The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) recently published a new revenue recognition accounting standard to eliminate global differences and conflicting requirements. IFRS lacked sufficient detail, whereas the accounting requirements of U.S. GAAP were considered to be overly prescriptive and conflicting in certain areas.
The changes pose will a challenge to many businesses, particularly those offering complex ‘bundles’ of goods and services, or long-term service contracts e.g. telecom providers. The core principle of the new standard is for companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration (that is, payment) to which the company expects to be entitled in exchange for those goods or services. The new standard also will result in enhanced disclosures about revenue, provide guidance for transactions that were not previously addressed comprehensively (for example, service revenue and contract modifications) and improve guidance for multiple-element arrangements.
As Dr Nigel Sleigh-Johnson, Head of ICAEW’s Financial Reporting Faculty, commented: “Revenue is a crucial number to investors and other users of financial statements seeking to understand and assess a company’s performance and prospects. Until now, there have been significant differences in how and when revenue has been recognised and reported under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Standards (US GAAP), which has made it difficult to compare reported revenues across companies, industries and capital markets. “This new ‘flagship’ convergence standard will improve comparability and the quality of information available.”
The converged revenue recognition standard, will come into force in 2017 and will clarify:
– when revenue should be recognised,
– how it should be measured
– the disclosures required about contracts with customers.
The amount of revenue recognised should not change but the timing will. One result will be to give companies greater leeway in recognizing revenue earlier, thus allowing them to report profits sooner than they previously might have. “Because there is a greater need to estimate, there is a greater need to disclose,” Russell Golden, the chairman of the Financial Accounting Standards Board, said in an interview. He said new disclosures would be required in footnotes to financial statements, “so that investors and other users of financial statements better understand the economics behind the numbers.”
Cellphone companies may now be able to report revenue earlier. When a telco sells a phone for $200, with a contract to pay $50 a month for two years, it generally now reports revenue when the cash arrives. In fact, the phone is worth more than $200, and some of its cost is included in the monthly fees, but that does not show up in the accounting. Under the new rules, the Telco would divide the revenue into two parts, for the service and for the equipment. When it delivered the phone, it would be able to take more than $200 in revenue, even though some of the cash would not arrive for many months. So it would report more revenue immediately, and less later.
The vendor-specific objective evidence (VSOE) requirement will be eliminated from software arrangements, resulting in accelerated revenue for many licenses that are currently deferred due to lack of VSOE for undelivered elements. Specified future upgrades or additional product rights or other vendor obligations that currently cause revenue referral due to lack of VSOE generally will not delay revenue recognition under the new standard. Entities that license their IP to customers will need to determine whether the license transfers to the customer over time or at a point in time. A license that is transferred over time allows a customer access to the entity’s IP as it exists during the license period. Licenses that are transferred at a point in time allow the customer the right to use the entity’s IP as it exists when the license is granted. The customer must be able to direct the use of and obtain substantially all of the remaining benefits from the licensed IP to recognize revenue when the license is granted. The standard includes several examples to assist entities making this assessment.
The real estate industry will see the elimination of specific requirements for profit recognition on sales of real estate under current US GAAP, which may result in accelerated revenue or gains.
An area where many companies will have to make new estimates is loyalty programs
Some companies may choose to amend contracts with customers, which in some cases have been written to correspond with specific accounting rules and assure the revenue will be reported as desired. To get a desired effect under the new rules, contracts might need to be altered.
An estimate of variable consideration is included in the transaction price if it is probable (U.S. GAAP) or highly probable (IFRS) that the amount will not result in a significant revenue reversal if estimates change. Even if the entire amount of variable consideration fails to meet this threshold, management will need to consider whether a portion (a minimum amount) does meet the criterion. This amount is recognized as revenue when goods or services are transferred to the customer. This could affect entities in multiple industries where variable consideration is currently not recorded until all contingencies are resolved. Management will need to reassess estimates each reporting period, and adjust revenue accordingly.
There is a narrow exception for licenses of intellectual property (IP) where the variable consideration is a sales- or usage-based royalty.
Companies need to asses impact of the standard on all the company’s revenue streams and to determine what customers pay for each element of goods and services sold as packages. The new standard provides much more detailed guidance The standard may require a business to make changes to, its information systems and processes, internal controls and bonus plans. Companies will need to develop processes to capture and document judgments at the source – such as executive management, sales, operations, marketing, and business development – and feed those judgments into their accounting processes.
Five Steps to Recognizing Revenue
Under the new standard, companies under contract to provide goods or services to a customer will be required to follow a five-step process to recognize revenue:
1.Identify contract(s) with a customer.
2.Identify the separate performance obligations in the contract.
3.Determine the transaction price.
4.Allocate the transaction price to the separate performance obligations.
5.Recognize revenue when the entity satisfies each performance obligation.
