Change in Revenue Recognition in 2018 from IFRS 18 to IFRS 15 – Are You Ready for this Accounting Change?
Revenue is a top-line metric that is one of the most crucial accounts for budgeting, business planning and making investment decisions. For years, companies under US GAAP and IFRS recognize revenue under two different sets of standards.
Difference in Revenue Recognition between US GAAP and IFRS
While US GAAP revenue recognition guidance is highly detailed and industry-specific, IFRS 18 Revenue lays out broad principles, without guidance for specific industries.
In May 2014, FASB and IASB issued a converged standard on revenue recognition (IFRS 15 Revenue from Contracts with Customers) to better align company’s revenue with its performance, and enhance consistency in revenue recognition for companies reporting under IFRS and US GAAP. This Standard will apply to annual periods beginning or after 1 Jan 2018, and will replace IAS 11 Construction Contracts and IAS 18 Revenue.
The new Standard will apply to all contracts with customers except for leases, financial instruments and insurance contracts, which are covered by other accounting standards. All companies deal with contracts in one way or another, so more likely than not, this change is going to affect your company in some way.
Let’s use an example of a telecommunications company (think of Singtel, Starhub, etc.) to understand what will change with this new standard.
A telecommunications company signs a contract with customer to provide a mobile phone and a 2-year mobile plan. Let’s say the mobile phone is free of charge, and the mobile plan is $50 per month. Current practice is no revenue will be recognised when the company issues the customer the free phone. However we all know that the customer is actually paying for the ‘free’ phone as part of the subsequent monthly payments under the contract. In fact, the customer is obliged to use the mobile network services of the telecoms company for 2 years based on the contract, and there will be a penalty (customer needs to pay for phone) if customer breaks the contract halfway.
So, how will revenue recognition change with the new Standard?
Under IFRS 15, the company needs to allocate the total transaction price to the mobile phone and network services, based on the stand-alone selling prices of each item. This means that even though the mobile phone could be marketed as ‘free’, some revenue will need to be recognised when the phone is issued to the customer. In essence, revenue will be recognised earlier under IFRS 15, as compared to current standard of IFRS 18.
Okay, that might sound a bit confusing. Let me go through the new Standard carefully, so we understand what it is all about and how we can apply it.
I will be using the example of telecoms company to explain the application of IFRS 15.
Deep dive into IFRS 15 Revenue from Contracts with Customers
To determine the amount and timing of revenue recognition, first think of this five-step model
For your info, this model is not created by me. It is the actual model prescribed by the new Standard. Let’s go through the model step by step.
Step 1. Identify the contract
First, consider the following questions to determine if IFRS 15 is applicable.
Does a contract exist? Is the contract with a customer? For a contract to exist under IFRS 15, it must fulfil all 5 criteria below.
– Both parties must have approved the contract
– Each party’s rights in relation to goods and services can be identified.
– Payment terms for the goods and services can be identified.
– Contract has commercial substance
– It is probable (in other words, more likely than not) that the consideration to which the entity is entitled to in exchange for goods and services will be collected.
This is relatively straight-forward for our earlier example of the telecoms company. Typically, a customer will formally sign a two-year mobile plan contract with the telecoms company, which will explicitly state the terms of the contract and each party’s rights in the contract.
IFRS 15 is therefore applicable to our example of the telecoms company. Let’s move on to step 2.
Step 2. Identify performance obligations
What is a performance obligation? A performance obligation is a promised good or service (promised in the contract) to be transferred to the customer.
Why is step 2 important?
Identifying performance obligations basically helps us to determine when and how revenue is recognized.
Here, we need to determine whether the goods or services provided are distinct, or a series of distinct goods or services. Accounting for a series of distinct performance obligations can be very different from accounting for one performance obligation, and therefore result in different revenue recognitions.
This will be further explained in step 4, but in short, if there are multiple performance obligations, the transaction price will need to be allocated to the performance obligations, based on their relatively stand-alone price. I will give an example, and explain this in greater detail in step 4.
Let’s return to our example of the telecommunications company signing a contract with a customer to provide a free mobile phone and a two-year mobile plan. There are 2 performance obligations here: (1) Mobile phone, and (2) two-year mobile plan.
