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IND AS NOTES

Revenue / Income Recognition in the Software Sector - Key Changes in IND AS

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Contents

Chapter Pg. No.

Overview 1

Applicability 3

Revenue / Income Recognition 5

Accounting for Fixed Price Projects

Discounts and Volume Rebates

Bundled Services

Fair Value and Payments Received on Behalf of Third Party

Recognition of Investment Income

Performance Obligation

Intellectual Property / Licenses

Variable Consideration

Conclusion 10

Overview

India is the world's largest sourcing destination for the information technology (IT) industry, accounting for approximately 67 % of the US$ 124-130 billion market. The industry employs about 10 million workforce. More importantly, the industry has led the economic transformation of the country and altered the perception of India in the global economy. India's cost competitiveness in providing IT services, which is approximately 3-4 times cheaper than the US, continues to be the mainstay of its unique selling proposition (USP) in the global sourcing market. However, India is also gaining prominence in terms of intellectual capital with several global IT firms setting up their innovation centres in India.

The IT industry has also created significant demand in the Indian education sector, especially for engineering and computer science. The Indian IT and ITeS industry is divided into four major segments – IT services, business process management (BPM), software products and engineering services, and hardware.

The IT-BPM sector in India grew at a Compound Annual Growth Rate (CAGR) of 15 per cent over 2010-15, which is 3-4 times higher than the global IT-BPM spend, and is estimated to expand at a CAGR of 9.5 per cent to US$ 300 billion by 2020.

India is the topmost offshoring destination for IT companies across the world. Having proven its capabilities in delivering both on-shore and off-shore services to global clients, emerging technologies now offer an entirely new gamut of opportunities for top IT firms in India. Social, mobility, analytics and cloud (SMAC) are collectively expected to offer a US$ 1 trillion opportunity. Cloud represents the largest opportunity under SMAC, increasing at a CAGR of approximately 30 per cent to around US$ 650-700 billion by 2020. The social media is the second most lucrative segment for IT firms, offering a US$ 250 billion market opportunity by 2020. The Indian e-commerce segment is US$ 12 billion in size and is witnessing strong growth and thereby offers another attractive avenue for IT companies to develop products and services to cater to the high growth consumer segment.

India Inc is currently bracing to deal with various changes in the regulatory and reporting landscape including Ind AS ( IFRS Converged Indian Standards ), Goods and Service Tax, Income Computation and Disclosure Standards and Companies Act 2013 among others. As India stands at the threshold of adopting Ind AS, the industry and professionals have started identifying and taking stock of the key areas which would impact the financial results of a company.

Revenue / Income Recognition in the Software Sector Page 2

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Applicability

In the presentation of the Union Budget 2014–15, the Honourable Minister for Finance, Corporate Affairs and Information and Broadcasting proposed the adoption of Ind AS. In accordance with the Budget statement, the MCA has notified Company (Indian Accounting Standard) Rules 2015 vide its G.S.R dated 16 February 2015 which includes 39 Indian Accounting Standards (Ind AS) to be applied by select class of companies as specified in the notification. As per the notification, Ind AS shall be applicable in phase wise manner as under:

Phase-1 Applicable from 1 April 2016 - Mandatory Companies listed/in process of listing on stock exchange in India or outside India and having networth

of Rs. 500 Crores or more. Unlisted Companies having networth of Rs. 500 Crores or more. Parent, Subsidiary, Associates and JV of above. Phase-2 Applicable from 1 April 2017 - Mandatory All Companies which are listed/or in process of listing on stock exchange in India or outside India

(Companies listed on SME exchange to be excluded). Unlisted Companies having networth of Rs. 250 Crores or more. Parent, Subsidiary, Associates and JV of above.

Phase Year of Adoption Comparative year

Phase-I FY 2016-17 FY 2015-16

Phase-II FY 2017-18 FY 2016-17

Voluntary adoption FY 2015-16 or thereafter FY 2014-15 or thereafter

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Revenue / Income Recognition

