Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 47

 

Subject:           Accounting treatment of an arrangement with a service provider for digital signage solution.[1]
A.        Facts of the Case  
                                                  
1.         A company is one of the fastest growing Indian life insurance companies in India. It has appointed three banks as its corporate insurance agents for marketing/sale of insurance policies to their customers. The company is desirous of having publicity of its products. Its potential customers are customers of these banks. Hence, the company explored a solution to advertise its publicity materials to be streamed/run inside the banks’ branches. It came across a solution which is offered by a service provider, who is one of the largest telecom/cellular/Dish TV service providers in India.

2.         The arrangement of the company with the service provider is in the form of a service agreement. (Copy of the purchase orders have been furnished by the querist for the perusal of the Committee). The terms have been agreed/finalised based on a Letter of Intent. (Letter of Intent has also been furnished by the querist for the perusal of the Committee). The highlights of the arrangement are as follows:

 

  • The company is desirous of having an end to end managed solution with respect to displays, connectivity and a robust platform with content storage services to be shared dynamically through multimedia contents to be displayed pan India at different bank branches of its corporate agents.
  • The company is desirous of having a centralised control and administration of the aforementioned activities for seamless streaming of its publicity material to the right audience.
  • The entire hardware (32” LCD, media player with operating system and relevant software, signage platform) for the above arrangement has to be owned and managed by the service provider including its warranties and maintenance throughout the term of the contract.
  • The service provider is also responsible to resolve any complaints, non-working/streaming of the publicity material of the company within an agreed turn over time on any of the bank’s branches.
  • The term of the contract is for 3 years with an early exit clause subject to payment of certain residual value. The company has introduced the exit clause through a provision that only LCD screens will be transferred to the company by the service provider (to safeguard its interest).
  • Under the said arrangement, the service provider is currently managing the said services at 900 bank branches.
  • The company has chosen the service provider, as the company is technologically/logistically not capable of managing the entire solution itself. 
  • The company is not having any data regarding to the cost of the 32” LCD screens. However, such screens of similar brands are available in the market in the range of Rs.18,000/- to Rs.20,000/-.

 
3.         The querist has stated that the company has treated the above arrangement as a service level agreement and, hence, has been accruing the expenses based on monthly charges payable to the service provider considering the following points:

  • Value of service is significantly higher than value of hardware. Total contracted payments over the 3 year period amount to Rs. 1,17,000 per unit (Rs. 39,000 p.a for 3 years). Out of this, the value of TV is not independently identifiable. Even if the value of TV is assumed to be Rs. 20,000, then also significant portion of the contracted payments of Rs. 97,000 (Rs. 1,17,000 less Rs. 20,000) is towards the services, AMC, upkeep and IT support of the complete arrangement.
  • The service contract mentions ‘Monthly Charges for Digital Signage Solution: Rs. 2,750/- per month per screen (Display: 32” LCD LG / Samsung Screen, Player: Media Player with Operating System and relevant software, Platform: Signage Platform, Responsible for managing the services)’. Important point to be noted in the above term is that the whole agreement is for a ‘Digital Signage Solution’, the display screen is just incidental and part and parcel of the larger service arrangement.
  • There are 3 major components of the whole solution:

-Display

-Player

-Platform

  • On the display piece (screen), an option has been given to the service provider to provide any LCD screen (LG/Samsung) without giving any specifications of the technical specification/quality/model/brand.
  • It is clear from the above facts that the company exercises no direct or indirect control over the hardware to be used by the service provider which is essential for considering such an arrangement as a lease.
  • Complete AMC, repairs, upkeeping of equipment and services etc. are the responsibilities of the service provider.
  • Risks associated with the hardware lies with service provider for the contracted period. As per paragraph 3.2 of Accounting Standard (AS) 19, ‘Leases’, issued by the Institute of Chartered Accountants of India, “A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset”.
  • The company has neither the capability nor intent of utilising the hardware without the service part as provided by the service provider.
  • Without the specialised services of the service provider, the associated hardware has no use to the company.
  • No capability exists with the company to use the assets for intended usage without paying the fees to the service provider as agreed in the service contract.
  • The company has neither the infrastructure nor the technical know-how to use the hardware on its own.
  • Insertion of the term of transfer of assets in the service contract was introduced just to safeguard the interest of the company, but assets will not have any usage to it as it does not have the capability of running the service without service provider’s support.
  • The said assets will be transferred to the company only after the end of the contract term of 3 years when the economic useful life of the assets will be negligible/Nil. In fact, the economic useful life of the screens will become Nil even much before the end of the contract period, as the assets are to be used at commercial places (banks’ branches) and the upkeep, repairs, AMC (and at few places, replacement as well, if required) will have to be taken care of by the service provider till the end of the contract period.
  • The company has the intention only to have the solution and not the assets. The transfer clause has been inserted only to safeguard its interest in case of any failure on the part of the service provider.
  • At the end of the contract period, in case the company does not have the intention of continuing with the arrangement, the said assets will most likely be scrapped by it given the commercial prudence, since, even the storage of 900 screens will involve a huge cost (transporting it to a central place, hiring of a warehouse, packing etc.) and it does not have more than 20-30 offices in India where these can be installed. (Even these premises are not big enough for installing more than 2 screens at a place).
  • Since, in such cases it is always the substance which prevails over form, and the intent being taking holistic services, it is a service agreement and not a lease of any equipment. As per paragraph 8 of AS 19, “Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than its form….”

