The Institute of Chartered Accountants of Sri Lanka recently adopted three new Accounting Standards which will be effective soon. SLFRS 9 – Financial Instruments and SLFRS 15 – Revenue will be effective from 1 January 2018 whereas SLFRS 16 – Leases will be effective from 1 January 2019.
For December reporting companies they are effective on 1 January of the respective years and for those who are obliged to report quarterly, the first reporting date will be 31 March. For those who are March reporting companies, these standards will be effective on 1 April of the respective years and the first reporting date for quarterly reports is 30 June. Consequently we have less than half a year to be fully accomplished with SLFRS 9 and 15 implementation.
The Central Bank of Sri Lanka recently issued a circular directing all Licensed Finance Companies (LFC) and Specialised Leasing Companies (SLC) to change their financial year to January – December with effect from year ending 31 December 2017. Accordingly those LFCs and SLCs who had March year ends will now have to advance their year ends to 31 December which means the time period available to transit to SLFRS 9 and 15 will be shortened by three months and will have less than just four months to do so by accelerating the transition process.
In part I of this article we discussed the implications of SLFRS 9 – ‘Financial Instruments’. Today we will look at what SLFRS 15 – ‘Revenue’ has on offer.
Need for a change in the revenue recognition framework
SLFRS 15 provides a single, comprehensive framework for revenue recognition eliminating diversity in revenue recognition practices arising from the existence of a series of Standards and Interpretations. Another reason for the significant diversity in revenue recognition practices was that previous revenue Standards provided limited guidance on many important areas. Furthermore, the limited guidance that was available was most of the time difficult to apply to complex transactions. Absence of bases for conclusions in the current revenue Standards is the main reason.
The disclosure requirements in previous Standards often resulted in information that was inadequate for users to understand a company’s revenue, and the judgements and estimates made by the company in recognising that revenue.
SLFRS 15 addresses those deficiencies by specifying a comprehensive and robust framework for the recognition, measurement and disclosure of revenue. In particular, SLFRS 15:
nimproves the comparability of revenue from contracts with customers;
nreduces the need for interpretive guidance to be developed on a case-by-case basis to address emerging revenue recognition issues; and
nprovides more useful information through improved disclosure requirements.
The framework will be applied consistently across transactions and industries and is expected to result in improved comparability in the ‘top line’ of the income statements across companies. This is because SLFRS 15 replaces a list of previous Standards and Interpretations as follows:
- LKAS 18 Revenue;
- LKAS 11 Construction Contracts;
- 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.
Overview of the new Revenue Recognition Framework
SLFRS 15 provides a comprehensive framework which assists preparers in determining the timing of recognising revenue and the quantum of revenue to recognise. The core underlying principle in recognising the revenue is the transfer of promised goods or services to the customer. With this new framework a company recognises revenue to represent the transfer of promised goods or services to the customer, in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services.
Accordingly, recognition of revenue is based on five steps to be followed by a company:
1.Identification of the contract(s) with the customer
2.Identification of the performance obligations in the contract
3.Determination of the transaction price
4.Allocation of the transaction price to performance obligations
5.Recognition of revenue when a performance obligation is satisfied
Let’s now look at each of these five steps in a bit more detail.
1. Identify the contract(s) with the customer
A contract is an agreement between two or more parties that creates enforceable rights and obligations. A company would apply SLFRS 15 to each contract with a customer that has commercial substance and meets other specified criteria. One criterion requires a company to assess whether it is probable that the company will collect the consideration to which it will be entitled in exchange for the promised goods or services. In some cases, SLFRS 15 requires a company to combine contracts and account for them as one contract. SLFRS 15 also specifies how a company would account for contract modifications.
2. Identify the performance obligations in the contract
Performance obligations are promises in a contract to transfer to a customer goods or services that are distinct. In determining whether a good or service is distinct, a company considers if the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer. A company also considers whether the company’s promise to transfer the good or service is separately identifiable from other promises in the contract. For example, a customer could benefit separately from the supply of bricks and the supply of construction labour. However, those items would not be distinct if the company is providing the bricks and construction labour to the customer as part of its promise in the contract to construct a brick wall for the customer. In that case, the company has a single performance obligation to construct a brick wall. The bricks and construction labour would not be distinct goods or services because those items are used as inputs to produce the output for which the customer has contracted
3. Determination of the transaction price
The transaction price is the amount of consideration to which a company expects to be entitled in exchange for transferring promised goods or services to a customer. Usually, the transaction price is a fixed amount of customer consideration. Sometimes, the transaction price includes estimates of consideration that is variable or consideration in a form other than cash. Some or all of the estimated amount of variable consideration is included in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved. Adjustments to the transaction price are also made for the effects of financing (if significant to the contract) and for any consideration payable to the customer.
