This article was first published in the June 2012 Singapore edition of Accounting and Business magazine.
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Some of us were still in school when IAS 11, Construction Contracts and IAS 18, Revenue were issued in 1993. Since then, a number of amendments have been made to both IAS 11 and IAS 18 as a consequence of other new or amended International Financial Reporting Standards (IFRSs), and a number of revenue-related interpretations were issued, for example IFRIC 13, Customer Loyalty Programmes; IFRIC 15, Agreements for the Construction of Real Estate and IFRIC 18, Transfers of Assets from Customers.
However, these amendments and interpretations do not necessarily change the principles in IAS 11 and IAS 18. Therefore, essentially, we have been relying on the same principles for revenue accounting for almost 20 years, and any significant change is expected to have significant effects.
Reasons for the proposed changes to revenue accounting
The aforementioned standards and interpretations have been criticised as being difficult to apply to complex transactions. It should be noted that business transactions and contractual agreements have become increasingly complex over the years. Possible reasons for this criticism include lack of guidance for multiple element sales contracts and diversity in the interpretation of the meaning of ‘continuous transfer’ when applying IFRIC 15.
Enter exposure draft (ED), Revenue from Contracts with Customers. This ED is a result of a joint project between the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board, and one of the objectives in issuing it is to address the aforementioned weaknesses in the current revenue standards. When issued as a standard, the ED will replace the current revenue standards.
The proposals in the ED are meant to be the single standard to be referred to for revenue recognition applicable to a range of industries, companies and geographical boundaries and thus have far-reaching effects. In acknowledgement of this, the boards have hosted numerous outreach activities involving auditors, preparers, regulators and users from multiple jurisdictions.
In fact, the boards issued the ED twice – this was unprecedented. The first ED was issued in June 2010 and nearly 1,000 comment letters were received. In response, the boards decided to revise many detailed aspects of the 2010 proposals, although the underlying conceptual basis is unchanged. As a result of these changes, and the importance of the revenue line item to users of financial statements, the boards decided to expose the revised ED in 2011. The comment period for the ED ended on 13 March 2012.
Summary of key changes
The ED’s core principle 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 to in exchange for those goods or services’. The impact of the proposals on revenue accounting is outlined below.
Identifying contracts with customers
The proposals would apply to an entity’s contracts with customers other than those within the scope of the leasing, insurance or financial instruments standards and non-monetary exchanges between entities in the same line of business, to facilitate sales to customers or potential customers other than the parties to the exchange.
The ED provides specific criteria for entities to consider in determining whether a contract exists. A contract can be written, oral or implied and must create enforceable rights and obligations between two or more parties.
The implication of this is that entities will need to identify all customer contracts and understand their key terms to ensure that the new revenue model is appropriately applied. This may include understanding the practices and processes for establishing contracts in an entity’s legal jurisdiction and the customary business practices of an entity and its industry.
Multiple element contracts
The ED lays out specific criteria as to when the individual element of goods and services in a contract should be considered separate revenue elements for accounting purposes, specifically when the entity regularly sells the good or service separately or when the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.
The ED uses the term ‘performance obligations’ (POs) to identify each of those different revenue elements. The ED also includes criteria as to when multiple elements of goods and services are considered one PO, specifically when the elements are highly interrelated, integrated and the bundle is highly customised or modified. These proposed criteria are helpful over current revenue standards as they provide criteria to entities on how many ‘revenue items’ there are in a single contract.
The implication of the above is that some entities may identify more or less POs as compared with current practice. In addition, where some entities account for a bundle of goods and services as separate revenue streams (or one revenue stream) in current practice, they may end up having to combine those different elements of goods and services as one PO (or split them up into various POs).
In all the above cases, since entities may only recognise revenue as each PO is fulfilled, entities may experience changes to the timing of revenue recognition as a result of the proposals.
The ED also prescribes the method of allocating the transaction price for a contract to the individual elements in the POs, ie based on relative standalone selling prices of each PO in the contract, which is largely similar to the ‘relative fair values’ approach in current practice. The proposals are helpful in determining the amount of revenue to be recognised as each PO is fulfilled, as current revenue standards are silent in this respect.
For certain industries, modifications to the scope or pricing of a contract may be a norm – for example, variation orders. The ED specifies that, depending on whether certain criteria are met, such modifications may be accounted for either as separate contracts or part of the existing contract. There is no clear guidance for this under the current revenue standards.
A modification may be a separate contract if the modification results in a separate PO with pricing that is largely independent of the existing contract. Otherwise the modification is accounted for as part of the existing contract. In the latter case, the accounting gets a bit complicated depending on whether the modification is on prices alone, on POs alone, or both. This may change the timing and amount of revenue recognised.
