Issue:-In late June 2010 the International Accounting Standards Board and US Financial Accounting Standards Board issued proposed changes to the recognition of revenue. The proposals aim to increase the consistency and comparability between the way revenue is recognised by entities, regardless of the industry they operate in.
In this aritcle of IFRS in brief we bring you up to date with key aspects of the proposals and identify five areas of accounting that may significantly change current practice.
Impact:-If adopted, the proposals would supersede AASB 111 Construction contracts and AASB 118 Revenue and all related interpretations. The effect of the proposals on existing revenue recognition practices will vary from industry to industry; however, all entities should expect some level of change. Management will need to evaluate how the proposed standard might change current business activities beyond accounting, including contract negotiations, key metrics (including debt covenants), budgeting, controls and processes, and information technology requirements.
When will it come into effect?
The Boards expect to issue the final standard in 2011, with a likely effective date no earlier than 2014. Full retrospective application will be required.
What are the key areas of change?
1. Change in determining when an entity earns revenue
Current guidance. The recognition of revenue is focused on completion of an earnings process’. This occurs when an entity i) has transferred the significant risks and rewards to a third party; ii) can reliably measure the revenue, stage of completion and cost of the transaction; and iii) has determined that economic benefits from the transaction are probable.
Under the proposals. Revenue is recognised when an entity satisfies its obligations to its customers, which occurs when control of an asset (whether a good or service) transfers to the customer. Revenue is recognised as each performance obligation is completed and control is transferred to the customer.
Insight. Under the proposals the control of a good or service can transfer at a single point in time or continuously over the contract period. Based on our experience, many customer contracts within the property and construction industry transfer control of a good or service continuously (for example, as construction of a building progresses). To determine when revenue is recognised these entities may continue to use methods based on inputs (ie, costs incurred or labour hours expended) or outputs (ie, units produced or delivered) or the passage of time. Whichever method is chosen, entities need to ensure that it reflects the transfer of control to the customer rather than simply the activities of the entity. Further, the percentage of completion method will no longer exist.
2. Further disaggregation of multiple element arrangements
Current guidance. For transactions that contain multiple elements it is necessary to apply the revenue recognition criteria to each separable component in order to reflect the transaction’s substance. For example, the sale of electronic equipment that includes delivery and installation would typically represent two separate components.
Under the proposals. Contracts with multiple elements or deliverables are known as performance obligations. These arrangements occur where goods and services are sold together but delivered at different times. Under the proposals, entities will need to ascribe revenue to each obligation that is distinct’. A good or service is distinct if the entity (or another entity) sells the good/service separately or if the performance obligation has a distinct margin or function. For example, an entity may grant a customer the option to acquire additional goods or services. That promise gives rise to a distinct performance obligation as the option provides a material right to the customer. The entity should recognise revenue allocated to the option when the option expires or when it transfers goods or services to the customer.
Insight: Determining when to separately account for performance obligations will require management’s judgement. Performance obligations that have different risks or margins or for which control transfers at different times should not be combined. We expect more performance obligations to be identified under the proposals than currently.
3. Licences and rights to use
Current guidance. Entities in the pharmaceutical and entertainment & media industries that licence the use of their intellectual property to a third party generally recognise revenue when the contractual performance has occurred to the extent that revenue can be measured reliably. For example, the fixed element of royalty revenues is typically recognised as a sale at the inception of the contract in cases where there are no outstanding contractual obligations.
Under the proposals. The recognition of revenue for the licence of intellectual property depends on whether the customer obtains control of the asset. For example, a licence that transfers control of intellectual property to the customer (ie, the exclusive right to use the licence for its economic life) would be treated as a sale of a good with revenue recognised upfront. In contrast, an entity that licences the use of its intellectual property but does not transfer control of the intellectual property to the customer (eg, a licence for less than its economic life) would need to determine whether the licence is exclusive or non-exclusive. For exclusive licences, revenue would be recognised over the term of the licence as the performance obligation is satisfied. For non-exclusive licences (such as off-theshelf software) revenue would be recognised when the customer is able to use the licence and benefit from it.
Insight: The proposals may result in some entities recognising revenue over the term of the licence instead of upon the granting of the licence, thereby delaying the recognition of revenue. The economic life of intellectual property is now pivotal to determining when revenue is recognised.
4. Collectability and credit risk Current guidance. Revenue is recognised when the customer’s payment is reasonably assured (or probable).
Under the proposals. The transaction price in a contract (ie, the consideration the customer promises to pay in exchange for goods and services) is adjusted to reflect the customer’s credit risk by recognising the consideration expected to be received on a probability-weighted basis. The customer’s ability to pay the consideration agreed in the contract affects the measurement of revenue; the credit risk is reflected as a reduction in the transaction price at contract inception (rather than as a bad debt expense). Any changes in the credit risk that affect the consideration to be received are recognised separately from revenue as income or expense.
Insight. Collectability is no longer a recognition threshold which might bring forward the recognition of revenue. Profit may be more volatile as changes to the assessment of customers’ credit risk are recognised as income or expense.
5. Accounting for contract-related costs
Current guidance. Existing IFRS guidance includes accounting for contract costs. Costs that relate directly to a contract and which are incurred in securing the contract are included as part of the contract costs if they can be separately identified; measured reliably; and if it is probable the contract will be obtained.
Proposed guidance. Only costs that relate directly to a contract and to future performance, and which are probable of recovery under a contract may be capitalised. These costs include direct labour materials, costs explicitly chargeable to the customer and other costs incurred only due to entering into the contract.
Insight. The proposals may significantly affect entities that previously capitalised certain pre-contract costs (eg, acquisition-related costs and legal fees). Management should carefully review their current cost capitalisation methods in order to understand the potential effects of these changes. For example, entities that pay significant amounts to third parties (eg, agents) in order to secure contracts, and that currently capitalise the amounts paid, would recognise such costs as an expense when incurred under the proposals.
