

Similarly, the option to purchase additional goods or services given by retail and consumer products entities to customers is treated as a separate performance obligation if it provides a material right that the customer would not receive without entering into the contract. If the discounted price offered in the option reflects the stand-alone selling price, the entity is deemed to have made a marketing offer, rather than having granted a material right. The standard states that this is the case even if the option can be exercised only because the customer entered into the earlier transaction. The assessment of whether the entity has granted its customer a material right requires a significant judgement and affects revenue to be recognized for satisfied performance obligation. b) Significant financing component For some transactions, the receipt of the consideration does not match the timing of the transfer of goods or services to the customer (e.g., the consideration is prepaid or is paid after the services are provided). When the customer pays in arrears, the entity is effectively providing financing to the customer. Conversely, when the customer pays in advance, the entity has effectively received financing from the customer. However, Ind AS 115 gives a practical expedient that an entity is not required to adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less. Significant judgment will be required by entities to decide whether the practical expedient applies to the contracts entered into by the entities. Further, the standard also mentions certain situations that do not provide the customer or the entity with a significant benefit of financing, as below: i.

The customer has paid for the goods or services in advance and the timing of the transfer of those goods or services is at the discretion of the customer.

ii. A substantial amount of the consideration promised by the customer is variable and is based on factors outside the control of the customer or entity. iii. The difference between the promised consideration and the cash selling price of the good or

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| An insight into practical application experience of implementing Ind AS 115

service arises for reasons other than the provision of financing to either the customer or the entity (e.g., a payment is made in advance or in arrears in accordance with the typical payment terms of the industry or jurisdiction).

Entities will have to exercise a significant judgement to determine whether a significant financing component exists when more than one year’s gap is between the transfer of goods or services and the receipt of contract consideration. Entities should consider sufficiently documenting their analyses to support their conclusions.

Engineering companies accept significant amounts as mobilization advance, for which these entities will have to determine whether there is a significant financing element embedded in the contract in light of the available practical expedient. Similarly, indefeasible right to use (IRU) agreements, in telecommunications industry, for the use of fiber lines are typically multi-year contracts that are either prepaid in full or include large upfront payments. A telecom entity will need to evaluate whether there is a significant financing component; making this evaluation a significant change from the current practice.

9. Warranty Warranties are commonly included in arrangements to sell goods or services. They can be explicitly stated, required by law or implied based on the entity’s customary business practices. Ind AS 115 identifies two types of warranties: •

•

Warranties that promise the customer that the delivered product is as specified in the contract (called “assurance-type warranties”) Warranties that provide a service to the customer in addition to assurance that the delivered product is as specified in the contract (called “service-type warranties”)

Since assurance-type warranties do not provide an additional good or service to the customer, these types of warranties are accounted for as warranty obligations and the estimated cost of satisfying them is accrued in accordance with the requirements in Ind AS 37. On the other hand, a service-type warranty represents a distinct service and is a separate performance obligation. Therefore, using the estimated stand-alone selling price of the warranty, an entity allocates a portion of the transaction price to the service-type warranty.

A major auto component company determined its warranty as a service-type warranty resulting in a change in its measurement and recognition of revenue.

10. Contract modification Parties to an arrangement frequently agree to modify the scope or price (or both) of their contract. If that happens, an entity must determine whether the modification is accounted for as a new contract or as a part of the existing contract. Certain modifications are treated as separate stand-alone contracts, while others are combined with the original contract and accounted for in that manner. In addition, some modifications are accounted for on a prospective basis and others on a cumulative catch-up basis. This is a significant change from the erstwhile revenue standard. However, companies may not have felt an impact of this change as a large majority of companies have elected the modified retrospective approach of transition to Ind AS 115, wherein this standard is applied only to contracts that are not completed contracts as at 01 April 2018.

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Way forward

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| An insight into practical application experience of implementing Ind AS 115

This publication gives an overview of the practical challenges on implementation of Ind AS 115 by companies in India. We believe that even for the entities that have not had significant changes in the measurement and timing of revenue recognition will need to identify necessary changes to policies, procedures, internal controls and systems to ensure that revenue transactions are appropriately evaluated through the lens of the new model. In addition, entities will need to plan for the significantly expanded disclosure requirements.

Ind AS 115 provides explicit presentation and disclosure requirements, which are more detailed than under Ind AS 18/Ind AS 11 and increase the volume of required disclosures that entities will have to include in their annual financial statements. Many of the new requirements involve information that entities did not previously disclose.

Entities may be required to review their disclosures to determine whether they have met the standards’ disclosure objective to enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. For example, some entities may make large payments to customers that do not represent payment for a distinct good or service and therefore reduce the transaction price and affect the amount and timing of revenue recognized. Also, entities operating in multiple segments with many different product lines may find it challenging to gather the data needed to provide the disclosures. As a result, entities will need to ensure that they have the appropriate systems, internal controls, policies and procedures in place to collect and disclose the required information. Additionally, Ind AS 115 requires entities to present a reconciliation of the amount of revenue recognized in the statement of profit and loss with the contracted price showing separately each of the adjustments made to the contract price, for example, on account of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, etc., specifying the nature and amount of each such adjustment separately.

In light of the expanded disclosure requirements and the potential need for new systems to capture the data needed for these disclosures, we believe that entities will now have to concentrate their efforts on disclosures required in the annual report.

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| An insight into practical application experience of implementing Ind AS 115

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