4. Allocation of the transaction price
A company would typically allocate the transaction price to each performance obligation on the basis of the relative stand-alone selling prices of each distinct good or service. If a stand-alone selling price is not observable, the company would estimate it. Sometimes, the transaction price may include a discount or a variable amount of consideration that relates entirely to a specific part of the contract. The requirements specify when a company should allocate the discount or variable consideration to a specific part of the contract rather than to all performance obligations in the contract.
5. Recognise revenue
when a performance obligation is satisfied
A company would recognise revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). A performance obligation may be satisfied at a point in time (typically for promises to transfer goods to a customer) or over time (typically for promises to transfer services to a customer). For a performance obligation satisfied over time, a company would select an appropriate measure of progress to determine how much revenue should be recognised as the performance obligation is satisfied.
Significant areas of impact
Consequent to the five step model as described above, the requirements in SLFRS 15 will result in changes in the accounting for some revenue transactions of some companies. However, those changes are necessary to achieve consistent accounting for economically similar transactions in contracts with customers.
For many contracts, such as many straightforward retail transactions, SLFRS 15 will have little, if any, effect on the amount and timing of revenue recognition. For other contracts, such as long-term service contracts and multiple-element arrangements, SLFRS 15 could result in some changes either to the amount or timing of the revenue recognised by a company.
Let’s now look at some of the areas which will have a significant impact arising from the new revenue model as explained above.
a. Timing of revenue recognition
There have been practical issues in determining whether a company should recognise revenue at a point in time or over time. For example, a company selling residential apartment in a multi-story complex may have had difficulty in determining whether the construction of such assets is a service that is provided over time (in which event, revenue is recognised over time; often known as percentage completion method) or an item that is transferred to the customer when construction is complete (in which event, revenue is recognised at that point in time; often known as completed contract method).
SLFRS 15, now provides very clear guidelines as to revenue recognition. In most cases a company will recognise revenue at the point in time when the customer obtains control of the promised good or service. However, in certain limited instances a company will be able to recognise revenue over time only if the criteria specified in SLFRS 15 are met. Therefore it is important for a company to negotiate with the customers, the terms and conditions of the contracts in an appropriate manner and draft the contracts accordingly if the company prefers to recognise revenue over time.
b. Absence or lack of observable selling price
Certain companies may be precluded from recognising revenue In respect of some contracts even upon the transfer of a good or service to a customer if there is no observable evidence of the stand-alone selling prices of each of the goods or service components promised in the contract. This is a common feature in the software industry when observable prices are not available for upgrades and additional functionality for computer software. This often results in the deferral of revenue recognition because revenue could not be recognised when the first of the promised piece of functionality is transferred to the customer.
SLFRS specifies that if there are no observable prices available for the promised goods or services, a company would allocate the transaction price on the basis of estimated stand-alone selling prices of those goods or services. The company need to recognise revenue as each distinct component of good or service is transferred to the customer.
c. Sales incentives and incidental obligations
Sometimes contracts with customers may have elements which are considered to be sales incentives or otherwise incidental or ancillary to the other promised goods or services in the contract. For example in the automobile industry a manufacturer may sell a car along with an incentive such as maintenance that will be provided at a later date. Some companies may not separately recognise revenue for these elements which practice leads to recognition of all of the transaction price as revenue even though the company has remaining performance obligations to satisfy.
According to SLFRS 15 a company is required to assess whether the promised goods or services arising from incidental obligations and sales incentives are goods or services that are distinct. If the goods or services are distinct, the company will recognise revenue when (or as) each distinct good or service is transferred to the customer.
d. Contingent revenue cap
Some practices for allocating the transaction price limit the amount of consideration allocated to a satisfied performance obligation to the amount that is not contingent on the satisfaction of performance obligations in the future. That practice is commonly used to account for telecommunications contracts that bundle the sale of a mobile phone with the provision of network services for a specified period.
