Get briefed on IFRS 15

Published on January 6, 2015

After more than 6 years in the making, on May 24, 2014, the International Accounting Standards Board (IASB), responsible for developing International Financial Reporting Standards (IFRSs), and its US counterpart the Financial Accounting Standards Board (FASB) issued a converged standard on the recognition of revenue from commercial contracts – lFRS 15 Revenue from Contracts with Customers. By 2017, companies applying IFRSs will have to adopt a new revenue recognition model.

With sales being a key metric in assessing a company’s performance, a change in revenue recognition model has numerous implications well beyond accounting considerations. Companies also need to consider how it might affect business decisions and strategic options.

The new standard poses a major reporting challenge since it applies to nearly all industries, as well as all transactions between a company and a customer. Even though some sectors and business models will hardly be affected by the new IFRS 15 accounting principles (especially cash retail sales), all contracts will have to be reviewed in light of the new revenue analysis table. In addition, the supplemental disclosure requirements apply to all companies.

Beyond changes in accounting

One of the objectives of the change, which should be met, is to enhance the comparability of financial information produced by companies worldwide. For example, for the first time, European, Canadian and American companies applying IFRS 15 will present and prepare the “revenue” line item based on the same rules. This is a major step for the investor and financial analyst community. Executives should therefore be prepared to explain these changes and anticipate market expectations regarding the standard’s expected effects.

The transition toward a new revenue recognition model should also prompt companies to question the way contracts are currently negotiated and how some business decisions are made. In particular, significant changes to the timing of revenue recognition are expected. In addition, the existence of a variable payment clause could result in a significant difference from past practice. Internally, the impact on figures reported as “revenue” has operational implications on overall performance indicators and compensation systems. Lastly, some companies should expect major changes to their information systems.

The IFRS 15 model in brief

The IFRS 15 model is a five-step approach that applies to all business transactions. As a result, there will no longer be separate guidance for the sale of goods, service contracts and construction contracts. An approach similar to that applied to multiple-element arrangements in practice now extends to all contracts. In the new model, the transfer of the risks and rewards is no longer sufficient to recognize revenue. Under IFRS 15, revenue will be recognized when there is a transfer of control.

The table below provides a step-by-step breakdown of the main changes resulting from the new standard.

Identify the contract(s) with the customer	Step 1 gives the definition of a contract with a customer and the criteria to be met under the new standard. A contract cannot be recognized until these requirements are met, including collectability of the amounts stated in the contract. An analysis of the unit of account is required: should contracts be combined or accounted for separately? Step 1 also includes new detailed principles on how to account for contract modifications.
Identify the performance obligations	Step 2 addresses the determination of various goods and services to be provided to the customer. In contracts with multiple performance obligations, the challenge is determining whether they should be distinct. This is expected to result in analysis and application issues for some industries, such as retail, construction and automotive. This step is critical for subsequent revenue recognition since each obligation identified will be accounted for separately.
Determine the transaction price	Step 3 helps an entity estimate the consideration it expects to receive in exchange for the transfer of goods and services to the customer. The new rules require a specific treatment for all types of variable consideration (e.g. bonuses, penalties, discounts, performance fees), which will pose significant assessment challenges for companies in certain sectors, such as investment management companies. In addition, when a contract contains a significant financing component beyond 12 months, the company will have to adjust for the effects of the time value of money. This can result in some issues in practice, notably when selecting the discount rate.
Allocate the transaction price	Step 4 introduces major changes with respect to old recognition practices. The transaction price will have to be allocated on the basis of the relative fair value of each obligation. The use of the residual approach to determine the value of each item is now defined. Therefore, this is expected to have significant effects for the telecom and IT sector. If the total transaction price is less than the sum of the stand-alone selling prices, the discount will have to be allocated proportionately to the various items, unless the company can demonstrate that it is attributable to a particular item.
Recognize revenue	Lastly, step 5 sets out the criteria for determining the timing of revenue recognition. The date to consider is now the date the customer acquires control of the good or service provided, which is a change from the traditional approach of considering the transfer of risks and rewards. While the new requirements take account of the transfer of risks and rewards, they are no longer limited to this factor alone. The transfer of control may occur over time (e.g. in the case of some service contracts or construction contracts) or at a point in time (e.g. the delivery of goods). Some sectors, including real estate and construction could be affected in particular, especially since the new criteria differ substantially from the approach defined in IFRIC 15 Agreements for the Construction of Real Estate.

The reporting challenge

Although IFRS 15 will bring about a revamped recognition model, companies in some industries may determine that it will not impact their accounting policies. In those cases, only the supplemental disclosure requirements will pose a real challenge. The new disclosure requirements should not be underestimated, as they provide for detailed and disaggregated disclosures on the various types of revenue and obtaining this information can be expensive. It is therefore crucial for companies to analyze the new requirements in conjunction with their contracts. Due to the sensitivity of some of the required information, management would be well advised to do a detailed analysis of these requirements early enough in the transition process.

The new standard will apply to companies adopting IFRSs for annual reporting periods beginning on or after January 1, 2017, with a requirement to restate comparative figures from 2016. The standard also provides for some relief and simplified policies for first-time adoption to facilitate the transition. Although the implementation date may be deferred, it is never too early to begin laying the groundwork for transition given the complexities and application challenges ahead.

Katell Burot, CPA (Colorado)
Consultant specialized in IFRSs and financial reporting

Member of the technical working group on IFRS – Financial Accounting – Part I