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In the first of a two-part series on startups, KPMG’s Ivan Lukanov ACCA looks at the challenges the forthcoming revised standard on revenue recognition is likely to create

This article was first published in the April 2013 International edition of Accounting and Business magazine.

The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have issued a revised exposure draft on revenue recognition (ED/2011/6, Revenue from Contracts with Customers). Applied in its current form, the proposed standard would change the current revenue recognition practice for crowdfunded companies significantly and must be applied retrospectively. This article explains what crowdfunding users need to know.

Major changes

If approved as it stands, this new revenue recognition standard will apply to all companies without exception, although it will not apply to financial instruments, leases, insurances and non-monetary exchanges.

The draft standard will change the timing of revenue recognition and how much revenue to record (the calculated transaction price). The most significant draft proposals, not considering special cases and exceptions, will affect transaction price determination. Some examples are:

  1. Management judgment will be necessary to estimate the total sales price of a transaction when the consideration is variable. For example, an add-on bonus payment for work finished early can be considered and recorded based on management judgment on the bonus receipt.
  2. An own-line item adjacent to revenue will be introduced with the obligation to record expected default amounts in it when revenue collectability is or is expected to be uncertain. For example, a 5% historical bad debt ratio on credit sales would be recorded as an own-line item adjacent revenue.
  3. There will be obligations at advance payments to consider the time value of money. For example, advance payments for goods or services that will be delivered after 12 months must incorporate credit-specific interest rates in the revenue record, if the financing component is significant to the contract.

The final point here, the obligation to consider the time value of money, will particularly affect startups that use the popular crowdfunding concept.

Time value of money

The consideration of the time value of money, drafted in ED 58-60 for International Financial Reporting Standards (IFRS) and BC143 for US GAAP, states that each company must consider its specific credit risk interests at upfront paid transactions that would be delivered after more than 12 months. The draft standard further states that the financing component must be significant. Let’s see the implications on a crowdfunded startup.

Rocket (a fictitious startup) has successfully pitched its idea on a crowdfunding platform for the development of a new role-play game. The company raised €10m on 1 January 2013, which is enough to develop the promised game. Game development will take around 24 months and the first games will be shipped on 31 December 2014.

How much revenue can the company record at 1 January 2013 (today) and on 31 December 2014 (the date of game shipment)?

The answer is none today and €12.1m (€2.1m more than cash collected) at the date of game shipment, if tax effects are neglected. Where does the additional €2.1m come from? The answer is that the new draft standard will make it possible.

That additional €2.1m

The objective of the draft standard is to reflect today’s cash selling price in the revenue record, if the financing component is significant to the contract. Rocket must consider the interest rate it would be required to pay if the funding was agreed with the customer in a separate contract.

Following the draft standard, Rocket will recognise interest expenses of the financing component in the P&L over the period of two years (eg, 10% for two-year compound/cumulative interest on €10m = €2.1m) and credit the revenue account (contract liability until delivery) with the €2.1m. As a result the net profit of the company is unchanged but the revenue record is higher than the initial cash received.

The book records to reflect the transaction would be as follows:

As at 1 Jan 2013
DR €10m cash (balance sheet – B/S)
CR €10m contract liability (B/S)The startup received the cash: the cashflow and the contract liability to deliver the game were recorded.

Over the two years, until the game is transferred
DR €2.1m cumulative interest (P/L)
CR €2.1m contract liability (B/S)

As at 31 Dec 2014
DR €12.1m contract liability (B/S)
CR €12.1m revenue (P&L)

The game was delivered to the crowd, so the contract liability was dissolved. The cumulative interest expense to record the time value of money is recognised in the P&L over the two years. The corresponding position is the revenue record.

The interest rate applied

The main trigger in the time value of money calculation is the interest rate applied. The draft standard defines the interest rate to be applied to mirror the vendor’s specific credit risk. However, the credit risk is difficult to determine for startups, due to the lack of a credit history. We assume that the interest rates would typically include a higher risk premium, which will increase the interest expense and the recorded revenue. As shown in this example a 10% interest rate would lead to a €2.1m higher revenue record; a 15% interest rate would lead to a €3.2m higher revenue record, assuming an annual compounding method.

What it means for management

A startup’s management may need to explain the composition of the revenue record and the calculation of the interest rate when reporting its financials to investors or other stakeholders in order to avoid misinterpretations. This would lead to higher documentation and administration requirements.

What it means for investors

Venture capitalists and angel investors may need to point out that the revenue record does not necessarily mean cash receipt, especially for long-term projects paid in advance.

To avoid these dangers investors should focus their analysis on earnings before tax (EBT – eg, after interest and depreciation/amortisation) instead of EBITDA in order to consider the two offsetting time value of money records. The EBITDA and EBT results of €2.6m and €0.5m respectively in the project margin comparison table (see below) illustrate the danger of making wrong investment decisions on a first-sight P&L analysis.

Project margin comparison


IAS 18

€mCurrent standardTime value of moneyNew draft standard
Cost of sales(9.0)-(9.0)
Gross profit1.02.13.1
SGA costs(0.5)-(0.5)
Time value of money interest-2.1(2.1)

Ivan Lukanov ACCA is a manager at KPMG Germany.

Last updated: 3 Apr 2014