Is Your Business IFRS 15 Ready
IFRS 15: Revenue from Contracts with Customers establishes a single and comprehensive framework which sets out how much revenue is to be recognized and when. The new standard is principles-based and provides more application guidance than the standards it has replaced. Adoption is required for annual periods beginning on or after 1 January 2018.
Revenue is one of the most important financial statement measures to both preparers and users of financial statements. It is one of the indicators to assess financial performance, future prospects and financial health of entities. Revenue recognition is therefore one of the accounting topics most discussed and debated by stakeholders and regulators. Despite its significance and the increasing globalization of the world’s financial markets, revenue recognition requirements prior to issuance of this standard differed at times, resulting in different accounting for similar transactions in different jurisdictions.
The previous standards allowed significant room for judgement in devising and applying revenue recognition policies and practices, IFRS 15 is more prescriptive in many areas. Applying these new rules may result in significant changes to the profile of revenue and, in some cases, cost recognition, resulting in broader impact on the business as a whole. In fact, most entities have seen some level of change as a result of the new standard. Many have been surprised initially at the length and complexity of implementation of IFRS 15 and, now, with the impact it has created on the businesses. The new standard has not only affected, the timing and profile of revenue recognition but in many cases depending on the entities, the changes have been significant.
The revenue standard is a complex standard, which has introduced far more prescriptive requirements than were previously included in IAS 18, IAS 11 and a number of interpretations. IFRS 15 has replaced the following standards and interpretations:
- IAS 18: Revenue,
- IAS 11: Construction Contracts
- SIC 31: Revenue – Barter Transactions Involving Advertising Services
- IFRIC 13: Customer Loyalty Programs
- IFRIC 15: Agreements for the Construction of Real Estate and
- IFRIC 18: Transfer of Assets from Customers
The core principle underlying the new model is that an entity should recognise revenue in a manner that depicts the pattern of transfer of goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Revenue is now required to be recognised by an entity when control over the goods or services is transferred to the customer. In contrast, IAS 18: Revenue based revenue recognition around an analysis of the transfer of risks and rewards. An assessment of risks and rewards now forms one of a number of criteria that are assessed in determining whether control has been transferred. The revenue standard applies to all contracts with customers, except for contracts that are within the scope of other standards, such as
- leases (IFRS 16: Leases or, for entities that have not yet adopted IFRS 16, IAS 17: Leases)
- insurance contracts (IFRS 17: Insurance Contracts, or for entities that have not yet adopted IFRS 17, IFRS 4: Insurance Contracts),
- financial instruments (IFRS 9: Financial Instruments or, for entities that have not yet adopted IFRS 9, IAS 39: Financial Instruments: Recognition and Measurement)
- The recognition of interest revenue and dividend revenue is not within the scope of IFRS 15. These matters are now dealt with under IFRS 9: Financial Instruments (or, for entities that have not yet adopted IFRS 9, IAS 39: Financial Instruments: Recognition and Measurement) and
- Non-monetary exchanges between entities in the same
line of business to facilitate sales to customers or
Some of the contract arrangements may also include elements that are partly in the scope of other standards and partly in the scope of this standard. The elements that are accounted for under other standards are separated and accounted for under those standards. Only contracts with a customer are in the scope of this standard. Management needs to assess whether a counterparty is a customer to determine if the arrangement is in the scope of this standard (for example, certain co-development projects).
The scope of IFRS 15 has been expanded to cover costs relating to contracts as well.
The five-step model
Certain criteria must be met for a contract to be accounted for using the five-step model in the revenue standard. An entity must assess, for example, whether it is “probable” that it will collect the amounts it will be entitled to before the guidance in the revenue standard is applied.
Step 1: Identify the contract(s) with a customer.
IFRS 15 defines a contract as an agreement between two or more parties that creates enforceable rights and obligations and sets out the criteria for every contract that must be met.
Step 2: Identify the performance obligations in the contract.
A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer.
Step 3: Determine the transaction price.
