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Accoun
think - Perspective
-CA
Amyn Jassani &
CA Bharat Shetty
Issues involving
accounting are
often among the
most complex in
case of information
technology (IT)
companies as these
are highly affected
by the business
dynamics. In certain
cases, the accounting
policies not only
have significant
impact on the
financial results
but also impact
the business practices.
This column is
intended to share
some of the critical
accounting issues
and the relevant
guidance which
can be referred
by these technology
companies.
MULTI ELEMENT
CONTRACT
Revenue is generally
the largest single
line item included
in an enterprise's
financial statements.
An area of concern
often for IT companies
is those involving
Multi element
contracts.
Many technology
based companies
provide multiple
products and /or
services as “deliverables”
to their customer
under a single
arrangement. At
times, it could
be a complex arrangement
for providing
an integrated
technology based
solution which
may include designing
and building the
equipment, maintaining
the equipment
and running it
on an outsourced
basis for an agreed
period of time.
Such agreements
may have complex
negotiated payment
terms. The payment
schedule may not
match the product
or service's delivery
date, but may
instead precede
or follow delivery.
Hence, it becomes
difficult to identify
or allocate what
portion of a payment
relates to which
deliverable included
in the single
arrangement. Thus,
the big accounting
question 'How
to allocate the
arrangement consideration
to the individual
deliverables?'
Accounting Standard
9 on Revenue Recognition
under Indian GAAP
does not provide
specific guidance
on multi- element
contracts. However,
the Expert Advisory
committee (EAC)
of the Institute
of Chartered Accountants
of India has issued
broad guidance
on accounting
for such arrangements.
In response to
a query raised
by a logistic
service provider
rendering multiple
services under
single consideration,
the EAC opined
that in such a
case;
a. The company
needs to ascertain
whether it is
feasible to segregate
the consideration
attributable to
each of the services
rendered by the
company. Further,
it should be determined
whether proportionate
completion method
or the completed
service contract
method should
be applied.
b. If it is not
feasible to segregate
the consideration,
the company will
have to determine
whether the liabilities
for risks related
to non-performance
of various services
are significant.
If not significant,
then the entire
revenue can be
recognized on
completion of
the main service
in the contract.
The EAC opinion
is in line with
the principle
enunciated under
International
Financial Reporting
Standards (IFRS)
which requires
each element in
the contract to
be fair valued
and recognized
separately for
multiple element
contracts as and
when the underlying
service is performed.
For example, in
case of an IT
company contracting
for sale of software
licenses, implementation
services and maintenance
of the system
for a lump sum
consideration,
the company will
have to allocate
the consideration
to each component
separately based
on the fair value
of each component.
Revenue on sale
of license will
be recognized
on transfer of
significant risk
and reward to
the customer,
revenue on implementation
services will
be recognized
as per the percentage
of completion
method (or completed
contract method,
if applicable)
and maintenance
services will
be recognized
over the period
of the contract.
However, considering
the business dynamics,
at times, in case
of multiple element
contracts, the
value of each
component may
not be mentioned
in the contract
or values stated
may not prima
facie appear to
be fair.
US GAAP provides
more comprehensive
guidance on such
matter. It requires
revenue recognition
to be based on
an allocation
of the total fee
to the individual
elements based
on vendor-specific
objective evidence
(VSOE) of fair
value.
If VSOE of fair
value does not
exist for each
element, the revenue
recognition must
be deferred till
sufficient evidence
is available,
or until all elements
have been delivered.
Emerging Issues
Task Force (EITF)
consensus on Issue,
00-2, lays down
detailed guidance
for identifying
multiple element
contracts and
deliverables in
an arrangement,
for identifying
separate units
of accounting
and for allocating
arrangement consideration
to multiple units
of accounting.
It requires any
price discount
given in respect
of a multiple
element contract
to be allocated
proportionately
to each element.
The following
illustration explains
the accounting
for multiple element
contracts:
Facts: Company
A is an established
Information Technology
(IT) company.
• Company
A's service center
provides all scheduled
maintenance services
at no additional
charge for any
customer who purchases
an IT product
from Company A
for the period
the customer owns
the product.
• The customer
may have the maintenance
services performed
by others without
affecting the
product warranty,
but most customers
utilize Company
A's maintenance
services unless
they move to a
distant location.
• Company
A also sells maintenance
services separately
to customers who
do not purchase
products from
Company A.
• The products
are sold subject
to a limited warranty
and there are
no general or
specific refund
rights in the
arrangement.
Evaluation: The
IT product sale
and the maintenance
services should
be considered
separate units
of accounting
in the arrangement.
Considering that
Company A also
provides maintenance
services separately
to customers,
fair value of
IT products and
the maintenance
services can be
identified and
accounted for.
Relevant extracts
from IBM's Revenue
Recognition policy
on Multiple-Element
Arrangements given
below further
illustrates the
accounting for
multi-element
arrangements and
the use of VSOE.
1. The Company
enters into multiple-element
revenue arrangements,
which may include
any combination
of services, software,
hardware and/or
financing. A multiple-element
arrangement is
separated into
more than one
unit of accounting,
if all of the
following criteria
are met:
(a) The delivered
item(s) has value
to the client
on a stand-alone
basis.
(b) There is objective
and reliable evidence
of the fair value
of the undelivered
item(s) and
(c) If the arrangement
includes a general
right of return
relative to the
delivered item(s),
delivery or performance
of the undelivered
item(s) is considered
probable and substantially
in the control
of the company.
2. If these criteria
are not met, the
arrangement is
accounted for
as one unit of
accounting which
would result in
revenue being
recognized on
a straight line
basis or deferred
until the earlier
of when such criteria
are met or when
the last undelivered
element is delivered.
3. If these criteria
are met for each
element and there
is objective and
reliable evidence
of fair value
for all units
of accounting
in an arrangement,
the arrangement
consideration
is allocated to
the separate units
of accounting
based on each
unit's relative
fair value.
4. There may be
cases, however,
in which there
is objective and
reliable evidence
of fair value
of the undelivered
item (s) but no
such evidence
for the delivered
item(s). In those
cases, the residual
method is used
to allocate the
arrangement consideration.
Under the residual
method, the amount
of consideration
allocated to the
delivered item(s)
equals the total
arrangement consideration
less the aggregate
fair value of
the undelivered
item(s).
Although, there
is no comprehensive
accounting guidance
available under
Indian GAAP for
such multi element
contracts, it
is open to debate
whether application
of US GAAP principles
would be appropriate
while presenting
Indian GAAP financial
statements. We
believe, it should
be acceptable
depending on the
specific facts
and circumstances.
The Indian IT
companies have
already started
adopting the principle
in their revenue
recognition polices
as seen from the
accounting polices
of many Indian
IT companies.
Authors can be
contacted at Amyn.Jassani@wcgt.in
and Bharat.Shetty@wcgt.in
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