Ben Levy, senior manager in Mazars’ Financial Reporting Advisory team, explains the impact of new financial reporting standards
There are some years in the life of a company where changes to the financial reporting environment are so extensive that the implications of change can seep into the financial management, decision making and costs of the company. 2018 is expected to be one of those years.
The International Accounting Standards Board (IASB) has issued two major accounting standards, which will be effective in 2018: IFRS 15 Revenue from Contracts with Customers (IFRS 15, or the “Standard”) and IFRS 9 Financial Instruments. In this article, we shall consider the implications of IFRS 15 and its US Generally Accepted Accounting Principles (GAAP) counterpart, ASC 606 Revenue from Contracts with Customers (“ASC 606”).
IFRS 15 is the new standard on revenue to replace all existing revenue standards, including:
- IAS 18 Revenue (IAS 18)
- IAS 11 Construction Contracts (IAS 11)
- IFRIC 13 Customer Loyalty Programmes (IFRIC 13)
- IFRIC 15 Agreements for the Construction of Real Estate (IFRIC 15)
- IFRIC 18 Transfer of Assets from Customers (IFRIC 18)
- SIC-31 Revenue – Barter Transactions Involving Advertising Services (SIC-31).
The new Standard sets out a five-step model and is generally considered to be more detailed and prescriptive than existing guidance. This model covers the following:
- Identifying the contract
- Identifying performance obligations
- Determining the transaction price
- Allocating the transaction price to performance obligations
- Timing of the recognition of revenue.
Timing of IFRS 15
IFRS 15 is effective for periods commencing on or after 1 January 2018. Early adoption is permitted, although the level of update from early adopters has not been extensive. Most companies who are therefore about to start their 2018 financial year will be in the same position and will need to account for their revenue under IFRS 15 for the first time.
Although the first year of adoption is 2018, the judgements required in the transition approach and the disclosures required mean that finance teams who have not started contemplating the implications of the new Standard may find themselves under pressure in the forthcoming year.
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Financial statements are required to disclose the impact of forthcoming accounting standards; therefore we should be able to have first sight of how market leaders in their sectors have been affected. To meet this disclosure objective, the European Securities Markets Authority (ESMA) has issued what can only be interpreted as a warning shot to companies, as well as further guidance on the matter.
ESMA highlights the fact that while they have ‘identified a number of informative qualitative disclosures on the implementation of the new standards, practice has varied concerning the specificity of the information provided’, they ‘expected a higher level of disclosure of the quantitative impact of the new standards’. In addition, ESMA ‘expects that entity-specific quantitative and qualitative disclosures about the application of the new standards will be provided’ and that since ‘the 2017 annual financial statements will be published after the requirements in IFRS 9 and IFRS 15 (and IFRS 16, if early adopted) will have become effective, ESMA expects that issuers will have substantially completed their implementation analyses (1).
ESMA guidance on the disclosure objective includes their expectation for issuers to ‘provide information about the accounting policy choices that are to be taken upon first application of IFRS 15’, ‘disaggregate the expected impact depending on its nature (i.e. whether the impact will modify the amount of revenue to be recognised, the timing or both) and by revenue streams’ and ‘explain the nature of the impacts so that users of financial statements understand the changes to current practices and their key drivers when compared with the existing principles on recognition and measurement in IAS 11, IAS 18 and related interpretations’ (2).
Key challenges for CFOs
While the implementation of all new accounting standards requires CFOs to think through its implications — because revenue is at the heart of all profit orientated business — the impact of IFRS 15 could fundamentally change the profit, forecasts and thus the business model of some companies. Other challenges to CFOs include the training of finance teams and communication to investors and other stakeholders.
We have identified a few areas which could have a significant impact on the current accounting for revenue for companies.
Identification of performance obligations
Gone are the days of thinking of a contract as a singular transaction; the performance obligation is now the new unit of account in revenue recognition. Each performance obligation is considered and accounted for separately. A performance obligation is a promise to transfer to the customer either ‘a good or service (or a bundle of goods or services) that is distinct’ or ‘a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer’.
The issues here are significant because the identification of more than one performance obligation in a contract means entities must:
- Allocate the revenue to each of the performance obligations identified (based on a prescribed approach) – a separate margin for each separately recognised performance obligation will need to be applied
- Determine the obligating event for recognition of revenue for each performance obligation separately. In some cases revenue will be recognised over time and in others at completion, depending on the way control of the underlying good or service is transferred to the customer, or possibly, the nuances in the wording of the contract.
