This article was first published in the February 2012 China edition of Accounting and Business magazine.
Revenue, the ‘top-line’, is one of the most closely monitored measures in financial statements by investors and other stakeholders. But did you know that the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are in the process of developing a new global accounting standard that will apply a single set of principles to all revenue transactions, regardless of industry?
On 14 November 2011 the boards issued an exposure draft, Revised Revenue ED, with the comment period ending on 13 March 2012. The boards have called it a ‘contract-based revenue recognition model’, sometimes referred to as the asset and liability model based on control.
What is an asset and liability model based on control? What are the five things you should know about the new model? Will you be affected?
Why this model?
Current revenue guidance under both US generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) focuses on an ‘earnings process’, but difficulties often arise in determining when revenue is ‘earned’ and when the earnings process is complete.
The boards believe a single, contract-based model that reflects changes in contract assets and liabilities will lead to greater consistency in the recognition and presentation of revenue. This asset and liability approach is the cornerstone of the IASB’s and FASB’s conceptual frameworks and is consistent with the development of other standards, for example consolidation and leases.
The boards initiated this joint revenue project in 2002. It hasn’t been easy to craft a principles-based approach that functions as intended for all industries. Their first exposure draft, Revenue from Contracts with Customers, issued in June 2010, received extensive, unprecedented feedback (almost 1,000 comment letters), which the boards discussed at length in the first half of 2011. The boards have addressed many of the key concerns raised by the constituents in Revised Revenue ED and are seeking additional comment.
So what is a ‘contract-based revenue recognition model’ and what does asset and liability have to do with revenue recognition? When first introduced in 2002, no one understood the concept and constituents did not think that revenue could be considered in the same way as an asset or liability. The fundamental under a ‘contract-based revenue recognition model’ is that when a company enters into a contract with the customer, the company will obtain rights to receive consideration from the customer (contract assets) and assume obligations to transfer goods or services to the customer (contract liabilities). At inception, the contract assets will equal the contract liabilities (ie precluding the recognition of revenue at contract inception).
When the company transfers the promised goods or services to the customer, it satisfies its performance obligation (contract liability decreases) and revenue is recognised.
Sounds easy – but the devil is in the detail! Understanding the impact will limit your surprises down the road.
What you need to know
The proposed revenue model requires a five-step approach:
i) identify the contract(s) with the customer
ii) identify separate performance obligations within the contract
iii) determine the transaction price of the contract
iv) allocate the transaction price to each separate performance obligation
v) recognise revenue when an entity satisfies its obligations by transferring control of a good or service to a customer.
The proposed model is easy to understand on its surface, but its application could result in significant changes from existing practice. The principles require significant judgment and estimate. The boards’ conclusions are subject to change until they issue the final standard and the following are just a few key aspects based on Revised Revenue ED:
* Change from ‘risk and rewards’ model to ‘control’ model Revenue is recognised when the customer obtains ‘control’ of the goods or services. A customer obtains control if it has the ability to direct the use of and receive the benefit from the goods and services. The transfer of risks and rewards is an indicator of whether control has been transferred under the proposed standard, but additional indicators will also need to be considered. As you might imagine, transfer of control of goods or services may not always coincide with the transfer of risk and rewards. For example, when companies sell goods to distributors with right of return and the level of return is significant, risk and rewards may not have been transferred at the time of delivery. However, control of those goods may have been transferred to the distributor depending on specific circumstances.
* One model does not fit all The new guidance will replace all existing IFRS (and US GAAP) revenue recognition literature. The boards did not want to create different models for recognising revenue from sale of goods or provision of services. However, the boards recognised that there are difficulties in determining when control is transferred, in particular for services and certain long-term construction contracts. Hence, Revised Revenue ED provides additional guidance such that performance obligations can be satisfied either at a point in time or over time if certain criteria are met. Based on the guidance, many service arrangements and long-term construction contracts may meet the recognition over time criteria.
* Revenue is only recognised to the extent that it is reasonably assured Management will need to consider a number of factors to estimate the transaction price, including the effects of variable consideration and time value of money, based on the probability weighted or most likely amount of cashflow. However, revenue recognised is limited to the amount to which the company is reasonably assured to be entitled. It is reasonably assured when the entity has experience with similar types of performance obligations and that experience is predictive of the amount of consideration to which the entity will be entitled.
* Bad debt adjacent to gross revenue line Today, a company defers all of the revenue from a contract unless the collectability from the customer is probable. Under the new model, this hurdle has been removed. Also, uncollectible amount is presented adjacent to gross revenue line. In addition to affecting margins, these changes require recording a ‘day one’ estimate of customer credit losses for all transactions.
