“Stakeholders react to proposed IFRS changes” by Roel E. Lucas (March 14, 2011)

Business World (03/14/2011)

Proposals to change how and when revenue is recognized under both International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP) can have far-reaching consequences for some entities.

The proposals were opened for comment until October 2010 and nearly 1,000 respondents submitted their views.

To better understand the respondents’ key concerns, Ernst & Young (EY) reviewed a sample of the responses that the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) (collectively, the Boards) received.

Here are some of the results from this EY survey.

The revenue project

The Exposure Draft Revenue from Contracts with Customers (the ED) was issued in June 2010 as a result of the Boards’ joint project to achieve convergence between IFRS and US GAAP, and to provide a single model for all revenue transactions arising from contracts with customers.

Revenue will be recognized upon transfer of control over the goods or services to the customer, rather than upon transfer of risk and rewards.

Although the system for accounting for some transactions may not change significantly, it is likely that all entities will be affected to some extent by the proposals.

In some cases, the proposals may change the timing and measurement of revenue recognition more fundamentally.

The ED provoked a large response from preparers, users, national standard setters, and auditors. Their detailed feedback offer insights on the impact that the proposed standard is expected to have across industries.

The survey respondents represented professional associations (40%), various corporate entities or groups (22%), professional services organizations(17%), financial services organizations and insurance (10%); government, national standard setter and securities commissions (7%); as well as academia and private submissions (4%).

The comment letters were generally supportive of the Boards’ efforts to develop a converged revenue recognition standard that would be applied across industries.

Many respondents also support a single model to deal with all revenue transactions, although a number of conceptual and practical issues were identified with the model as it is drafted.

Application of the control model

However, while the majority of respondents support the Boards’ objective, nearly all of them commented that the control model, as written, will be difficult to apply in practice.

Under the control model, revenue is recognized when an entity satisfies its obligation to its customers, which occurs when control of the asset or service is transferred to the customer.

The most common concern is that the model does not work for long-term construction contracts and service contracts.

A number of respondents were also concerned about how the indicators of control, described in the standard, should be applied in practice.

Paragraph 30 of the ED gives the following indicators that the customer has obtained control of goods or services:

• The customer has an unconditional obligation to pay;

• The customer has legal title;

• The customer has physical possession;

• The design or function of the goods or services is customer-specific.

On the concerns from the construction industry about applying the indicators of control to long-term contracts, the Boards need to clarify under what circumstances control should be considered to transfer continuously.

Identification of performance obligations

The ED defines performance obligation as an enforceable promise, whether explicit or implicit, in a contract with a customer to transfer goods or services to the customer.

Many of the comment letters also expressed concern about this issue.

Construction industry respondents, for example, raised the question that, since the proposals require identification of multiple performance obligations, this may not reflect the economic substance of the contract.

In the software and technology industry, respondents are particularly concerned that there is too much emphasis on goods or services being distinct if they have a distinct profit margin.

Determining transaction price

The model proposes that the transaction price reflects the probability-weighted amount of consideration that the entity expects to receive.

While some respondents acknowledge the conceptual merit of this approach, many note that, in circumstances with few or non-homogenous transactions, the approach would result in an outcome that is neither likely nor possible. Therefore, many suggested allowing management’s best estimate to determine the transaction price.

The model proposes that the transaction price should be adjusted to reflect the customer’s credit risk. This provoked a large number of comments disagreeing with the proposal across industries.

Allocation of the transaction price

The Boards received broad support for the proposal to allocate the transaction price to the individual performance obligations based on a stand-alone selling price.

However, several comment letters, mainly in the telecommunications and technology sector, expressed concerns about the requirement to determine a stand-alone selling price for each performance obligation, thereby removing the option to use a residual method.

Under the residual method, the transaction price is allocated first to the performance obligation where the stand-alone selling price is readily observable.

Any residual amount of the transaction price is then allocated to the other performance obligations of the transaction. The residual method was recently removed as an option under US GAAP, but a number of respondents have requested that it be included in the new model.

Transition requirements

While many respondents express their conceptual support for a full retrospective application and acknowledge the improved comparability this would give, there are significant concerns about the practicality of such a move, particularly those in industries where long-term contracts are prevalent.

At the November 2010 board meeting, the Boards confirmed their intention to begin deliberations on two key issues (the control model and separation of performance obligations) at the January 2011 board meeting.

Other issues will be discussed at board meetings later this year.

The Boards intend to issue a final standard by June 30.

Whatever decisions the Boards will have on the final standard will have pervasive effects on an entity, effects that extend beyond just accounting for revenues, including areas such as financial metrics, systems, tax, and stakeholder communications.

(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.