Case Study: Revenue Recognition

FCS Deepak Pratap Singh , Last updated: 28 August 2024
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QUESTION

The entity ABC is a public limited company domiciled in India. The Government of India holds 52% in the paid-up equity capital of the company as of 31st March, 2023. The entity is into the production of LPG and transmission of natural gas and LPG through pipelines. The transmission of natural gas during the year was 115.68 MMSCMD, and liquefied petroleum gas (LPG) was 5.162 MMTPA. The entity is facing difficulty in determining the timing of satisfaction of performance obligation to recognize revenue in its books.

Identifying Performance Obligations

PARA 22 OF IND AS 115: At contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either:

(a) a good or service (or a bundle of goods or services) that is distinct; or

(b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer (see paragraph 23).

PARA 23: A series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met:

(a) Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria in paragraph 35 to be a performance obligation satisfied over time; and

(b) In accordance with paragraphs 39-40, the same method would be used to measure the entity's progress towards complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.

PROMISES IN CONTRACTS WITH CUSTOMERS

PARA 24: A contract with a customer generally explicitly states the goods or services that an entity promises to transfer to a customer. However, the performance obligations identified in a contract with a customer may not be limited to the goods or services that are explicitly stated in that contract. This is because a contract with a customer may also include promises that are implied by an entity's customary business practices, published policies, or specific statements if, at the time of entering into the contract, those promises create a valid expectation of the customer that the entity will transfer a good or service to the customer.

PARA 25: Performance obligations do not include activities that an entity must undertake to fulfill a contract unless those activities transfer a good or service to a customer. For example, a service provider may need to perform various administrative tasks to set up a contract. The performance of those tasks does not transfer a service to the customer as the tasks are performed. Therefore, those setup activities are not a performance obligation.

DISTINCT GOODS OR SERVICES

PARA 26: Depending on the contract, promised goods or services may include, but are not limited to, the following:

(a) sale of goods produced by an entity (for example, inventory of a manufacturer);

(b) resale of goods purchased by an entity (for example, merchandise of a retailer);

(c) resale of rights to goods or services purchased by an entity (for example, a ticket resold by an entity acting as a principal, as described in paragraphs B34-B38);

(d) performing a contractually agreed-upon task (or tasks) for a customer;

(e) providing a service of standing ready to provide goods or services (for example, unspecified updates to software that are provided on a when-and-if-available basis) or of making goods or services available for a customer to use as and when the customer decides; (f) providing a service of arranging for another party to transfer goods or services to a customer (for example, acting as an agent of another party, as described in paragraphs B34-B38);

(g) granting rights to goods or services to be provided in the future that a customer can resell or provide to its customer (for example, an entity selling a product to a retailer promises to transfer an additional good or service to an individual who purchases the product from the retailer);

(h) constructing, manufacturing, or developing an asset on behalf of a customer;

(i) granting licenses (see paragraphs B52-B63); and

(j) granting options to purchase additional goods or services (when those options provide a customer with a material right, as described in paragraphs B39–B43).

PARA 27: A good or service that is promised to a customer is distinct if both of the following criteria are met:

(a) The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (i.e., the good or service is capable of being distinct); and

(b) The entity's promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (i.e., the good or service is distinct within the context of the contract).

PARA 28: A customer can benefit from a good or service in accordance with paragraph 27(a) if the good or service could be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits. For some goods or services, a customer may be able to benefit from a good or service on its own. For other goods or services, a customer may be able to benefit from the good or service only in conjunction with other readily available resources. A readily available resource is a good or service that is sold separately (by the entity or another entity) or a resource that the customer has already obtained from the entity (including goods or services that the entity will have already transferred to the customer under the contract) or from other transactions or events. Various factors may provide evidence that the customer can benefit from a good or service either on its own or in conjunction with other readily available resources. For example, the fact that the entity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources.

PARA 29: Factors that indicate that an entity's promise to transfer a good or service to a customer is separately identifiable (in accordance with paragraph 27(b)) include, but are not limited to, the following:

(a) The entity does not provide a significant service of integrating the good or service with other goods or services promised in the contract into a bundle of goods or services that represent the combined output for which the customer has contracted. In other words, the entity is not using the good or service as an input to produce or deliver the combined output specified by the customer.

(b) the good or service does not significantly modify or customize another good or service promised in the contract. (c) the good or service is not highly dependent on, or highly interrelated with, other goods or services promised in the contract. For example, the fact that a customer could decide not to purchase the good or service without significantly affecting the other promised goods or services in the contract might indicate that the good or service is not highly dependent on, or highly interrelated with, those other promised goods or services.

PARA 30: If a promised good or service is not distinct, an entity shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation.