This article deals with changes under Ind AS that significantly affect the accounting of revenue by Indian software/technology (IT/ITeS) companies. In addition to revenue recognition, this article also deals with recognition of investment income. 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 scrutinised 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. As of now, there is an ambiguity on the impact of IndAS, as well! The implementation of IFRS 15 (Revenue from Contract with Customers) has been deferred to 2018, and the date of implementation of corresponding Ind AS 115 is unclear since in September 2015, the National Advisory Committee on Accounting Standards (NACAS) has recommended to the Ministry of Corporate Affairs to defer the implementation of Ind AS 115. In the interim, the Institute of Chartered Accountants of India (ICAI) has issued exposure drafts of Ind AS 11 (Construction Contracts) and Ind AS 18 (Revenue) corresponding to the currently effective IFRS. For a bird’s eye view, AS-9, revenue recognition mainly focuses on the timing of recognition of revenue based on the transfer of risk and rewards of ownership. Uncertainties regarding the determination of the amount, or its associated costs are considered as influence in determining the timing of revenue recognition. Ind AS 18 also echoes the same principles for timing the recognition but requires revenue to be measured at fair value of the consideration received or receivable. Ind AS 115 moves away from the concept of transfer of risk and rewards and defines a five step framework for revenue recognition based on transfer of control which requires among other things determination of mutual enforceability of a contract, identification of performance obligation of each of the parties to the contract and allocation of the transaction price to the performance of the obligations. Given the above background, and for the purpose of the following analysis, the assumption is that companies adopting Ind AS would need to converge with Ind AS 11 and Ind AS 18 as a first step and later converge with Ind AS 115. Companies would need to keep a watch on development in this area and factor this uncertainty in their Ind AS implementation project. In the light of the above, let us look at the key areas that will have implications for IT/ITeS companies, in

particular:

1.0 Convergence to IND AS 18

1.1 Accounting for Fixed Price Projects

It is common for software companies to enter into fixed price projects (FPPs) with a series of milestones. Some software companies recognise revenue under completed service contract method as per AS9, especially in regard to milestones. So until a milestone is complete, the revenue is not recognised. This method of revenue recognition is conservative and does not typically require a judgement with regard to the extent of remaining work to complete the project but results in lumpiness in recognition of revenue . Ind AS 18 does not recognise completed service contract method. So it would be necessary for a company to recognise revenue based on stage of completion of the transaction as per percentage of completion method. Recognition of revenue on this basis will require certain amount of discipline and judgement to be used by the company from time to time. This method will indeed provide useful information on the extent of service activity and performance during a period. To achieve this, an effective budgeting and reporting system will be necessary. When the outcome of the fixed price contract cannot be reliably estimated, Ind AS 18 requires revenue to be recognised to the extent expenses are recoverable. Hitherto, under AS 9, most companies would have carried forward such expenses as work in progress, and deferred revenue recognition.


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1.2 Discounts and Volume Rebates

As per Ind AS 18, revenue is to be recognised at the fair value of the consideration received or receivable taking into account the amount of any trade discounts or volume rebates. It is not uncommon for a software service provider to offer volume discounts to its customers. Going forward, revenue will need to be recognised after considering an estimate of volume discount. There is no ambiguity in this regard. While most companies do follow the accounting practice as above in regard to trade discounts, any interpretation to the contrary will need to converge to the Ind AS requirement.

1.3 Bundled Services

In certain instances, software companies sell bundled services, for example, development and maintenance services could be bundled or implementation and maintenance services could be bundled. In the absence of specific guidance under AS 9, companies may not be identifying the service components separately, even if the components may have different profit margins. Ind AS 18 requires the components to be separately identified under normal circumstances. So the maintenance component (as compared to the development or the implementation component) would require to be indentified, deferred and recognised as revenue over the period of maintenance only. Similarly if the software company sells equipment or licenses alongwith implementation services, the company 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. The basis on which the allocation can be done is not specified in Ind AS 18. However, Ind AS 115 does provide for a basis in this regard. There can, however, be circumstances under which the recognition criteria are applied to two or more transactions together when they are linked in such a way that the commercial effect cannot be understood without reference to both the transactions. Again, Ind AS 18 does not provide detailed guidelines in this regard, though Ind AS 115 provides clarity as detailed further in this paper.

1.4 Fair Value and Payments Received on Behalf of Third Party

Revenue is required to be measured at the fair value of the consideration received. So if the cashflow is deferred, the amount of consideration receivable will need to be recognised at its fair value by discounting future cashflows (usually based on the interest rate of the customer/obligor of the consideration payable). The difference between the fair value and the nominal value will be recognised as interest income over the period of time when the cashflows are received. Ind AS 18 clearly provides that amounts received on behalf of third parties do not result in revenue. Therefore indirect taxes (collected on behalf of the government) or out of pocket expenses charged to customer would clearly not be part of revenue of the entity going forward.

1.5 Recognition of Investment Income

It is very common for software companies to have a significant treasury income given the strong cashflows over time. As per AS 13, investments are classified as long term or current. Current investments are intended to be held for not more than one year from the date of investment, and long term investments are those that are not current. Investments are carried in the books at cost under normal circumstances unless there is a diminution in value of a long term investment or the fair value of a current investment is lower than the cost. As a result, appreciation in value of say an investment in a growth mutual fund or a fixed maturity plan is not recognised overtime. Instead there is a lumpy recognition of income from such investments on maturity. There will be a significant change under Ind AS 109 going forward. Investments will need to be recognised at either fair value or amortised cost. In either of the circumstances, income would accrue over time on such investment either in the P&L or Other Comprehensive Income (OCI) of the company.