I will explain how we will allocate the transaction price (from step 3) to the 2 performance obligations later in step 4, but for now let’s move on to step 3 first to determine the transaction price.
Step 3: Determine transaction price
Transaction price is basically the amount of consideration the company expects to be entitled in exchange for the transfer of goods and services. This is generally straight-forward, but it can be complicated by variable consideration, significant financing component and non-cash consideration. Sales returns and refunds are an example of variable consideration. In such cases, you will need to estimate the variable consideration, using either the expected value or most likely amount method. I won’t go into details here, but some judgment will be required to estimate the amount, if variable consideration is involved.
Back to our example. Let’s say the customer needs to pay $50 per month to the telecoms company for mobile services. The transaction price (or consideration the company expects to be entitled) is $50 x 24 = $1200.
Step 4: Allocate transaction price
Alright, now to the exciting part – step 4, the key that links step 2 and step 3 together!
From step 2, we have identified 2 performance obligations: (1) Mobile phone, and (2) two-year mobile plan. And from step 3, the transaction price (or consideration the company expects to be entitled) is $50 x 24 = $1200.
Now, we need to allocate the transaction price from step 3 to the performance obligations identified in step 2. To allocate the transaction price, first we will need to determine the stand-alone selling price of the mobile phone and mobile plan. In other words, what is the individual selling price of the mobile phone and mobile plan, if they had not been sold in a bundle?
Let’s say, the phone issued to the customer is a brand-new iphone 7 which cost $1000, on stand-alone basis. (If you don’t have the cost readily available, you will need to estimate reasonably.) And a two-year mobile plan, with no additional perks, is $40 per month which amounts to $960 for 24 months.
|Stand-alone selling prices||Allocation ratio based on stand-alone selling price, (A)||Transaction price, (B)||Allocated transaction price, (A) x (B)|
|2 year-mobile plan||$960||49%||$588|
We allocate the transaction price of the mobile phone and mobile plan, based on their stand-alone selling prices in the table above.
What’s the implication? The iphone 7 was given free of charge to the customer, but under the new standard, we need to allocate $612 revenue, as allocated revenue for the mobile phone. Contrast this with current practice of not recognising any revenue, when the company gives away the free phone to the customer!
Step 5: Recognise revenue
Now on to the final step – recognizing revenue.
Revenue is recognized when performance obligations are satisfied by transferring control of the promised good or service to the customer. In other words, revenue is recognized when control is passed. Contrast this with current accounting method of transferring risks and rewards for revenue recognition (IFRS 18), which can be difficult to assess in practice.
Control is defined by the ability to direct the use of, and obtain substantially all the remaining benefits associated with the asset. Control can be transferred over time, or at a point in time which will affect when revenue is recorded.
Let’s recap our example of the telecoms company providing the phone bundled with the 2 year-mobile plan.
At the point of signing the contract and handing the phone to the customer, revenue will be recognised since control of the phone is now passed to the customer. Amount of revenue to be recognized will be $612, as determined in step 4. The entry in your books will be:
DR unbilled revenue (liability) $612
CR revenue $612
The 2-year mobile plan will be considered as transfer of control over time. Amount of revenue to be recognized will be $588 over 24 months, or $24.50 per month. The corresponding entry to be recorded in your books each month, over the 24 month period, should be:
DR customer (AR) $50
CR unbilled revenue (liability) $25.50
CR revenue $24.50
Effectively, the result is that the unbilled revenue of $612, or the consideration of the free mobile phone, is amortized over the life of the 2-year contract.
This five-step method is definitely more complicated than existing method, but it certainly has its merits. In current accounting under IFRS 18, the free mobile phone is not recognized as revenue, even though a performance obligation has been fulfilled when the phone is handed to the customer. New accounting method under IFRS 15 recognizes revenue earlier as it allocates a portion of the revenue to the phone, which is a fairer representation of revenue recognition in my opinion.
Have you started thinking whether this accounting standard will affect you? Is your company prepared for IFRS 15 which will take effect in 2018? I have used an example of the telecoms company to illustrate the impact of IFRS 15, but the new Standard is likely to impact revenue recognition for other industries with customer contracts as well.
Feel free to drop me a note, if you have any questions on the new Standard, or how this will affect revenue recognition from your company. I will be glad to provide further explanation on application of the new Standard for your company.