“Dissecting revenues” by Julie Christine O. Mateo (August 30, 2010)

SUITS THE C-SUITE By Julie Christine O. Mateo
Business World (08/30/2010)

A proposed new income model

It goes without saying that revenues have a major function in business.

It is normally used as a key performance metric that the market uses to determine whether an entity is performing well or not.

Measuring revenues can be complicated, but there is now a proposal to standardize its reporting.

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) are currently working on a number of projects to improve the existing accounting standards, to merge the International Financial Reporting Standards (IFRS) and the US generally accepted accounting principles (US GAAP) and, eventually, to come up with a single high quality, globally accepted financial reporting framework.

One of the areas of focus is that of revenue recognition. The IASB and FASB recently released an exposure draft (ED) that proposes a single revenue recognition model applicable to a range of various industries.

Main changes to current rules

The ED proposes a five-step approach to determine the appropriate amount and timing of revenue recognition. These are:

• Identify the contract with the customer;

• Identify the separate performance obligations in the contract;

• Determine the transaction price;

• Allocate the transaction price to the separate performance obligations; and

• Recognize revenue when each performance obligation is satisfied.

The ED basically requires companies to look into their business practices and policies to identify whether a contract — which may be written, oral or implied — exists. This includes identifying all of the performance obligations within the contract. A performance obligation such as a warranty coverage that is identified to be “distinct” should be accounted for separately.

Correctly identifying the goods and services promised through a contract is quite critical, as more and more companies now resort to bundling products and services to remain competitive in the market. For instance, a company that sells photocopiers may include repair and maintenance as part of the contract.

Therefore, applying the provisions of the ED, the seller should determine if, aside from the rental, the promise to render repair and maintenance is a distinct performance obligation and account for it separately.

The ED also discusses the determination of the transaction price.

Normally, the transaction price will be fixed and can be readily determined based on the terms of the contract.

However, there may be instances when the transaction price varies as a result of refunds, incentives, and discounts, or may contain performance-related bonuses.

The ED requires that the variable considerations will be recognized only if the company has the ability to reasonably estimate it. Otherwise, only the fixed portion will be recognized.

Furthermore, the transaction price under the ED should be reflective of collectability, time value of money, non-cash considerations and consideration paid to a customer.

Revenue previously recognized under the current accounting standards may be higher than under the ED. For example, a company currently recognizes 100% of the revenue based on the contract terms.

However, under the ED, the revenue will be lower since the transaction price is adjusted to reflect the credit risk and a probability-weighted average approach to measuring variable consideration.

It is evident that a considerable amount of estimation will be required of companies under the proposed provisions of the ED.

Companies may already be doing these estimations currently, but the nature of the estimates may be different. For instance, companies who offer warranties on products or services sold will currently recognize revenues in full and accrue the estimated incremental costs of the warranty. Under the ED, the revenue will not be recognized in full as the value of the warranty will be recognized as revenue when the obligation is satisfied.

Another significant change introduced by the ED is the timing of the revenue recognition.

Revenue is recognized upon the satisfaction of a performance obligation, that is, when control over the goods or services are transferred to the customer. In some instances, the determination of when control is transferred is quite straightforward.

But in the case of companies in the construction industry, this could be tricky. For a building under construction, when does control transfer? Is the performance obligation satisfied over a period of time or at a point in time?

Given that the tax rules remain the same, there will be a marked difference between the revenues reported in the financial accounting and tax books. This difference may result in temporary differences for which deferred income tax assets or liabilities may have to be recognized.

Impact on the business and operations

Although the ED is not yet effective, companies are encouraged to assess how it might affect business and operations.

Revenue is probably one of the most critical elements of a business. Most companies are measured based on the level of its revenues and revenue growth, as well as other performance indicators such as earnings before interest, taxes, depreciation and amortization (EBITDA) or return on capital, which still mainly hinges on revenue as a main factor.

With the anticipated move to the proposed model here discussed, there are changes expected as to how companies will transact with customers and enter into contracts, as well as how and when revenues will be recognized.

Some of the areas that companies can start looking into are their current processes, their existing contracts with customers and business practices, the sustainability of their information systems as it relates to data capture, processing and financial reporting, ED’s impact on key performance indicators and the differences with taxation rules.

Furthermore, since a retrospective adoption of the proposed standard is currently being proposed, an early assessment of possible impact will help companies avoid surprises when the proposed standard is adopted.

(As of publication, Julie Christine O. Mateo is an Assurance Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.