Revenue Recognition – One Standard For All
Revenue is the life blood of organisations, and it is of fundamental importance that all users of financial statements understand the revenue line. Preparers and auditors must have a robust standard which provides the basis on which financial statements inform all stakeholders about an organisation's revenues.
Since 2008 the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have been jointly engaged in developing a new standard. In November the Boards published an exposure draft of a standard, 'Revenue from Contracts with Customers', being a re-exposure of the proposals made initially in June 2010, with significant amendments for the purposes of clarification and simplification. The comment period is open until 13 March 2012.
Diverse revenue recognition practices have arisen, under IFRSs, because IAS 18 'Revenue' and IAS 11 'Construction Contracts' contain limited guidance on some topics and the guidance that is provided can be difficult to apply to complex transactions. Some companies also supplement the limited guidance in IAS 18 by selectively applying U.S. GAAP.
In U.S. GAAP there are numerous industry and transaction specific requirements that can result in economically similar transactions being accounted for differently.
Disclosure requirements are also considered inadequate, particularly in relation to judgements and estimates made by the company in recognising revenue, with 'boiler-plate' disclosure being a common problem.
The proposed standard would improve IFRSs and US GAAP by
- Providing a more robust framework for addressing revenue recognition issues
- Removing inconsistencies from existing requirements
- Improving comparability across companies, industries and capital markets
- Providing more useful information to users of financial statements through improved disclosure requirements
- Simplifying the preparation of financial statements by streamlining the volume of accounting guidance
The core principle of the proposed standard is that a company should recognise revenue to depict the transfer of promised goods or services to a customer in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services.
A final standard will replace IAS 18 and IAS11 and the FASB guidance on Revenue Recognition. The proposed standard provides a robust and comprehensive framework that can be applied consistently across various transactions, industries and capital markets.
Framework for Recognising Revenue
The proposed standard outlines a five-step framework for recognising revenue
- Identify the contract(s) with the customer
- Identify the separate performance obligations in the contact
- Determine the transaction price
- Allocate the transaction price
- Recognise revenue when a performance obligation is satisfied
While for many companies with relatively uncomplicated revenue streams this five-step framework should not be problematic to apply and should not give rise to significant change in practice, for others with more varied transaction types and customer contracts there may be many potential challenges. It is likely to be of particular consequence for companies that engage in multiple-element contracts and those that engage in contracts which may extend for more than one year with a number of different stages.
Challenges that may arise include:
- Combining of individual contracts as one single overall contact
- Unbundling of separate performance obligations in a contract
- Estimation of consideration that is variable or in a form other than cash
- Consideration of credit risk and the determining of the charge
- Measurement of the time value of money
- Allocation of discount or contingent consideration to separate performance obligations
- Selection of an appropriate measure of progress to determine how much revenue should be recognised as the performance obligation is satisfied
- Evaluation of onerous performances obligations that are satisfied over a period of time greater than one year together with the potential implications for inventory values
- Recognition of incremental costs of obtaining a contract
- Provision for warranty obligations
The above is not intended to be all inclusive with regard to the recognition and measurement challenges that companies may face. These are likely to vary widely according to industry, transaction type and other variables. The intention of the proposed standard is to provide a consistent framework to guide all revenue recognition accounting.
The Need for Disclosure
Users of financial statements need to have an enhanced understanding of the nature, amount, timing and uncertainty of revenue and cash flow from contracts with customers. The Boards propose the disclosure of qualitative and quantitative information including the significant judgements, and changes in judgements, made in applying the proposed requirements to those contracts. The timing of recognition of revenue and the existence of any onerous obligations are also matters which require significant additional disclosure.
The ED proposes that an entity should provide specific revenue recognition disclosures in interim financial statements, including a disaggregation of revenue, reconciliation of movements in contract assets and liabilities and an analysis of remaining performance obligations, including onerous commitments.
The Boards have proposed an effective date for the standard of not earlier than annual periods beginning on or after 1 January 2015, with retrospective application. There are optional reliefs available to retrospective application, which include:
- not restating for contracts that begin and end within the same accounting period and were completed before the date of initial application
- using the transaction price for contracts with variable consideration which were completed before the date of initial application
- not requiring the onerous obligation test to be performed before the date of initial application unless an onerous obligation liability was recognised previously, and
- not requiring disclosure for prior periods of the amount of the transaction price allocated to remaining performance obligations and an explanation of when the entity expects to recognise that amount as revenue
If an entity applies the standard retrospectively subject to any of the above reliefs, it would be required to state which reliefs have been availed of with a qualitative assessment of the likely effect of applying those reliefs.
The Boards plan to issue the final standard before the end of 2012 which allows at least two full years before mandatory application.
The application of the proposed standard will not only impact on financial reporting by entities and the manner in which financial results and key performance indicators are presented to investors and other stakeholders. The sensible course would be for everyone to think through how it may affect them. Systems may have to be changed, accounting policies adapted, debt covenants reviewed and customer contracts may need to be modified. Entities may also need to consider if there are any further implications for the timing of the recognition and settlement of tax liabilities.
Companies that prepare well should avoid any unwelcome surprises which could potentially upset their ratings in the marketplace.
First published in Finance Dublin Online.