Please read our blog 104 - to understand the effect of small revenue recognition policy changes. This blog has been dedicated to analysing a big accounting standard change IND AS 115 introduced by ICAI and it’s impact on financial statements.
In FY19, we saw a change in revenue recognition policies of all firms as Accounting standards corresponding to revenue recognition were revised from IND AS 18 to IND AS 115. Without getting too much into technicalities, Ind AS 115 focuses on the ‘control approach’ to determine revenue recognition as against the ‘risk and rewards’ model under Ind AS 18. Both the terms sound similar, but they aren’t. All of the companies had to change their revenue recognition policies under the new accounting standards and this transition had a significant impact across telecom, information technology, engineering, real estate and construction i.e. businesses involving long term contracts.
IND AS 115 Impact Case Study: Mahindra holidays & Resorts
Mahindra holidays & Resorts sells holiday packages to its clients with a tenure of almost 25 years! It has such long term contract arrangements with its clients and saw a drastic impact due to the AS changes for Revenue recognition. If you take a look at time series Revenue figures as reported by the firm, you will see that there has been a crazy dip of 14% in revenues of FY19 !
Clearly something’s off. Upon taking a closer look at the revenue recognition policies, a lesson we just learnt, we see that there have been Accounting Standard changes from IND-AS 18 to IND-AS 115. Below is the explanation
From Chairman’s comments in the Annual report, we can understand the recognition policy for one of the major revenue generating services has changed as below (while others have almost stayed same):
Earlier, Revenue from sales of vacation ownership were 60% recorded upfront as it was non-refundable to the customers and the rest 40% was recorded over the tenure of membership. However, post IND AS 115, as you can see above, it is now prorated equally across the entire tenure.
Applying it numerically over a dummy numerical, if a 25 year membership was sold for 3 Lakh rupees in FY 2018, earlier, 60% of 3 Lakh would have been recognised in FY18 (1.8 Lakh) itself and remaining 40% were to be equal for the remaining 24 years (1.2/24 lakh per annum).
However, since the company is now reporting under new accounting standards IND-AS 115 applying it prospectively, all new contracts sold in FY 19 will see a revenue recognition of 3/25 lakh per annum (equally split across tenure of 25 years) instead of 1.8 lakh per annum as it was earlier (60% in first year) and the old contracts have been adjusted with a retrospective adjustment directly to equities without impacting income statement. Hence a significant drop in revenues!
An analyst also needs to check revenue recognition policies even within the industry the company is part of. This is only to get a sense of judgement how the other industry partners are recognising revenues and if our company is being aggressive or at par with them.
Given the old accounting standards and 60% upfront revenue recognition by Mahindra holidays, we took a look at Sterling holidays, its peer, and we found it had a similar revenue recognition policy, giving us a sense of comfort that the company we are analysing was not applying something out of the blue but at par with industry practices.
Source: Sterling Holidays AR-2020
Another analytical angle to confirm our understanding of the change would be the composition of revenues have changed post the AS change naturally since the majority of the revenue of Vacation Ownership sales (VO sales) which was earlier being recorded upfront is now being prorated across the tenure, giving way for other segments to take up the share of VO revenue contribution in FY19
Putting it gently for the readers who are finding it difficult to comprehend the above discussion, imagine earlier, business was generating 100Cr revenue, VO was contributing almost 50Cr to that amount and the rest divisions were contributing 50Cr. Now that VO revenue recognition AS have changed, it doesn't contribute 50Cr anymore but say 25Cr is the new contribution towards the firm's revenue. In that case, total revenue of the firm would be 75 Cr (assuming zero growth for other divisions), making VO contribution to be 25/75= 33.33% contribution and rest segments contribution increased from 50% to 67%. Degrowth in revenue of one division, will provide an illusion of growth of other divisions in common size analysis (even when they aren’t growing). More on Common size analysis will be covered in our Blog around Analysis of Financials.
Source: Investor Presentation, Q4-FY20.
Enough gyan, let’s get on with the analysis. Below is the disclosure provided by the company for the AS changes and its impact, in its AR2019. As you can see, what this table is trying to tell us is that if IND AS 18 were to be applied to FY19, its revenues would have been 1125.2 Cr instead of 918.29 Cr (which is as per IND AS 115)
(IND-AS 115 is new accounting standard & IND AS 18 was old accounting standard)
As a result, to calculate actual Year on year growth rate, we should be using IND AS 18 figures of FY19 and compare them to FY18 figures to get an understanding of actual business growth rather than using IND AS 115 FY 19 figures. This gives us a growth rate of 6% instead of an incorrect figure of degrowth of 14% seen earlier.
This way, we segregate the impact and judge the true business growth rather than a cumulative change impact of doing a plain vanilla YoY analysis would have never enabled us to attribute the changes to AS changes and business growth!
For next year YoY figures, you will have to compare both new accounting standard figures and let go of old figures for the two years as both year figures correspond to the new Accounting Standard. As time proceeds further, and we have more and more Revenue figures corresponding to New AS, we would be able to compute multiple year CAGR accordingly. A similar analysis has been already done by Mahindra Holidays in their Investor Presentation of Q2 FY21.