SOLUTION: As per paragraph 31 of Ind AS 115, an entity shall recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service (i.e., an asset) to a customer. An entity 'transfers' a good or service to a customer when (or as) the customer obtains control of that asset.

As per para 32 of Ind AS 115, for each performance obligation identified in accordance with paragraphs 22-30, an entity shall determine at contract inception whether it satisfies the performance obligation over time (in accordance with paragraphs 35-37) or satisfies the performance obligation at a point in time (in accordance with paragraph 38). If an entity does not satisfy a performance obligation over time, the obligation is satisfied at a point in time.

Further, paragraph 35 of Ind AS 115 states that "an entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met:

(a) the customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs (see paragraphs B3-B4);

(b) the entity's performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced (see paragraph B5); or

(c) The entity's performance does not create an asset with an alternative use to the entity (see paragraph 36), and the entity has an enforceable right to payment for performance completed to date (see paragraph 37)".

Revenue is recognized at a point in time if it does not meet the above criteria.

As mentioned above, paragraph 35 gives three criteria for recognition of revenue over a period of time. In the given fact pattern, revenue recognition has been evaluated considering the criteria under paragraph 35(a).

Paragraph 35(a): The customer simultaneously receives and consumes the benefits of the entity XYZ's performance in supplying natural gas/LPG through pipelines.

Consequently, the criteria mentioned in paragraph 35(a) are met, and entity ABC has two performance obligations that it satisfies over time. To recognize revenue for these two performance obligations satisfied over time, entity ABC should measure its progress toward complete satisfaction of its performance obligation in accordance with paragraphs 39-45 and paragraph B14-B19.

Appropriate methods of measuring progress include output methods and input methods.

As per para B15 of Ind AS 115, output methods recognize revenue on the basis of direct measurements of the value to the customer of the goods or services transferred to date relative to the remaining goods or services promised under the contract. E.g., milestones reached, units produced or units delivered, etc.

As per para B18 of Ind AS 115, input methods recognize revenue on the basis of the entity's efforts or inputs to the satisfaction of a performance obligation (for example, resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used) relative to the total expected inputs to the satisfaction of that performance obligation.

In determining the appropriate method, the entity shall consider the nature of the good or service that the entity promised to transfer to the customer.

Satisfaction with Performance Obligations

PARA 31: An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e., an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.

PARA 32: For each performance obligation identified in accordance with paragraphs 22-30, an entity shall determine at contract inception whether it satisfies the performance obligation over time (in accordance with paragraphs 35-37) or satisfies the performance obligation at a point in time (in accordance with paragraph 38). If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.

PARA 33: Goods and services are assets, even if only momentarily, when they are received and used (as in the case of many services). Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of and obtaining the benefits from an asset. The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly in many ways, such as by:

(a) using the asset to produce goods or provide services (including public services);

(b) using the asset to enhance the value of other assets;

(d) selling or exchanging the asset;

(e) pledging the asset to secure a loan; and

(f) holding the asset.

PARA 34: When evaluating whether a customer obtains control of an asset, an entity shall consider any agreement to repurchase the asset (see paragraphs B64–B76). Performance obligations are satisfied over time.

PARA 35: An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time if one of the following criteria is met:

(a) the customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs (see paragraphs B3-B4);

(b) the entity's performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced (see paragraph B5); or

(c) the entity's performance does not create an asset with an alternative use to the entity (see paragraph 36), and the entity has an enforceable right to payment for performance completed to date (see paragraph 37).

PARA 36: An asset created by an entity's performance does not have an alternative use to an entity if the entity is either restricted contractually from readily directing the asset for another use during the creation or enhancement of that asset or limited practically from readily directing the asset in its completed state for another use. The assessment of whether an asset has an alternative use for the entity is made at contract inception. After contract inception, an entity shall not update the assessment of the alternative use of an asset unless the parties to the contract approve a contract modification that substantively changes the performance obligation. Paragraphs B6-B8 provide guidance for assessing whether an asset has an alternative use for an entity.

PARA 37: An entity shall consider the terms of the contract, as well as any laws that apply to the contract, when evaluating whether it has an enforceable right to payment for performance completed to date in accordance with paragraph 35(c). The right to payment for performance completed to date does not need to be for a fixed amount. However, at all times throughout the duration of the contract, the entity must be entitled to an amount that at least compensates the entity for performance completed to date if the contract is terminated by the customer or another party for reasons other than the entity's failure to perform as promised. Paragraphs B9-B13 provide guidance for assessing the existence and enforceability of a right to payment and whether an entity's right to payment would entitle the entity to be paid for its performance completed to date.