International Financial Reporting Standard (IFRS) 15 on Revenue from Contracts with Customers was issued on May 28, 2014 and will become effective for annual periods beginning on or after January 1, 2017, subject to endorsement by the European Commission for adoption in the EU.
This new IFRS, which was almost six years in the making, introduces a single revenue recognition model that will apply to all contracts with customers, except leases, financial instruments and insurance contracts. The standard will supersede currently applicable revenue standards and interpretations, including IAS 18 Revenue, IAS 11 Construction Contracts, IFRIC 13 Customer Loyalty Programmes and IFRIC 15 Agreements for the Construction of Real Estate.
IFRS 15 was developed jointly by the IASB and the US Financial Accounting Standards Board; the standard will therefore also eliminate a major source of inconsistency in US GAAP, which currently consists of numerous disparate, industry-specific pieces of revenue recognition guidance which IFRS preparers use in the absence of specific IFRS guidance.
Under IFRS 15, entities will apply a five-step model to determine when to recognise revenue, and at what amount. The model specifies that revenue should be recognised when (or as) an entity transfers control of goods or services to a customer at the amount to which the entity expects to be entitled. Depending on whether certain criteria are met, revenue is recognised over time, in a manner that depicts the entity’s performance, or at a point in time, when control of the goods or services are transferred to the customer.
Adoption of the new standard may be challenging, particularly for certain industries. First and foremost, an entity needs to identify those contracts with customers that meet the criteria in the standard in order to kick off the revenue recognition process. Among others, the standard requires that contracts with customers have commercial substance, commit each party to certain obligations and establish the probability that the entity (the seller) will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. If these criteria are met at contract inception, the seller needs to re-assess the validity of such contracts only in the event of a significant change in facts and circumstances, such as a significant deterioration in the customer’s creditworthiness – in which case no further revenue on that contract would be recognised. If on the other hand, the criteria are not met at contract inception, the seller needs to continue assessing the contract to determine whether the criteria are subsequently met, until which time no revenue on that contract may be recognised.
Contract modifications are quite common, in some industries more than others. Those impacted businesses will need to start considering the criteria in IFRS 15 to determine whether such modifications result in the identification of a new, separate contract, or the termination of the original contract and the creation of a new one, or as part of the original contract altogether. The accounting implications vary in the different circumstances.
Under the new standard, revenue will be recognised as the entity satisfies a performance obligation by transferring control of the promised good or service to the customer. The identification of performance obligations and the allocation of the transaction price to those performance obligations will therefore be key to the whole revenue recognition process. A performance obligation is a promised good or service in the contract that is distinct, that is, the customer can benefit from the good or service on its own or together with other readily available resources and the promise is separately identifiable from other promises in the contract. While the first criterion is familiar, the second criterion is a new concept that will require entities to think differently about promised goods or services.
Adopting the new standard may be challenging, particularly for certain industries
Compared to current practice, this approach may result in more goods or services being unbundled from others in a contract. Alternatively, an entity might bundle together promised goods or services that have stand-alone value to the customer today, because they are highly inter-related with other promised goods or services in the contract and are therefore not separately identifiable.
Determining the transaction price may also be challenging, in particular where part of the consideration is variable. The new standard in fact requires entities to estimate the amount of any variable consideration and constrain such to the extent that the revenue will not be subject to a significant reversal. This may be highly judgemental, depending on the merits of the case at hand. Going forward, entities will need to evaluate contracts with variable consideration, analyse those contracts and decide on the applicability of the revenue constraint and put in place processes to update variable consideration for changes in facts and circumstances.
IFRS 15 establishes two patterns for the transfer of control – over time or at a point in time. Where control is transferred over time, entities will recognise revenue over time, similar to the current stage of completion accounting. If control is not transferred over time, entities will need to identify at which point is control transferred to the customer (and revenue is recognised) by considering the relevant criteria in IFRS 15 to that effect.
Entities may see a change to the current revenue recognition pattern and a disconnect between the revenue recognised (and the tax incidence thereon) and the cash inflows from the contract.
In view of possible changes to revenue recognition patterns when compared to current practice, entities may need to consider the resultant tax consequences for adjustments to the timing and amounts of revenue, expenses and capitalised costs, compliance with covenants, and sales incentive plans such as staff bonuses to ensure that these remain aligned with corporate goals.
Entities may also need to communicate with investors and other stakeholders who will want to understand the impact of the new standard on the overall business. Areas of interest may include the effect on financial results, the costs of implementation, any proposed changes to business practices, and the transition approach selected.
Jonathan Dingli is an associate director with KPMG Malta.