(Emphasis in the above points, supplied by the querist).

 

4.         The querist has separately clarified the following:

(i) The service provider is free to use media player and platform of his choice. Also, the service provider is free to use dongles of his choice. The company has not made any specific request regarding model/brand/quality/technical specifications of the hardware proposed to be used by the service provider.

 

(ii) Model/brand/quality/technical specifications of the display, media player and platform used by the service provider cannot be considered as implied. With regard to ‘dongles’, as the service provider is one of the largest telecom/cellular/Dish TV service providers in India, it can be assumed that it will be using dongles belonging to its brand/group company. However, an important point to be noted is that though the service provider is one of the largest telecom/cellular/Dish TV service providers in India, still it does not have a pan India presence/capability. Hence, at certain locations, it has been using ‘dongles’ of other service providers and the same is decided by the service provider itself and the company has no explicit or implied say in choosing the alternate ‘dongle’ provider. The company has not made any specific request regarding model/brand/quality/technical specifications of the hardware and software to be used by the service provider. The service provider is expected to provide a complete end to end display solution and is expected to use resources as deemed fit for the same.

(iii) The service provider can replace any display, media player, platform and dongles during the contract period even though there is no defect in their functioning.

(iv) The players and screens are not meant for exclusively advertising material of the company only. Advertising material of the partner banks where these are installed would also be displayed in case of requirement from the banks.

 

(v) According to the querist, if everything goes fine and the company is satisfied with the services of the service provider, then, after the period of 3 years, LCD screen along with media player and dongles would be transferred to the company on free of cost basis. For dongles, the lock-in-period is 18 months, which, would start from the ‘effective date’ (i.e., date of acceptance of letter of commission). If, after 18 months from the ‘effective date’, early exit clause is exercised by the company paying Rs. 8,000 for LCD screen, dongles also will become the assets of the company.

(vi) After the completion of 3 years, media player will be given to the company along with the operating software, if the company opts to continue the arrangement with the service provider. Currently, the media player is programmed with software of the service provider. However, if required, the media player can also be programmed with software of other service providers.

(vii) At the end of the contract period, if the company does not have the intention of continuing with the arrangement, the assets will most likely be scrapped. All material related to the display solution, including players and dongles, will most likely be scrapped by the company.

 

5.         The querist has separately given the following additional information:

 

(i) Risk in respect of damage and obsolescence to the hardware lies with the service provider and not with the company. However, risk with respect to physical damage and theft lies with the company. The service provider would be responsible for the replacement of equipment in case of any technological or other obsolescence. An important point to be noted here is that although the company has entered into a contract with the service provider for LCD screens (as mentioned in the Purchase Order and Letter of Intent), however, the service provider has installed LED screens (instead of LCD screens, LED screens being better quality product and the need has arisen due to technological obsolesce of LCD screens) at many of the locations. Also, the service provider has already replaced media players at all locations because of technological obsolescence. To clarify further, the company has not made any specific request regarding model/brand/quality/technical specification of the hardware  and software (except in case of display screens where only an option has been given to the service provider in terms of brand i.e., LG/Samsung, but model has not been specified). The service provider is expected to provide a complete end to end display solution and is expected to use resources as deemed fit for the same. In case of non-functioning of the installed equipment, it is the service provider who would be held responsible for it and will have to rectify the defects. The company is concerned with the display of its advertising materials and the means for the same i.e., model/display equipment/software etc., fall under the domain/ responsibilities of the service provider. (Emphasis supplied by the querist).

