Revenue Recognition: changes on the horizon
Revenue recognition has been in the headlines quite a lot over the last five years or so, not only in IFRS, but also in UK GAAP. In November 2011, the IASB issued an exposure draft containing proposals to change the way an entity recognises revenue and applies to entities with contracts with customers except leases, financial instruments and insurance contracts. If these proposals go ahead, they could well affect other jurisdictions, such as the UK as many countries often converge their own standards to be aligned to IFRS. The project is in collaboration with the American standard-setters – the Financial Accounting Standards Board (FASB) and if adopted the standard would replace IAS 18 Revenue and IAS 11 Construction Contracts. It would also replace the guidance on revenue recognition in Topic 605 Revenue Recognition in US GAAP. At the time of writing, the IASB are now sifting through the comments received on the exposure draft with a target IFRS forecast to be issued in 2012/13.
Why change now?
Revenue, in all countries, is the headline figure in a set of financial statements and therefore plays a pretty important part in not only the calculation of profits, but it also has the ability influence all sorts of external stakeholders such as banks, other financiers, taxation authorities, suppliers and credit rating agencies. In a nutshell, the IASB have re-introduced the proposals (they originally issued proposals in 2010) in order to give analysts and investors the confidence that revenue is being recognised on a consistent basis and across all industries and continents which adopt IFRS. Indeed these proposals are likely to affect certain listed companies in the UK that report under EU-adopted IFRS.
IAS 18 and IAS 11 weaknesses
There are already quite detailed standards on revenue recognition both in IAS 18 Revenue and IAS 11 Construction Contracts. IAS 18 currently deals with revenue arising from:
- Sales of goods
- Rendering of services
- Interest
- Royalties
- Dividends
IAS 11 deals with (among other things) the revenue recognition requirements which relate to construction contracts (in a similar fashion to the UK’s SSAP 9 Stocks and Long-Term Contracts). In IAS 11 the recognition of revenue is done by reference to the ‘stage of completion method’ (which is also referred to as the ‘percentage of completion method’). Essentially, contract revenue and costs are recognised as revenue and expenses in profit or loss in the period in which the work is performed. When losses are foreseen they are immediately recognised, which is consistent with SSAP 9 requirements.
IAS 11 is a fairly complicated standard because in order to be able to recognise revenue, the construction company has to be able to make reliable estimates of its income and costs. This is easier to do once the contracting parties have drawn up an enforceable contract which stipulates the contract consideration and the terms of settlement. However, as is often the case in such matters, the company has to have the ability to review and (where necessary) revise the estimates of contract revenue and contract costs during the life of the contract. This means, therefore, that the company has to have an effective system of internal financial budgets and reporting systems.
The IASB have acknowledged that it is not possible to amend IAS 18 and IAS 11 to incorporate their proposals on the grounds that simply amending the existing IAS’s would not resolve the ‘fundamental weaknesses’ in those standards. Essentially because both standards are entirely different, a company reporting under the IFRS regime could recognise and report significantly different levels of revenue depending on which standard it applies. The difficulty is down to the fact that IFRS does not clearly distinguish between goods and services which poses difficulty on some companies because they are not entirely sure whether to account for some transactions under the provisions in IAS 18 or IAS 11. The interpretation committee issued IFRIC 15 Agreements for the Construction of Real Estate on 3 July 2008. The interpretation committee issued this interpretation in order to clarify the application of both IAS 18 and IAS 11, but only for one type of transaction. The problem with IFRIC 15 is that it does not address the fundamental inconsistencies with revenue recognition principles contained in both IAS 11 and IAS 18.
A summary of the inconsistencies and weaknesses are as follows:
Inconsistencies
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Current accounting practice |
Proposed intended outcome |
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Further obligations/incentives Some companies currently offer sales incentives or have ongoing incidental obligations. Current practice is that some companies recognise all of the transaction as revenue despite the fact the company still has outstanding obligations to fulfil. |
The proposals require companies to assess if the promised goods or services arising from incidental obligations are distinct (see further in the article for how ‘distinct’ is defined). If they are distinct a company can only recognise revenue as each distinct good or service is transferred to the customer. |
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Limit on contingent revenue The exposure draft cites the practice of a mobile phone provider where the provider may sell a mobile phone to a customer as well as the provision of network services for a period of time. Sometimes the transaction price will be limited to the amount of the consideration in respect of network services which are not contingent on the satisfaction of the provider’s performance obligations in the future. |
The transaction price (in the mobile phone scenario) would be based on the amount of money the customer pays on entering into the contract and the monthly payments for the network services. The proposed standard would prohibit the transaction price to be allocated on a basis which is not consistent with the contingent revenue cap. |
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No observable selling price Observable selling prices are those selling prices which can be identified to one particular good or service. The exposure draft cite upgrades and additional functionality for computer software/consumer electronics. What this does is result in the deferral of revenue recognition because some revenue might not be recognised in the financial statements when some goods or services are transferred to the customer. |
When it is not possible to obtain an observable selling price the company will allocate the transaction price on the basis of estimated observable selling prices of those goods and services and would then recognise revenue as each distinct good or service is transferred to the customer. |
Weaknesses
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Current accounting practice |
Proposed intended outcome |
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Timing of revenue recognition Many companies remain uncertain at which point in time they should be recognising revenue because there is a lack of clear and comprehensive guidance in IAS 18 and IAS 11. This is particularly the case for goods and services because goods are sold at a point in time whereas services may be provided over time. |
The proposed standard would require a company to recognise services provided over time as revenue when certain specified criteria have been met. In other cases, the proposed standard would require a company to recognise revenue at a time when the customer obtains control of the promised good or service (see later in the article). |
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Variable consideration Many contracts will be variable in terms of the consideration passed to the company from its customer. IAS 18 and IAS 11 currently do not include comprehensive guidance for measuring the amount of revenue which should be recognised in such cases. |
When contract terms allow variable consideration, a company needs to estimate the expected value, or most likely expected value in order to ascertain the transaction price. The method adopted by the company must have the ability to best predict the amount of consideration to which the company will become entitled to. |
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Time value of money It’s true to say that what is worth £1,000 now won’t be worth £1,000 in five year’s time and indeed some companies do not take into consideration the time value of money when determining the amount of revenue that they need to recognise. |
The proposed standard would require a company to consider the effects of the time value of money when determining the transaction price – particularly in terms of long-term contracts or other such contracts which give rise to payments by the company’s customer at significantly different times. |
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Disclosures The disclosures currently required in respect of revenue recognition are weak and some users’ have said they lack cohesion when compared to the disclosures for other areas of the financial statements. |
The proposed new standard would require users’ to make a comprehensive set of disclosure requirements in terms of qualitative and quantitative information relating to its contracts with customers. IAS 34 Interim Financial Reporting requires companies using IFRS to prepare interim financial reports and some of the disclosures required in the proposed new standard would also be required to be disclosed in those interim reports. |
The exposure draft proposes a new standard which will clarify exactly when a company should recognise revenue and how much revenue should be recognised. The exposure draft proposes a five step approach:
1. The company will identify the contract(s) with the customer
2. The company will identify the separate performance obligations in the contract
3. The company must determine the price of the transaction
4. Allocate the Transaction Price
5. Revenue recognition on completion of a performance obligation
Impact of the proposals
For many, the proposals won’t have any effect (or extremely little). However, for those companies which operate long-term service contracts (such as construction companies) the proposals may result in changes to current accounting practices insofar as revenue recognition is concerned.
Category: Accounting and standards
