1 Revenue recognition
Fintech companies, which initially focused on providing payment services, have evolved, and diversified their revenue streams beyond just payments. They provide a multitude of services which can include sourcing of customers for other regulated entities, providing loan management and collection services, facilitating payments through their applications, etc. It is essential for fintech companies to carefully analyze each arrangement and apply the principles of Ind AS 109 'Financial instruments' and Ind AS 115 'Revenue from contract with customers' to ensure proper revenue recognition and financial reporting compliance.
Identifying the customer in complex arrangements: In complex arrangements involving multiple counterparties such as regulated entities (Banks or Non-Banking Financial Companies (NBFCs)), merchants, co-lending partners and end-consumers/borrowers, it is essential for fintech companies to clearly identify their customer within the value chain. For instance, when a fintech company provides personal lines of credit (for example, credit cards for bill payments, cash withdrawals, and online or offline purchases, loans, etc.) in partnership with financial institutions or lenders to fund the lines of credit or loans. Fintech platforms typically collect payments from users who utilize these financial products and then transfer the corresponding proceeds to the lending partners. In return, it receives certain percentage of the revenue generated from the fees or interest charged on the utilization of credit cards or loans.
In such arrangements, it is crucial for fintech companies to evaluate who their customer is and determine whether they are acting as a principal or an agent. This principalagent assessment is significant because it impacts revenue recognition (gross versus net), which in turn affects the top-line presentation in the financial statements.
Standalone versus consolidated financial statements reporting: A common structure is where the fintech parent entity sources the borrower for its NBFC subsidiary.
Typically, in the standalone financial statements of the subsidiary, the sourcing fees paid to the parent and the processing fees received from the borrower are included in Effective Interest Rate (EIR) computation. However, in consolidated financial statements, the elimination of intercompany transactions poses a scenario which may result in the group expenses towards sourcing (incurred by parent) being recognized upfront whereas the processing fees income (received by subsidiary) is included in EIR, leading to a significant difference in the timing of expense and income recognition at the group level. Such issues create challenges in aligning financial reporting across both standalone and consolidated statements and need careful evaluation.
Cashback and incentives: Fintech companies often employ strategies such as discounts, cashbacks, credits, and incentives to drive platform usage, including applications, digital wallets, or payment services. These promotional initiatives are aimed at encouraging customer adoption and increased transaction frequency. Key evaluation areas include assessing whether the cashback and incentives offered should be categorized as variable consideration, consideration payable to customers or general advertising/promotional expenses. If promotional incentives (for example, cashbacks, discounts) are provided to the customers that purchases entity's goods or services, they may need to be treated as a reduction of revenue rather than an upfront expense, depending on the facts and circumstances.
In some arrangements, the consideration paid to a customer may exceed what the entity expects to receive for the promised goods or services. In these situations, recognition of payments to the customer as a reduction of revenue could result in negative revenue. The entity needs to carefully evaluate all its historical contractual arrangements with the customer before reclassifying any cumulative shortfall in revenue to expense. In addition, when making this evaluation, an entity needs to incorporate revenue from any current or anticipated contracts with the customer to transfer goods or services in the future.
On the other hand, cashback or discount incentives provided to users who are not yet customers may be recorded as an expense, as they may not meet the criteria for revenue reduction or cost to fulfil the contract. In such cases, the treatment of these incentives could depend on various factors, such as the nature of the promotion and its expected impact on future customer acquisition or retention.
When offering bundled services, fintech companies should consider identifying distinct performance obligations and accordingly allocate the transaction price, considering whether services are distinct or highly integrated. The treatment of cashbacks, incentives, discounts, and other promotional expenses may require judgment to ensure revenue is recognized only to the extent that it is highly probable that a significant reversal will not occur. This judgment impacts whether the incentives reduce the transaction price or represent separate payables, affecting both the timing and the amount of recognized revenue. Clear identification of the customer— whether a Bank/NBFC, merchant, or end-consumer—is crucial for determining who is contracting for and paying for the services.
2 Financial instruments
Fintech companies often rely on frequent investor funding rounds, and there are various investment options available to these fintech companies. Equity shares and convertible preference shares are two of the most prevalent choices when it comes to fundraising by fintech companies. Convertible preference shares, in particular, offer flexibility as they allow investors to convert their shares into equity at a predetermined ratio or formula in the future. These investment instruments offer a dynamic and potentially rewarding way for investors to participate in the growth and success of fintech companies, aligning their interests with the company's performance and future milestones.