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In case of debt instruments, that are not intended to be traded (i.e. the objective is not to sell the investment prior to maturity), the periodic recognition of the asset will be based on amortised cost (i.e. by accruing the effective interest on the instrument) over the period of holding. For other debt instruments, the periodic recognition of the asset will be at fair value and the gains or losses would be recognised in OCI. However, at the time of initial recognition, the company may irrevocably designate that it will measure the fair value through profit and loss account, rather than OCI, if this reduces a measurement inconsistency. Investment in equity instruments would be recognised at fair value through P&L. However, the company may irrevocably chose to measure changes in the carrying value of the investment through OCI, at the time of initial recognition, if such investment is neither held for trading nor is the same a consequence of contingent consideration arising out of business combination.

2.0 Convergence to IND AS 115

Ind AS 115 provides clarity on following aspects that are worth noting:

2.1 Performance Obligation

The standard indicates that an entity must determine at contract inception whether it will transfer control of a promised good or service over time. If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time. Three scenarios are specified in which revenue will be recognised over time – broadly, they are when:

i. the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.

ii. the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. An example would be installing network equipment on the customer’s premises, if the customer controls the equipment during the installation period.

iii. 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. An example would be significantly customising an asset to the customer’s specifications and the entity also has a right to payment for performance completed to date. As a result of the customisation, it is less likely that the entity would be able to use the asset for another purpose (e.g., sell to a different customer) without incurring significant costs to re-purpose the asset.

If revenue is to be recognised over time, a single method (either an input method or an output method) should be used which best reflects the pattern of transfer of goods or services to the customer. If a transaction does not fit into any of the three scenarios described above, revenue will instead be recognised at a point in time, when control passes to the customer. Many technology companies provide their customers post contract services (PCS) or maintenance i.e. a right to receive services or unspecified product upgrades/enhancements, offered on ‘when-and-if available’ basis or both offered to customers after the software license period begins or other time provided for by PCS arrangement. Ind-AS 115 requires an entity to evaluate the contractual terms and its customary business practices to identify all the promised goods or services within the contract and determine which of those promised goods or services will be treated as separate performance obligations. A good/service is distinct if the good/service is capable of being distinct (the customer can benefit from the good/service on its own or together with other readily available resources) and the good/service is distinct within the context of the contract (i.e., the good or service is separately identifiable from other promises in the contract). A promised good or service that an entity determines is not distinct is combined with other goods or services until a distinct performance obligation is formed.


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2.2 Intellectual Property / Licenses

Entities that license their IP to customers will need to determine whether the licence transfers to the customer ‘over time’ or ‘at a point in time’. A licence that is transferred over time allows a customer access to the entity’s IP as it exists throughout the licence period–such revenue is recognised over time. Licence provides right to access IP if all of the following criteria are met: The licensor performs activities that significantly affect the IP. The rights expose the customer to the effects of these activities. The activities are not a separate good or service. Licences transferred at a point in time allow the customer the right to use the entity’s IP as it exists when the licence 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 licence is granted. The standard includes several examples to assist entities making this assessment. In certain circumstances, this could result in change from current practice.

2.3 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. For example, where an entity agrees to transfer control of a good or service in a contact with customer at the end of 30 days for Rs. 1,00,000 and if it exceeds 30 days, the entity is entitled to receive only Rs. 95,000, the reduction of Rs. 5,000 shall be regarded as variable consideration. In other cases, the transaction price shall be considered as fixed. 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 India Inc, 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. 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.

Similarly there will be implications of Ind-AS 115 in other areas for technology industry such as accounting for contract modifications, warranties, customer options, non-refundable upfront fees.


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CONCLUSION

Technology entities should gain an understanding of Ind-ASs and evaluate how it will affect their specific accounting policies and practices. Entities should perform a preliminary impact assessment so they can determine how to prepare to implement the new standards. While the effect on entities will vary, some may face significant changes in accounting. All entities will need to evaluate the requirements of Ind-ASs and make sure they have processes and systems in place to collect the necessary information to implement the standards and make the required disclosures. The experiences of companies that have already been through an IFRS conversion globally have demonstrated that making strategic decisions early in the project prevents duplication of effort, changes in direction, and cost overruns at a later stage.

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an association governed by article 60 et seq of the Civil Code of Switzerland whose seat is in Zug.

This publication is general in nature. In this publication, we have summarized the changes under Ind AS that significantly affect the accounting of

revenue by Indian software/technology (IT/ITeS) companies, on the background of deferment of IFRS 15 and the likely deferment of IND AS 115. It

may be noted that nothing contained in this publication should be regarded as our opinion and facts of each case will need to be analyzed to

ascertain applicability or otherwise of the respective circulars and notifications and appropriate professional advice should be sought for

applicability of legal provisions based on specific facts. We are not responsible for any liability arising from any statements or errors contained in

this publication.

5 January 2016

© RSM International Association, 2016

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