Timing of revenue recognition
The timing of the recognition of revenue depends on the timing of the transfer of the promised good or service to a customer. A simple enough concept that isn’t necessarily different to current recognition models; however, those companies used to recognising revenue over a period of time may fall foul of the prescriptive requirements in the Standard for such recognition.
Under IFRS 15, revenue will be recognised over time if it can be shown that either:
- The customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs. For example, maintenance services which do not represent significant improvements to an asset; or
- The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. This criterion will be relevant if a contract transfers ownership to the customer as the asset is constructed. For example, building improvements carried out on the customer’s land and buildings; or
- The entity’s performance does not create an asset that the entity could use in any other way, and that throughout the duration of the contract the entity has an enforceable right to payment for performance completed to-date should the customer terminate the contract for its convenience before its termination date. In practice, this right to be paid, evidenced by the contractual terms and/or the applicable legal framework, must cover the costs incurred up to the termination date, plus a reasonable margin. For example, this criterion is likely to be relevant to many contracts for the construction of highly customised assets.
Capitalisation of costs of obtaining a contract
IFRS 15 establishes a restrictive definition of the costs that shall be recognised as an asset when obtaining a contract. Only the costs that would not have been incurred if the contract had not been obtained (typically, a sales commission) shall be recognised as an asset, provided it is probable that they will be recovered.
Where companies expect to be significantly impacted by IFRS 15, it is important that all relevant areas of the business are trained on the impact of the transition to IFRS 15. For example, as seen above, the timing of the recognition of revenue could be impacted by the contractual terms, such as the right to be paid. Therefore, those team members, such as procurement or sales teams should be aware that contractual terms that they negotiate and agree could have a direct impact on the recognition of revenue.
Communication of the impact of the transition to IFRS 15
As explained above, ESMA has provided guidance on the disclosures required in the 2017 financial statements. However, businesses should also consider engaging with their shareholders through other means if they are aware of a significant impact on transition to the new Standard.
The impact of the implementation of ASC 606
The US standard setter (the Financial Accounting Standards Board; FASB) issued ASC 606 at the same time IFRS 15 was issued by the IASB. Although substantially converged when originally published, subsequent amendments have resulted in a few areas of divergence between the two standards, which are important to identify for US GAAP preparers and UK subsidiaries of US groups.
Some of the key differences between IFRS 15 and ASC 606 are as follows:
Identification of distinct goods and services
In the situation where the customer obtains control of the goods before shipping, the shipping and handling activities may be a separate performance obligation. Under ASC 606, there is a policy election to treat shipping and handling activities undertaken by the company after the customer has obtained control of the related goods as a fulfilment activity (i.e. not a performance obligation). All revenue and costs are then recognised on transferring control of the goods to the customer. The US GAAP policy election simplifies the accounting and may accelerate recognition of the revenue and costs relating to the shipping and handling activities in comparison to IFRS, which is silent on the issue.
Measurement date for non-cash consideration
Non-cash consideration, such as shares or advertising, must be measured at fair value for inclusion in the transaction price. Fair value can be measured at contract inception under both IFRS and US GAAP. However, other dates (e.g. when the consideration is received) are acceptable under IFRS 15, but are not permitted under US GAAP.
Reversal of previously impaired contract acquisition and contract fulfilment costs
Under IFRS, an entity recognises a reversal of an impairment loss that has previously been recognised when the impairment conditions cease to exist. Whereas, under US GAAP, the reversal of a previous impairment of contract costs is prohibited.
The impact of the transition to IFRS 15 and ASC 606 depends on companies’ current accounting and the nature of their contracts. For companies involved in delivering complex and long-term projects, the impact of IFRS 15 or its US counterpart will be significant. However, it is expected that all companies should be determining the impacts through an internal transition project, so that this can be communicated externally, if required.
(1) ESMA public statement: “European common enforcement priorities for 2017 IFRS financial statements”, issued 27 October 2017
(2) ESMA public statement: “Issues for consideration in implementing IFRS Contracts with Customers”, issued 20 July 2016
Ben Levy is a senior manager in Mazars’ Financial Reporting Advisory team