 

(ii) The company is intimated by the service provider once the installation of the equipments is complete at the bank branch and display of its advertisements has been commenced. Documentation/supports evidencing the same are attached with the invoice raised by the service provider.  As equipments have been installed at various bank branches, entry into the branches for replacing such equipments is coordinated by the company.

 

(iii) The company, as a part of its marketing strategy/plan, has entered into the arrangement on a pan India basis involving 1,000 locations (approximately) and to ensure an uninterrupted arrangement, has introduced the transfer clause to safeguard its interest. Also worth noting is that the company has neither the capability nor the intent of utilising the equipments on its own and, hence, has introduced the transfer clause in the arrangement to ensure that the service provider offers long term services to the company.

 

(iv) Partner banks’ advertising material is displayed only for a small portion of the total air time. This, in turn, helps the company to cross sell its products, thereby, assisting the company only. Hence, no fee is charged for the same as it helps boosting revenue of the company.

 

(v) The equipments are to be used only for displaying marketing material of the company and partner banks (for a small portion of total air time).

 

B.        Query

6.         The querist has sought the opinion of the Expert Advisory Committee on the following issues:

 

(i) Whether the above arrangement with the service provider can be categorised as a lease or a service agreement for hiring of services.

(ii) If it is a lease, whether the same is an operating lease or a finance lease as per the provisions of AS 19.

 

C. Points considered by the Committee

7.         The Committee notes that the basic issue raised by the querist relates to whether the arrangement with the service provider is a lease or is simply a service contract. The Committee has, therefore, considered only this issue and has not examined any other issue that may be contained in the Facts of the Case, such as, accounting implications of exercise of early exit clause, etc.

 

8.         The Committee notes the following paragraphs of Accounting Standard (AS) 19, ‘Leases’, notified under the Companies (Accounting Standards) Rules, 2006:

 

“2. This Standard applies to agreements that transfer the right to use assets even though substantial services by the lessor may be called for in connection with the operation or maintenance of such assets. On the other hand, this Standard does not apply to agreements that are contracts for services that do not transfer the right to use assets from one contracting party to the other.”

“3.1 A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.”

9.         From the above, the Committee notes that an arrangement may involve both lease and service elements and that AS 19 applies to such arrangements even though service element may be substantial. However, the Committee notes that AS 19 does not apply to agreements that are contracts for services that do not transfer the right to use assets. The Committee is of the view that whether an arrangement is, or contains, a lease, should be determined based on the substance of the arrangement and requires an assessment of whether:

(a) fulfillment of the arrangement is dependent on the use of a specific asset or assets; and

 

(b) the arrangement conveys the right to use the asset.

10.       The Committee notes that in the extant case, the company has, in substance, outsourced advertising activities in respect of its publicity material using the digital signage solution provided by the service provider. The facts and additional clarifications/ information furnished by the querist in paragraphs 2-5 above indicate that the intention of the arrangement is to enable the company to have a complete end to end digital signage solution from the service provider rather than to have a right to use ‘specifically’ identified assets for an agreed period of time with or without effective ownership of such assets. The mere fact that the company is responsible for physical damage/theft of the equipments does not alter this situation, especially, because, the equipments are installed in the partner banks’ branches. The service provider bears all other risks, including risk of technological obsolescence. The fulfillment of the arrangement is dependent on use of display (LCD screen), player, dongles and signage platform. However, the ‘specific’ pieces of the hardware are not identified in the arrangement, either expressly or impliedly, as evident from the facts furnished by the querist in paragraphs 3 to 5 above. In particular, the Committee notes that although LCD screens were contemplated in the purchase orders/Letter of Intent, the service provider has installed LED screens at many locations and also has replaced media players at all the locations due to technological obsolescence. Since the fulfillment of the arrangement does not depend on ‘specific’ pieces of the hardware, there is no need to examine whether the arrangement conveys the right to use the asset. The Committee is, therefore, of the view that the arrangement with the service provider does not contain a lease and that it should be accounted for as a service arrangement.

D.        Opinion

11.       On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 6 above: 

(i) The above arrangement with the service provider should be categorised as a service agreement for hiring of services.

(ii) In view of (i) above, this question does not arise.

___________________________

 

[1]Opinion finalised by the Committee on 6.2.2015.