Ind AS 115: Revenue from Contracts with Customers||Step-1 Model: Identifying the Contracts

Introduction

Ind AS 115 Revenue from contracts with Customers talks about revenue recognized in financial statements. There is a 5-step model to recognize the revenue. Here we will talk about Step 1 of such a model, i.e., identifying the contracts.

A contract is an agreement between two or more parties that creates enforceable rights and obligations. Contracts can be oral, written, or based on the entity’s customers and business practices. Some contracts with customers have no fixed duration and can be terminated/modified by either party at any time. Some other contracts renew as per their agreement.

Criteria for recognizing a contracts

An entity shall account for a contract with a customer that is within the scope of this Standard only when all of the following criteria are met:

Criteria 1: Approved the Contracts

The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to performing their respective obligations.

First and foremost, the parties must have approved the contracts, whether in writing, orally, or through other means. The form of approval of contracts is not determinable, as it is at the discretion of both parties. An entity must consider the relevant fact while entering the contracts and assessing whether parties are bound by any term or condition of the contracts. At times, parties approved the contracts orally to perform the obligation(s), while in some cases, written contracts may be required for the performance of the obligation. In respect of the above, parties should be committed to performing the obligations under the contracts.

Example:

1. XYZ & Co., Chartered Accountants agreed to the supply of service to ABC Limited, then they formally enter into the written contracts. So that there is no dispute regarding any scope of work, fees, etc.
2. MNO Limited and ABC Limited are related parties to each other and orally enter into contracts for the supply of Goods. They entered into the contracts orally on the basis of trust in each other as they are purchasing/selling goods for a long time.

Criteria 2: Identify each party’s rights

An entity should understand the rights of all parties to the contracts. An entity cannot assess the transfer of goods or services if it cannot identify each party’s rights regarding those goods or services.

Criteria 3: Identify the Payment Terms

An entity should identify the payment terms for the goods or services within the contracts. At this stage, payment terms not required the fixing of the transaction price. We will identify the transaction price in Step 3 of this model.

Criteria 4: Commercial Substance

The contracts should have a commercial substance that involves the risk that the timing or amount of the entity’s future cash flows is expected to change as a result of the contract. In simple words, transactions should have an economic benefit. This helps to prevent goods or services being transferred to one party and then forwarded to the same party from whom goods or services are received without consideration in order to inflate revenue. In addition to the above, this is applicable to both monetary and non-monetary transactions, without such commercial substance, we have to check whether such transactions have economic benefits.

Criteria 5: Collect substantially all of the consideration

The entity will receive the payment in return for the goods and services. An entity must only take the customer’s ability and intention to pay the amount of consideration when it is due into account when determining whether it is likely that the amount of consideration will be collected.

Term of Contracts

The contracts should have a contractual period over which the parties have enforceable rights and obligations. Some contracts have no set duration and can be terminated or modified at any time, whereas others automatically renew on a regular basis. Contracts can be terminated at any time after they are signed by either party. In some situations, customers have the right to terminate contracts without any penalty, and in such cases, accounting should be shorter than stated in the contract.

Combining Contracts

 An entity must combine multiple contracts with the same or nearly the same customer that were entered into at the same time and account for them as a single contract if one or more criteria is met:

• Contracts are negotiated together with a single commercial objective;
• The amount of the consideration to be paid in one contract depends on the price or performance of the other contracts;
• The goods or services promised in the contracts are a single performance obligation.

Example: Software Company S enters into a contract to license its customer relationship management software to Customer B. Three days later, in a separate contract, S agrees to provide consulting services to significantly customize the licensed software to function in B’s IT environment. B is unable to use the software until the customization services are complete.

Analysis: Company S determines that the two contracts should be combined because they were entered into at nearly the same time with the same customer, and the goods or services in the contracts are a single performance obligation.

Modification of Contracts

A contract modification is a change in the scope, price, or both of the contract that is agreed upon by both parties. A “contract modification” exists as a change in order, variation, or amendment and is approved by both parties. Contract modifications should be made in writing, orally, or as business practice dictates. Contract modifications shall only apply to existing contracts.

Identifying a modification

If three requirements are met, a contract modification is possible.

• When  there is a change in scope, price, or both in contracts;
• When the changes(modification) are approved by both parties;
• When the change is enforceable.

Contracts modification as Separate Contracts

Contracts for modification must be treated separately by an entity if both parties are agreed and the following conditions are met:

• Changes in Scope of Contracts(i.e. work promised);
• The contracts’ price is increased by a certain amount to reflect the promised work’s entity-standalone prices.

Example: A manufacturer of alloy wheels and an automaker agree to a price of Rs. 1050 per 1000 alloy wheels. The customer receives the distinct goods over the course of three months. In the second month, the parties amend the contracts to sell 200 additional alloy wheels for Rs. 950/-. The price of additional alloy wheels represents the standalone selling price as of the modification date.

Analysis: Yes. The modification to sell an additional 200 goods at Rs. 950/- each should be accounted for as a separate contract because the additional goods are distinct and the price reflects their standalone selling price. The existing contract would not be affected by the modification.

Contracts modification that does not constitute Separate Contracts

First, account for the modification prospectively, as long as the goods or services provided following the modification are different from those that were offered to the customer.

Second, the entity shall recognize the impact of the modification on a cumulative catch-up basis when the remaining goods or services are not distinct and are part of a single performance obligation that is partially satisfied. Third, when a modification results in a combination of distinct and non-distinct goods or services being offered as the remaining goods or services. In this instance, the entity accounts for any remaining distinct goods or services on a prospective basis and for any remaining non-distinct goods or services on a cumulative catch-up basis.

Third, when a modification results in a combination of distinct and non-distinct goods or services being offered as the remaining goods or services. In this instance, the entity accounts for any remaining distinct goods or services on a prospective basis and for any remaining non-distinct goods or services on a cumulative catch-up basis.