* New disclosures requirements The exposure draft requires an entity to make extensive disclosures intended to enable users of financial statements to understand the amount, timing and judgment around revenue recognition and corresponding cashflows arising from contracts with customers (eg disaggregation of revenue, and reconciliations of the opening and closing of contract assets/liabilities). Preparing those disclosures requires system changes and could convey important information about business practices and prospects to its investors and market competitors.
For a more comprehensive description of the proposed standard, refer to PwC’s Practical Guide to IFRS: Revenue from Contracts with Customers, and the industry supplements in www. pwcinform.com, or www.fasb.org or www.ifrs.org can be visited.
Who is affected?
Still wondering if the new revenue standard will affect you? Actually, the proposed revenue standard, if issued, will impact every company to some extent but the degree may depend on the nature of the company’s operations. Companies that previously followed industry-specific guidance or established industry practices will likely feel the greatest impact. The examples below represent only a small sample of affected industries:
* Contractors Those in the engineering, construction, aerospace and defence industries, among others, currently apply specific guidance under IAS 11, Construction Contracts. This includes rules for recognising revenue (usually on a percentage of completion basis), recording contract costs and accounting for change orders. The new model has similar concepts but there are nuances that could catch some by surprise. For example, there could be differences in the costs that are capitalised or how progress to completion is measured. At the extreme, some arrangements might not result in revenue until the project is completed (eg aircraft with no significant customerisation). Each company will have to assess its own specific facts under the new model.
* Real estate developers Industry-specific guidance under IFRIC 15 for real estate includes prescriptive requirements in areas such as the continuing involvement of the real estate developers. Revised Revenue ED takes more of a principles-based approach and focuses on whether the construction creates an asset with alternative use to the developer and whether the developer is entitled to payment that compensates its performance completed to date. Companies may decide to modify arrangements to meet the new requirements (eg to establish the right to payment for compensation of work performed instead of loss of margin) to better align with their business objectives.
* Telecom The timing of recognition of revenue for telecom entities that currently do not account for equipment (eg ‘free’ handsets) separately from the telecom services will be significantly affected if the performance obligations in their bundled offerings meet the proposed standard’s definition of distinct performance obligations. Furthermore, under the revenue proposal, direct costs of obtaining and fulfilling contracts are capitalised as assets if they meet certain criteria, bringing consistency to an area of mixed practice today (eg sales commissions). Management will need to use judgment to determine the amortisation period as the proposal requires entities to consider periods beyond the initial contract period – for example, the renewal of existing contracts and anticipated contracts.
* Retail and consumer Transfer of risk and rewards may not always coincide with transfer of control. Shipping terms, as well as sales with rights of returns, will have to be assessed under the new model. Additionally, under the proposal, revenue from licences of intellectual property is recognised when the customer obtains control of the rights. Compared with the current practice, this could result in earlier revenue recognition and have fewer licence fees recognised ratably over the licence period if the licence is separable from other unsatisfied performance obligations in the contract. Licence revenue might, however, be constrained if the consideration is determined by reference to the customer’s sales under the new model.
What it means for you
Applying the new model is almost like starting with a clean sheet of paper. This fresh look could prompt changes to contract terms or other business strategies, and companies also need to assess and document their revenue recognition policies under the new model. An important first step is analysing existing sales transactions and modelling the impact of the proposed guidance. Some of the operational implications may include:
1) Changes in how contract terms affect reported revenue, such as contingent fees and prepayments or extended payment terms, could influence how companies and their customers negotiate these terms. Companies may need to modify contract terms to maintain the original intent of arrangements or better align reported revenue with business objectives.
2) The impact of changes to the revenue model will affect key financial measures and ratios, and will likely impact a wide range of arrangements that are linked to their financial measures, including compensation and bonus plans, earn-out arrangements, and covenants in financial agreements. Early communication to stakeholders will be critical.
3) Changes to revenue might also have tax implications and could affect the timing of cash tax payments if, for example, revenue recognition is accelerated.
4) Companies may need to change information technology systems to capture different information and develop new processes for estimates and disclosures that are not required today.
5) Judgments and estimates can be challenged by others in hindsight. The resulting need for increased judgment will require thoughtful documentation and dialogue with those charged with governance.
6) Adopting the new guidance will entail adjusting prior period financial statements, with a few practical exceptions. Gathering data on historical transactions could be challenging, particularly for companies with multi-year contracts. Successful implementation of the standard will require upfront planning.
7) The comment period for Revised Revenue ED ends on 13 March 2012 and the boards anticipate issuing the final standard by the end of 2012. Companies should take this opportunity to participate in the standard-setting process and provide input to the boards.
The final standard will have an effective date no earlier than 2015. While still a few years away, its successful implementation will require planning ahead and keeping stakeholders well-informed. The extent of impact may be extensive; don’t be caught by surprise!
Vivian Lai is senior manager of Accounting Consulting Services at PwC