The transaction price is the amount of consideration (for example, payment) to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties.
Step 4: Allocate the transaction price to the performance obligations in the contract.
For a contract that has more than one performance obligation, an entity should allocate the transaction price to each performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each performance obligation.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation
Specifies how an entity should determine when to recognise revenue in relation to a performance obligation, and whether that revenue should be recognised at a point in time or over a period of time.
In addition to the five-step model, IFRS 15 provides specific guidance relating to licences and costs relating to a contract, such as:
- In respect of licences, IFRS 15 distinguishes between two different types of licence (right of use and right to access), with the timing of revenue recognition being different for each.
- how to account for costs relating to a contract, distinguishing between costs of obtaining a contract and costs of fulfilling a contract. When this results in costs being capitalized.
- Requirements for accounting for costs related to a contract with a customer. These are recogised as an asset if certain criteria are met.
The standard requires qualitative and quantitative disclosures in respect of revenue, contract balances, performance obligations, significant judgements and assets recogised from costs to obtain or fulfill a contract.
Broader business implications
IFRS 15 has created a much broader business impact than merely changing the accounting treatment in relation to revenue, some of those aspects include:
- Financial results and performance of the entities – changes in the revenue recognition principles have changed the amount and timing of revenue recognition which in turn has impacted the gross margin, net income, EBITDA, and net worth and earnings per share.
- Dividends– Due to changes in timing and amount of revenue recognition in certain jurisdictions, the ability to pay dividends to shareholders has been impacted.
- Income and Dividend Tax– The profile of tax payments, and the recognition of deferred tax has been impacted due to differences in the timing and amount of recognition of revenue under IFRS 15.
- Financing and covenants– changes in timing and ount of revenue recognition and resultant changes in the profits and net worth of the entities have affected the calculation of covenants, and which in turn resulted in renegotiation of covenants and revised financing requirements.
- Key Performance Indicators– Revision /adjustment in KPIs is one of the significant changes which is taking place due to changes in revenue and /or profit figures.
- Incentives and compensation– Changes in the recognition of revenue as a result of IFRS 15 has an impact on the revenue and consequently on profit based targets, incentives, compensation and ESOPs.
- Communication with stakeholders– Users of the financial statements such as the shareholders, board members, audit committee, investors and creditors require an explanation of the changes on account of implementation of IFRS 15 in order to understand how the financial statements have been impacted.
IFRS 15 is affecting the recognition, measurement, and disclosure of revenue for many entities and, revenue being an important financial performance indicator for entities, those entities which are still in the implementation phase need to expedite the process as gaining an understanding of the effect of the standard and providing early communication to stakeholders is crucial for a successful implementation.
Even entities that do not expect significant changes in the measurement of revenue and timing of recognition should validate that assumption.
Furthermore, entities shall identify any necessary changes to policies, procedures, internal controls and systems to ensure that revenue transactions are appropriately evaluated in light of the standard. Entities also need to plan for the significantly expanded disclosure requirements.
But this is not just an accounting change; as a result of the potential wide-ranging impact of IFRS 15, the implementation process has to be comprehensive and include several functions outside of the traditional finance function, including IT, tax, legal, sales, marketing, human resources, investor relations and the executive management. Some entities may have disciplined pricing practices in place to allocate consideration to elements in a multiple element arrangement. However, even in such situations, an entity is required to evaluate whether its pricing practices will change, and also its methods for estimating stand-alone selling prices.
Will IFRS 15 result in any changes to business practices e.g., changes in contract terms or pricing policies? Are there changes in contract terms that would affect revenue recognition under the new standard e.g., amending termination provisions to obtain appropriate payment for performance to date? Are there changes in contract terms that would affect revenue recognition under the new standard? Will there be any effect on transfer pricing?
These are some of the questions which the management of entities can answer with a comprehensive implementation plan and to avoid any last minute surprises for the users of the financial statements.
(This article is compiled by Mr. Vinod Joshi, Director, Assurance Services Division, Dubai)