Between vendors and customers: Significant changes proposed for the accounting and disclosure of revenue from contracts

Revenue is a key performance measure for business, and there are recognised problems with the two main brands – the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) – which are based on different principles and give no guidance in certain key areas, such as arrangements involving multiple elements. The decision to re-examine the draft on revenue is seen as a positive step as concerns have been raised about the cost and complexity of the proposed new standard.

Businesses commercially registered with the Ministry of Industry and Commerce are required to file annual financial statements prepared in accordance with International Financial Reporting Standards (IFRS), and will face the challenge of complying with the new standard. The objective of the revised Exposure Draft (ED), Revenue from Contracts with Customers, issued by the IASB and the FASB on November 14, 2011, is to clarify existing revenue recognition principles and develop a common standard under IFRS and US Generally Accepted Accounting Principles. This includes removing inconsistencies and weaknesses in existing standards and also improving the comparability of revenue recognition practices across firms, industries and markets.

The ED would replace International Accounting Standard (IAS) 18 Revenue, IAS 11 Construction Contracts and related interpretations (International Financial Reporting Interpretations Committee [IFRIC] 13 Customer Loyalty Programmes, IFRIC 15 Agreements for the Construction of Real Estate, IFRIC 18 Transfers of Assets from Customers and SIC 31 Revenue – Barter Transactions Involving Advertising Services) and most of the requirements on revenue recognition in FASB Accounting Standards Codification (ASC) Topic 605.

SCOPE, EFFECTIVE DATE & TRANSITION: The ED is applicable to all entities that enter into contracts with customers unless those contracts are within the scope of other standards (for example, lease contracts, insurance contracts or financial instruments). The effective date of the proposed standard would not be before January 1, 2015. Early adoption is permitted by the IASB’s proposal; however, the FASB plans not to permit early adoption. Retrospective application is required under the ED, although certain transition relief is available.

PROPOSED MODEL: The proposed model is built on the contract between a vendor and a customer for the provision of goods and services. The ED addresses when the vendor should recognise revenue and how much should be recognised. It attempts to depict the transfer of goods and services to customers in an amount that reflects the consideration the vendor expects to receive. To accomplish this, the proposed standard requires the application of the following five steps: Step 1: Identify the contract. The proposal applies to all oral, written or implied contracts with the following characteristics: the contract has commercial substance; the entity and customer have approved the contract and are committed to performing under it; the entity can identify each party’s rights with respect to the goods or services to be transferred; and the entity can identify the payment terms.

These provisions are generally applied to each individual contract with a customer. However, if certain criteria are met, separate contracts with the same party entered into at or near the same time must be combined under the ED. Contracts are to be combined and accounted for as one contract if 1) they are negotiated with a single commercial objective, 2) the consideration paid in one contract is dependent on another contract, or 3) the goods or services to be provided under the contracts represent a single performance obligation (i.e., they are not “distinct” as described below).

The proposed standard also addresses contract modifications. These would be accounted for as a separate contract if 1) they include a separate performance obligation and 2) the additional consideration reflects the entity’s stand-alone selling price for that performance obligation. If these criteria are not met, the modification is accounted for as an adjustment to the original contract. Depending on circumstances, the modified contract would be allocated to the remaining performance obligations on a prospective basis or reflected as a cumulative catch-up adjustment to revenue.

Step 2: Identify the separate performance obliga- tions. The ED defines a performance obligation as a contractual promise to deliver a good or service to the customer. Each promised good or service is treated as a separate performance obligation if it is “distinct”. A good or service is distinct if it is regularly sold separately by the entity, or if the customer benefits from the good or service on its own or together with resources that are readily available to the customer.

Nevertheless, the proposals require a bundle of goods or services to be combined and treated as a single performance obligation if both are 1) highly interrelated and the entity provides a significant service of integrating the goods or services into the combined item, and 2) significantly modified or customised to fulfil the contract. The ED does not define “highly interrelated” and judgment will be required to determine when performance obligations are considered as such.

Step 3: Determine the transaction price. A contract’s transaction price is the amount of consideration to which an entity expects to be entitled in exchange for the promised goods or services. The transaction price can be a fixed or variable amount. The proposal contains guidance for variable consideration, the time value of money, non-cash consideration and consideration payable to a customer when determining the appropriate transaction price. The amount of consideration can vary for a variety of reasons including discounts, rebates, refunds, performance bonuses, etc.

If the consideration is variable, an entity would estimate the transaction price by one of two methods: 1) the expected value method – consideration is equal to the sum of probability weighted amounts in the range of total possible consideration; or 2) the most likely amount method – consideration is the single most likely amount in the range of possible amounts.

The method selected depends on the approach that the entity expects to better predict the amount of consideration to which it will be entitled. For example, it would be appropriate to estimate the most likely amount when the contract has only two possible outcomes.

When determining the transaction price, an entity would not consider the effects of customer credit risk. Instead, an entity would account for this by applying IAS 39 Financial Instruments: Recognition and Measurement (or IFRS 9 Financial Instruments), or ASC 310, Receivables. Any impairment losses or reversals recognised in profit or loss for collectability would be presented as a separate line item adjacent to the revenue line item and not with other expense items.

Payments that an entity makes (or expects to make) to its customer are treated as a reduction of the entity’s transaction price unless the payment is in exchange for a distinct good or service, as described above, that the customer transfers to the entity.

Step 4: Allocate the transaction price. For contracts with more than one performance obligation, an entity must allocate the transaction price using a relative stand-alone selling price basis. The best evidence of this is based on the observable price at which the good or service can be sold separately. If an observable price is not available, the stand-alone price should be estimated. The ED provides several examples of how to do this. These include a market-based approach, an expected cost plus margin approach and a residual one. The latter may only be used if the stand-alone price is highly variable or uncertain, although it applies to delivered and undelivered performance obligations.

Any changes to the transaction price subsequent to contract inception are generally allocated to all performance obligations on the same basis as at inception. However, in limited circumstances, the change is allocated to one or more specific performance obligations, rather than rateably to all of the obligations.

Step 5: Recognise revenue. Revenue is recognised when the entity satisfies each performance obligation. Obligations are satisfied when (or as) the entity transfers control of a promised good or service to a customer. This occurs when (or as) the customer can direct the use of and can obtain substantially all the remaining benefits from it. The ED provides indicators for assessing when control has been transferred. Entities will need to exercise judgment to determine if the obligations are transferred over a period, or at a single point.

One of the following two criteria must be met for control to transfer over time: 1) the entity’s performance creates or enhances an asset controlled by the customer as it is created or enhanced, or 2) its performance does not create an asset with alternative use to the entity. In addition, at least one of the following criteria must be met: a) the customer simultaneously receives and consumes benefits; b) if another entity was hired to perform the remainder, it would not need to substantially redo completed work; or c) the entity has the right to payment for performance completed to date and expects to fulfil the contract as promised.

If the entity determines that control is transferred continuously, the corresponding revenue would be recognised over time by using an input or output method for measuring progress. Input methods include resources consumed, labour hours, costs, etc. Output methods are generally more visible to the customer and include milestones reached or units produced, etc.

When control is transferred at a point in time, rather than continuously, some key indicators of when revenue should be recognised are listed below. Note that no individual factor is determinative: the entity has a present right to payment for the asset; the customer has legal title to the asset; possession has been transferred; the customer has the significant risks and rewards of ownership of it; and the customer has accepted it.

Variable consideration associated with a performance obligation that has been satisfied is only recognised when collection is reasonably assured. Entities will need to exercise judgment to make that determination based on their prior experience with similar contracts.

OBG would like to thank THE REPORT Bahrain 2012