The above proposals may require careful consideration by, for example, entities that engage in construction of assets or professional services.
POs satisfied over time
The ED provides guidance that an entity must consider in determining whether a PO is satisfied continuously over time. This will have a bearing on whether the stage of completion method of revenue accounting can be applied to a PO and is a significant issue faced by many entities under the current revenue standards. The ED appears to articulate two broad concepts on this.
First, this happens when the entity’s performance creates or enhances an asset that the customer controls as it is created or enhanced.
Second, this happens when the entity’s performance does not create an asset with alternative use to the entity – for example, the contract does not allow the entity to sell the work in progress to another customer or the work in progress is highly customised and would not be suitable for another customer – and at least one of the following criteria is met:
- the customer simultaneously receives and consumes the benefit as the entity performs each task;
- another entity would not need to substantially reperform the work completed to date if that other entity were to fulfil the remaining obligation to the customer (without having access to work in progress or any other asset controlled by the entity); or
- the entity has a right to payment (assuming that the seller complies fully with its contractual obligations) for performance completed to date and expects to fulfil the contract as promised. If the customer cannot cancel the contract, or the full contract price is payable on cancellation, this would appear to meet the criteria. If the contract can be cancelled by the customer and a fixed amount is payable on cancellation, which is lower than the total contract price, this may not be considered to be sufficient to compensate for performance to date and therefore may not satisfy this criterion.
From the above, there is a subtle but significant shift in focus for construction-type activity. The existing guidance in IAS 11 and IFRIC 15 focuses on whether an item is being constructed to a customer-specific design. The ED instead focuses on whether the asset under construction has ‘alternative use’ to the entity. This may result in a different analysis in some cases, particularly for some property contracts.
The ED specifies that in some cases, warranties may constitute a separate PO to be accounted for as a separate revenue stream, instead of as a selling cost under current practice. This happens when the customer has the option to purchase the warranty separately, or when the warranty provides a service beyond assuring a good or service complies with agreed-on specifications. This may change the timing and amount of revenue recognised, particularly when the warranty price is significant and warranty term is for long extended periods.
Presentation of credit losses
Where entities currently present credit losses relating to bad debts as an expense, the ED specifies that such credit losses will be presented as a separate line item adjacent to the revenue line in the income statement. This may have an impact on key performance indicators, for example gross margin ratios.
The ED specifies that POs that are to be satisfied over a period greater than one year would be evaluated on whether they are onerous POs. This is a test similar to tests of onerous contracts under IAS 37, Provisions, Contingent Liabilities and Contingent Assets, except that it is done at a PO level instead of at the contract level. An implication is that a ‘day one’ onerous provision is required on a multiple-element contract that is profitable as a whole, but has one onerous PO among other profitable POs within the same contract. Entities will need to evaluate each of their multiple-element contracts for such onerous ‘day one’ losses.
Costs associated with obtaining and fulfilling a contract are capitalised under the ED when certain criteria are met. This may require new policies, processes and data in order to capture and amortise these costs.
Transition and effective dates
An entity would be required to apply the proposed revenue standard retrospectively, subject to the several optional reliefs. The IASB will not make a final decision on the effective date of the new standard until it completes its deliberations on the revised proposals in 2012. However, the IASB tentatively decided that the effective date of the proposed standard would not be earlier than for annual reporting periods beginning on or after 1 January 2015.
Entities may need to review their internal information systems to determine whether there is a need to modify their internal systems, controls and processes to gather necessary information to comply with the new disclosure requirements and changes in revenue recognition and cost capitalisation in a consistent manner.
Entities may need to assess the implications of any potential changes to the presentation of financial results on key performance indicators (for example, gross margin ratios), covenants and existing contracts (for example, remuneration agreements). Entities may also need to consider if there are any further tax implications from the revised proposals. Stakeholder education may be necessary to explain any potential changes to the financial statements.
Entities will need to consider the effects of the revised proposals as they negotiate new contractual arrangements and modify existing agreements.
The application of various aspects of the revised proposal will require judgment and estimation.
The ED has been subject to significant debate, in particular around the area of continuous transfer of control. It will be interesting to see the outcome of the boards’ deliberation on these areas and how the final standard will be worded. At the time of writing, the boards have indicated that the final standard will be issued either in 2012 or 2013. Entities will have to start setting aside resources to carefully consider the implications of the requirements in the final standard.
Shariq Barmaky is partner and Mohamed Ghamazy is senior manager at Deloitte Singapore’s IFRS Centre of Excellence