Automotive Spotlight New Revenue Recognition Model

Automotive Spotlight New Revenue Recognition Model

For Private Circulation Only January 2015

Contents

Executive summary

3

Background

4

Key Accounting Issues

5

Challenges for Automotive Entities

11

Thinking Ahead

12

2

Executive summary

On May 28, 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued their final standard on revenue from contracts with customers. The standard, issued as Accounting Standards Update 2014-09 (and codified as Topic 606 in the FASB Accounting Standards Codification) by the FASB and as IFRS 15 by the IASB, outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition standard (including industry-specific guidance in U.S. GAAP).

The Institute of Chartered Accountants of India (ICAI) has recently issued an Exposure Draft (ED) of the proposed Indian Accounting Standard (Ind AS) 115, Revenue from Contracts with Customers i.e. the proposed IFRS Converged accounting standard for Indian entities, which is identical to IFRS 15.

The new revenue recognition standard outlines a

The new revenue recognition standard [(Topic 606/ IFRS 15 / exposure draft Ind AS 115), hereafter through this document the reference to "new revenue recognition standard" implies Topic 606/ IFRS 15 / exposure draft Ind AS 115] requires management to use judgment to (1) determine whether contracts with one customer (or related parties) should be combined and treated as a single contract, (2) identify the number of performance obligations in a contract, and (3) determine the transaction price.

single comprehensive model for entities to use

Revenue from contracts for customised parts that an entity creates by providing a "service" to a customer (i.e., the parts have no alternative use to the entity and the entity has a right to payment for performance to date) will need to be recognised over time as the parts are constructed.

in accounting for revenue arising from

Entities will need to determine whether contract costs should be capitalised and amortised as goods and services are transferred to the customer or whether such costs should be expensed as incurred.

contracts with customers and

Entities will need to evaluate the appropriate accounting when a contract with a

supersedes

most current customer contains a repurchase right (e.g., an option that allows the customer to "put"

the product back to the entity may represent a lease or a sale with a right of return).

The new standard requires significantly more extensive disclosures than current standard; therefore, automotive entities may need to modify their systems and processes to gather information about contracts with customers that is not otherwise readily available.

revenue recognition standard.

IASB and FASB have formed a joint Transition Resources Group (TRG) to inform both standard setting bodies about potential implementation issues arising when companies implement the new standard. TRG will not issue any guidance. The Board of TRG have met twice in 2014.

This Automotive Spotlight discusses the new revenue model and highlights key accounting issues and potential challenges for automotive entities.

Automotive Spotlight ? New Revenue Recognition Model

3

Background

The goals of the new revenue recognition standard are (1) streamlining, and removing inconsistencies from, revenue recognition requirements; (2) providing "a more robust framework for addressing revenue issues"; (3) making revenue recognition practices more comparable; and (4) increasing the usefulness of disclosures. The new revenue recognition standards states that the core principle for revenue recognition is that an "entity shall recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services."

Under the new revenue recognition standard, entities must perform the following five steps in recognising revenue:-

"Identify the contract(s) with a customer" (step 1);

Automotive entities must reassess their current revenue accounting and determine whether changes are necessary.

"Identify the performance obligations in the contract" (step 2);

"Determine the transaction price" (step 3);

"Allocate the transaction price to the performance obligations in the contract" (step 4); and

"Recognise revenue when (or as) the entity satisfies a performance obligation" (step 5)

Entities must also reassess their current revenue accounting and determine whether changes are necessary. In addition, the new revenue recognition standard requires significantly expanded disclosures about revenue recognition, including both quantitative and qualitative information about (1) the amount, timing, and uncertainty of revenue (and related cash flows) from contracts with customers; (2) the judgment, and changes in judgment, exercised in applying the revenue model; and (3) the assets recognised from costs to obtain or fulfill a contract with a customer.

Automotive Spotlight ? New Revenue Recognition Model

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Key Accounting Issues

Certain automotive entities (including suppliers, original equipment manufacturers, and dealers) may encounter accounting and operational challenges in applying the new revenue recognition standard. Some of these key accounting issues are discussed below.

Identifying the Contracts With Customers (Step 1)

In evaluating whether a contract with a customer exists, an entity would analyse the specific terms and conditions of an arrangement to determine whether the parties to the arrangement have a supplier-customer relationship or some other relationship (e.g., as collaborators or partners that are outside the scope of the new revenue recognition standard). The entity would consider all relevant facts and circumstances in assessing whether the counterparty to a contract meets the definition of a customer as given in the standard and whether the contract is within the scope of the standard. Contracts with customers may be written, oral, or implied and must create enforceable rights and obligations between two or more parties. Further, for a contract to exist, management must conclude that it is probable that the entity will collect the consideration to which it expects to be entitled.

If a contract with a customer does not meet the criteria to be accounted for under the new revenue recognition standard, the entity would recognise consideration received under the contract as revenue only when (1) the entity has no remaining obligations to transfer goods or services to the customer (because of complete fulfillment or cancellation of the contract), (2) the entity has collected all promised consideration, and (3) the consideration received is non-refundable.

Further, when assessing the contractual period to apply the new standard (e.g., to each outstanding purchase order or over a three-year master services agreement), entities will need to evaluate the contract to determine the period in which the parties to the contract have "present enforceable rights and obligations."

Contract Combination

Entities must also assess whether to account for multiple contracts as a single contract. The standard requires entities to combine contracts entered into at or around the same time with the same customer (or parties related to the customer) if one or more of the following criteria are met:

"The contracts are negotiated as a package with a single commercial objective."

"The amount of consideration to be paid in one contract depends on the price or performance of the other contract."

"The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation.

Thinking It Through Unlike current standard, under which entities may consider combining contracts in certain circumstances, the new standard requires contract combination when the above criteria are met. Automotive entities (especially suppliers) often enter into multiple contracts with the same customer around the same time but may not specifically evaluate whether those contracts are interdependent. After establishing controls to ensure that this evaluation is performed, automotive entities may need to use judgment to determine whether the above contract-combination criteria are met. A conclusion that the criteria are met could significantly affect (1) how performance obligations are identified, (2) how consideration is allocated to those obligations, or (3) when revenue is ultimately recognised. Note that contracts with different customers (that are not related parties) would not be combined.

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