Fintech companies are aware that investors often require an exit strategy within a specific time frame. To cater to these needs, fintech companies offer various exit options for their investors. Some of these options include:
- Sale of investor securities to third party: Fintech companies may allow their investors to exit their investments by facilitating the sale of their securities to third-party buyers. This provides investors with an opportunity to realize their gains and exit their investment positions.
- Exit via Initial Public Offering (IPO): Fintech companies may choose to go public through an IPO, which allows existing investors to sell their shares on the public market. This provides a potential exit route for early investors, allowing them to monetize their investments.
The availability of multiple exit options reflects the fintech company's understanding of investor needs and their commitment to ensuring a smooth and efficient process for investors to exit their investments when the time is right.
Accounting for such instruments, particularly from a classification perspective, under Ind AS 32, Financial Instruments: Presentation can be quite complex. Features such as put options or buyback arrangements further add to the complexity. The measurement of such instruments depends on their classification as either equity instrument or liability or potentially an embedded derivative. Fintech companies should carefully assess detailed terms of each agreement relating to transactions with shareholders to evaluate the appropriate classifications and measurement.
The table below outlines a few illustrative conversion features provided by fintech companies and key considerations while evaluating such financial instruments under Ind AS:
| Conversion feature | Illustrative terms of the financial instrument | Key considerations |
| Optionally convertible preference shares (OCPS) | The company issued preference shares with a five-year term, which are redeemable at the end of five years. It has a 6% annual discretionary, non-cumulative dividend. The shares are optionally convertible into five ordinary shares at any time before maturity at a predetermined price at the option of the investor. | The OCPS are redeemable at the end of its five-year term, indicating a liability component. The discretionary, non-cumulative dividend and the option to convert into fixed number of ordinary shares at any time until maturity suggest the presence of an equity component. Therefore, the OCPS contains both liability and equity components, requiring separate analysis for measurement. |
| Contingent conversion rights | The company issued convertible preference shares to a private equity investor. The shares automatically convert into 15 equity shares of INR10 each for every INR100 preference share if the company conducts an IPO within three years. If the IPO does not occur within three years, the company is obligated to redeem the preference shares in cash, along with a 15% internal rate of return on the investment. | The contingent settlement feature in the convertible preference shares triggers redemption if the IPO does not occur within three years. This feature is considered genuine under Ind AS 32, as it provides a defined return to the investor if the IPO fails. It has economic substance, ensuring the investor's exit strategy is protected in the absence of the IPO. Therefore, the convertible preference shares contain a liability, regardless of the likelihood of cash settlement. |
| Buyback arrangements/put options | Options that give investors the right to sell their shares back to the company or create an obligation on the company to execute buyback to provide exit to investors. | Will be classified as liabilities as there is an obligation to buy back the shares. |
The actual classification under Ind AS 32, Financial Instruments: Presentation, will depend on the detailed terms and conditions of the instrument. Entities must carefully evaluate the specific features and contingencies associated with each instrument to determine the appropriate classification. It is crucial to evaluate the substance of the instrument, including the existence of any obligations for settlement in cash or through equity conversion, as well as the impact of contingent settlement provisions.
By carefully analyzing the nature of the instrument and the contingencies involved, companies can ensure accurate classification as either liabilities or equity, which is essential for proper financial reporting and compliance.
Some of the key considerations for evaluating financial instruments with contingent settlement provisions include:
- Contingent trigger events: Assess if the settlement obligation depends on uncertain future events beyond the issuer's and holder's control, such as changes in market indices, interest rates, or the issuer's key performance indicators (revenue, net income, etc.). Whether or not the contingency is within the control of the issuer is an important consideration when classifying financial instruments with contingent settlement provisions as either financial liabilities or equity
- Genuine contingencies: Evaluate whether the contingent settlement provision is genuine. If the settlement event is extremely rare, highly abnormal, and very unlikely to occur, the contingent settlement provisions are not taken into account in the instrument's classification. While the specific facts and circumstances relevant to an instrument will need to be assessed, it would be unusual to include settlement terms in a contract that are not genuine.
The above factors are illustrative and actual terms of the instrument may be far more complex. Fintech companies must carefully assess the terms of each financial instrument, particularly convertible instruments, put options, buyback arrangements, etc., to determine their appropriate classification under Ind AS 32. The classification as either equity or liability depends on specific features such as the company's obligations and the nature of conversion rights or options. A detailed evaluation is necessary at the contracting stage, to ensure accurate financial reporting and avoiding unintended consequences, especially when dealing with complex instruments that may involve embedded derivatives or contingent conditions.
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