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Financial Reporting Brief     

April 2018

This month’s article 'IFRS 15 Revenue Recognition – Already Here!' comments on the introduction of IFRS 15 in 2018 and some of its major considerations, mainly from an investor’s perspective.

IFRS 15 Revenue Recognition – Already Here!

IFRS 15- Revenue from Contracts with Customers – for many companies, the most significant recent accounting and reporting development of all! 

Effective for accounting periods beginning on or after 1 January 2018, it is a result of many years of development, with much of that being the product of convergence initiatives between the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) from 2002 onwards.   IFRS15 brings the benefit of replacing a number of standards and interpretations which have come into being over the years, and brings with it a more cohesive and consistent approach to accounting for revenue.

Importance of the Top Line

Why is IFRS 15 of such importance? Reported revenue amounts and growth trends are ‘top line’ indicators of potential economic-value creation under any business model. Hence, revenue is arguably the most important and pervasive company performance metric because it is the starting point for determining many key measurements and defining many other performance indicators. 

The pervasiveness of revenue as an input for valuation and bottom-line performance analysis probably explains the prevalence and seemingly unending high-profile episodes of revenue reporting scandals in the 21st century from Enron Corporation, in 2001, on up to the present day.  General indicators of this are:

  • The 2016 International Forum of Independent Audit Regulators (IFIAR) noted that revenue was one of four areas with the most audit inspection findings; 
  • A review of SEC Accounting and Auditing Enforcement Releases over more than ten years revealed that revenue was the most frequently affected item, with alleged manipulation in 54% of 674 firms with misstatements. This is supported by a 2013 Centre for Audit Quality Study; 
  • The Financial Reporting Council (FRC) has issued many reports which show that revenue is consistently one of the primary areas in inspection and review findings. 

Revenue is a driver of reported results and overall financial position.  It will continue to receive attention and primary focus from regulators and inspectors. There is belief that IFRS 15, and its US GAAP counterpart, will address many of the difficulties that have been experienced over the years – time will tell!

Investors – Top Ten Questions

A Report published by the CFA Institute in recent weeks ‘Revenue Recognition -  Top 10 questions investors should ask about the adoption of the New Standard IFRS 15’ examines the key questions investors should consider as they review year-end 2017 results and consider first quarter 2018 reporting as it relates to the adoption of the new standard. The Report highlights questions that should be considered when evaluating whether there will be a significant change in how revenue is recognised for any particular company, which include inter alia:

  • Multiple deliverables? Do the entity’s arrangements with customers include multiple deliverables?
  • Long-Term Contracts: Are there long-term contracts in which revenue is recognised based on progress on the project?
  • Costs: Are significant costs associated with offering or fulfilling a contract with a customer, or a contract that may extend beyond one year?
  • Financing: Is financing a significant element of the arrangement with the customer?
  • Performance versus Cash Collection? Is there a significant difference in the timing of the completion of obligations under the contract and the collection of cash?

There are numerous other considerations outlined in the Report. 

Importance of Disclosure

The CFA Institute is firmly of the view that disclosures are a critical part of the new standard, and in its Report makes the following observations:

  • Greater Disaggregation of Revenue Disclosures: the CFA expresses strong support of the new disclosure requirements, which will apply even to those companies expecting minimal quantitative impact;
  • Transparency Regarding Significant Estimates and Judgements: significant disclosure is required regarding what constitutes a performance obligation, how transaction price is allocated to such performance obligations, as well as the timing of satisfaction, (i.e. when revenue is recognised).  Investors should seek insight into these judgements, in evaluating the quality of earnings, and the CFA has expressed concern that many of the disclosures will be highly qualitative and boilerplate; 
  • Connection of Disclosures to and Cohesiveness between Financial Statements: The CFA advocated for greater use of rollforwards and connectors within the financial statements, but these were not required by IFRS 15, and only elements of the contract balances will be disclosed; 
  • Limited Contract Costs Disclosures: There is no requirement to disclose the costs deferred or amortised each period.  The CFA expresses concern that it will be difficult for investors to glean the amounts affecting the income statement and how they relate to cash; 
  • Differences among Disclosed Performance Obligations, Contract Liabilities and the SEC: The CFA are concerned with differences in definitions and the consequent quality of disclosure.

The CFA expresses the view that in the first year of adoption, best practice should be for companies to provide the disclosures at the time of the earnings release.  This will ensure that investors have the full complement of disclosures at the time the market reacts to the earnings announcement.

The Challenge of Transition

An interesting consideration and matter of much discussion is how are companies transitioning to the new guidance. The IASB has allowed for early adoption and a number of transition methods. As such, investors need to understand when and how a company they follow plans to transition to the new revenue recognition standard. Very few companies have adopted early. 

The standard-setters have provided for both (a) full retrospective application, and (b) modified retrospective application, with some variations available. With different transition methods allowed, comparability between periods and between companies may be challenging for investors. For companies themselves, determining an appropriate accounting policy with the judgement involved is a matter that requires detailed consideration. 

While full retrospective may be relatively straightforward, the modified retrospective application method presents issues. Under the modified approach, entities can apply the standard only from the date of initial application, with adjustment to the opening balance of equity on the date of initial application but no requirement to restate prior year comparatives. This means that companies do not need to consider contracts that have been completed prior to the date of initial application. In addition, entities applying the modified approach may use the practical expedient available under the standard either for (a) all contract modifications that occur before the beginning of the earliest period presented, or (b) those that occur before the date of initial application. The change in the trend of revenue over time would not be disclosed, and it is possible that a restatement of revenue may in effect be recycled and accounted for twice, or conversely, revenue may not appear in the financial statements in any period. 

Comparability differences will not exist simply at adoption, but will exist until such time as all contracts in place at date of adoption have been fully completed and all revenue associated with those contracts has been recognised.  This will arise because of the difference in assumptions underlying the revenue estimation techniques. 

It is anticipated that most companies plan to follow the modified retrospective method, and the issues regarding comparability and trends will be challenging for both preparers and investors. It is important that disclosures are complete and transparent, and that full explanation is provided of each financial statement line that is affected and of the significant changes between the reported results under IFRS I5 and the previous standard followed. 

Conclusion

It is imperative that entities take time to consider the impact of IFRS 15, as in addition to its core importance for accounting, it may significantly affect other aspects of operations e.g. internal controls and processes, KPIs, compensation and bonus plans, bank covenants, tax and other matters. 

Previously, IFRS 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 under IFRS 15 may result in significant changes to the profile of revenue and, in some cases, cost recognition as well as other business impacts. 

Deloitte has recently published ‘Revenue from Contracts with Customers’. In 250 pages, the Deloitte publication provides detailed guidance and illustrative examples and should act as a valuable support for companies in dealing with the challenges of moving forward with IFRS 15.

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