“Revised revenue recognition proposals: What has changed? [2nd of 2 parts]” by Roel E. Lucas (February 6, 2012)

Business World (02/06/2012)

(Second of two parts)

Last week, we started to discuss the second exposure draft (ED), Revenue from Contracts with Customers that was jointly released by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) (collectively, the Boards). This new ED revises, clarifies and simplifies certain points in the original ED published in June 2010, and aims to adopt a single revenue model to be followed by both International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP) reporters.

Core principle of control
The core principle of the revenue recognition proposals is anchored on control. Revenue can only be recognized when the related performance obligation is satisfied by the transfer of the promised goods or services to the customer.

However, the previous ED primarily focused on the control of goods transferring to the customer. This elicited comments from various sectors especially from the construction industry.

While applying the concept of control is relatively easy to determine when applied to performance obligations involving the transfer of goods, it is less intuitive and rather difficult to apply to performance obligations for services.

It is inherently difficult to determine when a customer obtains control of the service. In many contracts involving service, the service asset is simultaneously created and consumed. Even in the case of the construction industry where there is a recognizable asset, an entity will still have difficulty in evaluating whether the customer has the ability to direct the use of and obtain the remaining benefits from an asset that is in the process of construction by the seller.

As a consequence, the Boards have developed criteria to assess when control of a good or service transfers either over time or at a point in time. There is no assumption that goods transfer at a point in time or that services transfer over time. Instead, the criteria drive (1) the determination of whether the related performance obligation had been satisfied and, (2) the timing of revenue recognition.

Therefore, it is critical for entities to fully understand the concept as this will have an impact on their accounting of revenues. For certain performance obligations which are satisfied as of a point in time, the related revenue would also have to be recognized at that point in time. However, for other performance obligations that are satisfied over time, the associated revenue is recognized over the period the performance obligation is satisfied.

Onerous performance obligations
The previous ED required that an entity should recognize a liability for an onerous performance obligation. This liability results when the costs that relate to directly satisfying the performance obligation exceed the transaction price allocated to it.

This proposal raised concerns from respondents since recognizing a loss for all the performance obligations in a contract may not always provide useful financial information especially if that performance obligation is a “loss leader” (i.e., those intentionally priced at a loss in expectation of profits to be generated on subsequent contracts with the customer).

As a result, the Boards have changed the proposed model on how entities should determine whether their contacts with customers are onerous. The onerous test would apply only to performance obligations that are satisfied over a period of time greater than one year, and not those satisfied at a point in time. The Boards decided, however, that the onerous test should still be performed at the level of performance obligation rather than at the contract level since this is consistent with the core principle of revenue recognition and their objective to reveal different margins on different performance obligations within a contract.

Other concerns
When the transaction price is variable, the previous ED required using the probability-weighted technique to measure the transaction price which reflects the full range of possible consideration amounts, weighted by their respective probabilities. This raised a concern among respondents that the method could be too complex to apply and may not result in meaningful information.

It may well lead to a situation where an entity will recognize revenue even though it does not believe that it is likely such amount of revenue will become due to the entity. An example is a contract where receiving the consideration is a binary outcome; i.e., the entity is entitled to receive an additional fixed amount or no additional consideration at all depending on the result of certain future events. Under the pure application of the probability-weighted technique, revenue will be recognized even if the entity believes that it has low probability of receiving the amount. This approach requires high level of judgment to be applied and increases the uncertainty relating to the amounts that are recorded as revenues of the entity.

To address the concern, the Boards decided that an entity should estimate the variable consideration at either the expected value amount determined using the probability-weighted technique or the most likely amount, depending on which method better predicts the amount of the consideration that the entity will be entitled to.

The revised proposals also concluded that an entity is not required to consider the time value of money when the period between the customer’s payment and the entity’s satisfaction of the performance obligation is less than one year.

The Boards likewise simplified the requirements for standard warranties (e.g., product defects). The requirement of the revised proposals is consistent with the current practice of recognizing a liability for the estimated warranty costs for delivered goods and services. Warranties that provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications will be treated as distinct performance obligations.

Direct costs incurred to fulfill a contract and incremental costs incurred to obtain a contract can be capitalized, provided those costs are expected to be recovered. Otherwise, these costs will be expensed as incurred, as would costs that relate to previously satisfied performance obligations for which there is no future benefit and costs for abnormal amounts of wasted materials or excess labor. Capitalized costs will be subject to amortization and impairment testing.

This proposal could represent a significant change for entities that currently expense the costs of obtaining a contract including contract renewals and would be required to capitalize them.

The Boards have not yet proposed an effective date, but have indicated that it would not be before 1 January 2015. All current IFRS and US GAAP reporters will be required to apply the ED retrospectively, with limited transitional relief. Early adoption will be permitted under IFRS.

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.