SLFRS 15 does not permit the transaction price to be allocated to performance obligations on a basis that is consistent with the contingent revenue cap. Instead, IFRS 15 requires a company to allocate the transaction price—which would be any amount that the customer pays on entering into the contract and the monthly payments for the network services—to the mobile phone and the network services on the basis of the relative stand-alone selling prices of each item.
e. Significant financing components
If a customer pays for goods or services in advance or in arrears, some companies may not consider the effects of any financing components in the contract when determining the amount of revenue to be recognised.
SLFRS 15 requires a company to consider the effects of any significant financing components in the determination of the transaction price (and thus the amount of revenue recognised). This may affect long-term contracts in which payment by the customer and performance by the company occur at significantly different times.
f. Variable consideration
The current revenue recognition requirements do not include detailed guidance for measuring the amount of revenue when the consideration is variable.
If the consideration promised by a customer is variable, a company will estimate it using either the expected value or the most likely amount, depending on which amount better predicts the amount of consideration to which the company will be entitled. When such estimated amount of variable consideration is included in the transaction price the company would exercise judgement to assess any possibility of a significant reversal in the amount of cumulative revenue recognised once the associated uncertainty is resolved.
Other requirements in SLFRS 15
Portfolio of contracts: Having specified the revenue recognition principles from an individual contract point of view SLFRS 15 allows, in some cases, for a company to apply the requirements to a portfolio of contracts instead of applying the requirements separately to each contract with a customer.
Contract costs: SLFRS 15 also addresses the treatment on certain costs that are related to a contract with a customer.
A company would recognise an asset for the incremental costs of obtaining a contract if those costs are expected to be recovered. For costs to fulfil a contract that are not within the scope of other Standards, a company would recognise an asset for those costs if the following criteria are met:
nthe costs relate directly to a contract (or a specific anticipated contract);
nthe costs generate or enhance resources of the company that will be used in satisfying performance obligations in the future; and
nthe costs are expected to be recovered.
Linkage between SLFRS 15 and SLFRS 9
SLFRS 15 is not a standard that can be dealt in isolation. Particularly with the applicability of SLFRS 9, Financial Instruments, the two Standards go hand in hand. SLFRS 15 requires that an entity assesses a contract asset for impairment in accordance with SLFRS 9. An impairment of a contract asset shall be measured, presented and disclosed on the same basis as a financial asset that is within the scope of SLFRS 9. Accordingly every entity to which SLFRS 15 applies need to bring their receivables arising from contracts with customers under SLFRS 9.
Consequently trade receivables or contract assets are subjected to impairment under Expected Credit Loss (ECL) model of SLFRS 9 which means application of SLFRS 9 is not limited to banks and financial institutions but to all entities which has receivables arising from revenue on contracts with customers.
Most of the receivables arising from the revenue transactions within the scope of SLFRS 15 do not contain significant financing components. The loss allowances of those are allowed to be measured at an amount equal to lifetime expected credit losses using the simplified approach to apply ECL model. However the entities may choose to apply the general approach to ECL model as well.
To assist users of financial statements to better understand the nature, amount, timing and uncertainty of revenue and cash flows from contracts with customers, SLFRS 15 requires a company to disclose quantitative and/or qualitative information about:
nrevenue recognised from contracts with customers, including the disaggregation of revenue into appropriate categories;
ncontract balances, including the opening and closing balances of receivables, contract assets and contract liabilities;
nperformance obligations, including when the company typically satisfies its performance obligations and the amount of the transaction price that is allocated to the remaining performance obligations in a contract;
nsignificant judgements, and changes in judgements, made in applying the requirements; and
nassets recognised from the costs to obtain or fulfil a contract with a customer.
Are you ready?
SLFRS 15, as discussed above, introduces many new requirement in relation to revenue recognition, measurement as well as disclosure requirements. The five-step revenue recognition model introduced in the Standard requires the management to exercise many judgements and make many estimates. This will require necessarily analysis of information pertaining to the company as well as market information which may require reference to data bases.
On the other hand, the companies may need to take a re-look at all the contracts they have entered in to with the customers in applying the five step model. Particularly with regard to revenue recognition over time and at a point in time, companies may need to modify the clauses and redraft the contracts.
Finally the onus is put on the management with the requirement of comprehensive disclosures with regard to revenue recognition together with the disclosure of significant judgements and estimates made. This may also require among other things a paradigm shift in the mind sets.
(The writer is Managing Director – BDO Consulting Ltd.)