“Revised revenue recognition proposals: What has changed?” by Roel E. Lucas (January 30, 2012)

Business World (01/30/2012)

(First of two parts)

The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) (collectively, the Boards) jointly released on 14 November 2011 a second exposure draft (ED), Revenue from Contracts with Customers. From this joint project will emerge a single revenue model which will be adopted by both International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP) reporters when the proposed standard becomes effective.

The revised ED is based on significant feedback received from preparers, users, national standard setters and auditors. The Boards also made certain revisions to the previous ED which was published in June 2010. The comment period for the revised proposals will end on 13 March 2012.

The control model

The revised proposals still retain the core principle of the June 2010 ED, which is to recognize revenue when “control” of goods or services is transferred to the customer. This means that an entity should recognize revenue to depict the transfer of promised goods or services to a customer, in an amount that reflects the consideration to which the entity expects to be entitled, in exchange for those goods or services.

Further, the revised proposals retained the following five-step model that an entity will apply in recognizing revenue:

1. Identify the contract with a customer.
2. Identify the separate performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate performance obligations.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.

However, significant revisions were made to the application of these steps in the previous ED.

What has changed?

The previous ED required segmenting contracts if some goods or services are priced independently of other goods or services; meaning the goods or services are regularly sold separately and not provided at a significant discount when combined with other goods or services. This was in addition to the requirement of identifying distinct promised goods and services, referred to as “performance obligations.”

Segmentation will result in accounting a single contract into two or more contracts. The objective of segmenting the contract was to “ring fence” the allocation of the transaction price, which means any subsequent changes in the transaction price that is attributable to a segment of a contract are only allocated to the performance obligations within that segment. However, the proposed model of segmenting a contract in the previous ED was not clearly articulated.

Some sectors believed that the provisions were not clear how many contracts will qualify for segmentation based on the criteria under the previous ED. In many cases, where agreements are negotiated as one contract, it is difficult to see how price independence can be demonstrated. Most arrangements include discounts as a result of bundling multiple goods and services or may contain pricing incentives that can only be associated with the entire contract.

The Boards conceded that their proposed guidance on “segmenting” a contract was confusing. Therefore, they decided to eliminate the additional step of segmenting the contract and instead require separation of a contract solely into distinct performance obligations.

The revised proposals also clarified that entities would treat multiple goods or services (e.g., a bundle) as one performance obligation if they meet certain specified criteria. It was a change from the previous ED, which required all distinct performance obligations to be accounted for separately.

This addresses the concern on the difficulty of entities to identify separate performance obligations in transactions that involve a large number of goods and services and are highly interrelated. For example, construction contracts would indicate that the contractor will provide significant services to integrate the design and the construction of the project which are considered to be highly interrelated and customized. As a result of the clarification, many construction contracts may be accounted for as a single performance obligation under the revised proposals.

Transaction price
The measurement of the transaction price was also simplified. Previously, it was proposed that a measure of collectability be included within the transaction price. Respondents were concerned that the proposal to reflect the customer’s credit risk in the measurement of the transaction price would result in a significant change from the current practice of measuring revenue and may result in differences between the amount invoiced to the customer and the amount of revenue recognized in the books.

The Boards decided that the effects of a customer’s credit risk should not be reflected in the measurement of revenue. As a result, entities will present revenue without deducting amounts that may not be collectible and will present a provision for expected impairment losses on a separate line immediately below gross revenue. The line item will include recognition of the initial allowance and the effects of subsequent changes in collectability.

The requirement to present uncollectible amounts adjacent to revenue will result to a potentially significant change as to how companies use financial metrics to measure financial performance as this will affect the gross margins. Currently, entities generally record their bad debt expense below the gross margin line as part of their operating and administrative expenses.

The revised proposals also provide limited relief for entities concerned about the elimination of the residual technique of allocating the transaction price. Under the residual technique, an entity would determine the selling price of a good or service on the basis of the difference between the total transaction price and the stand-alone selling prices of the other goods or services in the contract.

The previous ED proposed that transaction price should be allocated to the separate performance obligations using their stand-alone selling prices, and eliminated the residual technique as a method of allocation. Respondents to the previous ED generally agreed that, in some circumstances, it might be appropriate to use a residual approach to estimate a selling price. Take the case of a software company that sells a license as part of a bundled package where the pricing of the entire arrangement is significantly different for every customer. In this situation, the entity would have difficulty in estimating the stand-alone selling price of the license given the wide range of historical prices that it has been selling the bundle for.

Based on the re-deliberations, the Boards allowed the use of residual technique if the stand-alone selling price of a good or service is highly variable or uncertain. Notwithstanding this relief, many entities are expected to allocate the transaction price using stand-alone selling prices of the performance obligations in the contract which may result in the recognition of more revenues upfront.

In next week’s column, we will continue the discussion on the revised ED, Revenue from Contracts with Customers and the changes regarding control, onerous performance obligations and other matters.

Roel E. Lucas is a 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.