The New Revenue Recognition Standard

Revenue Recognition Standard

For almost all entities barring a few like financial institutions, revenue is the largest single figure in the financial statements. The figure ascertains an entity’s financial performance and position. While it might be accepted that profit is generally considered the most important single pointer of corporate financial performance, revenue does not fall far behind.

The FASB has issued an accounting standards update (ASU) for revenue recognition related to contracts with customers. On 28 May 2014, the IASB and the FASB jointly issued a new standard on revenue recognition titled “Revenue from Contracts with Customers”, IFRS 15 for IFRS and ASC 606 for US GAAP. Companies in the US, mostly private companies that follow the U.S GAAP, need to start implementing the new revenue recognition rules if they haven’t already.

Overview

The board initiated a joint project to clarify the principles for recognizing revenue and to develop a common revenue standard for IFRSs and US GAAP that would:

  • Remove inconsistencies and weaknesses in existing revenue recognition system
  • Provide a more robust framework for analyzing revenue
  • Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets
  • Provide more useful information to users through improved disclosure requirements, and
  • Simplify and streamline the preparation of financial statements by reducing the number of requirements to which an entity must refer to

IFRS 15 specifies the accounting treatment for all revenue arising from contracts with customers. It applies to all entities that enter into contracts to provide goods or services to their customers other than contracts in the scope of other standards (eg insurance, leases, financial instruments etc)

The core principle is that revenue is recognized when the goods or services are transferred to the customer at the transaction price. The principles in IFRS 15 will be applied using the following five steps:

  • Identify the contract(s) with a customer
  • Identify the performance obligations in the contract
  • Determine the transaction price
  • Allocate the transaction price to the performance obligations in the contract
  • Recognize revenue when (or as) the entity satisfies a performance obligation

The new change in the standard indicates that revenue is recognized when a company satisfies a performance obligation by transferring goods or services to a customer at the amount to which the company is entitled (when the customer obtains control of the goods/services). Depending on whether certain criteria are met, revenue is recognized either over time, in a manner that demonstrates the company’s performance, or at a point when control of the goods or services is transferred to the customer.

The Impact

Almost all companies will be affected to a certain degree either by a change in time for recognizing revenue or due to a significant increase in required disclosure. In addition to an increase in disclosures, the impact on businesses will depend on the industry and current accounting practices.

The Impact on Businesses

  • Technology – Most companies draw their revenue numbers form the billing system, following a change in the standard companies will need to consider changes that might be necessary to the billing system, processes, and internal controls to capture new data according to the specified rules
  • Contracts – The existing terms of the contract with the current customers will have to be restructured, negotiated under the new standard. New customer agreements needs to be developed
  • Compensations and bonus – Bonus and compensation to employees may change in the new revenue recognition standard. You may need to consider how timing changes may play a role in recognizing revenue
  • Tax: The new standard will have an impact on taxes and will result in a change in the presentation of collected taxes. Most companies may have to change its tax method of accounting for an item.
  • Investor relations: Companies may need to explain to the stakeholders the new revenue recognition and its effects on the financials

Best Practices

  • Educating the entire management team, stakeholders, board of directors on adoption alternatives under the new standard and its impact. Training sessions should be conducted to prepare the team for the impact of the new standards
  • Agreements/Contracts should be designed in a simple manner which clearly defines the performance obligations. Have a clear communication with the customer when a particular milestone has been achieved
  • Ensure you are in a position to manage and recognize all types of revenue, such as time-based, percentage of completion, event-based, etc. and ensure that your existing billing system is ready to handle these multiple elements
  • Annualized revenue or revenue received in one go (eg. magazine subscriptions) can be amortized and recognized on a monthly basis
  • Companies selling goods should pay attention to return/refund and warranties clauses and a provision should be created in circumstances of return or a refund

It is important for companies to understand how the new system will change the current accounting procedures. What transition method will be followed? What role will technology play in the implementation? These are a few questions which the entities will have to figure early in order to map out the implementation plan.

Need assistance in familiarizing with the new standard?

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