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IFRS 15 Is Set Have A Major Impact

The new accounting standards

9Dec

The release of the the International Accounting Standard Board’s (IASB) IFRS 15 Revenue from Contracts with Customers, the new revenue recognition standard, has been a long time in the making, undergoing multiple revisions during the drafting process. Around a decade in the making, it was finalized in April 2016 and will affect all companies reporting under IFRS as of January 1 2018.

IFRS 15 will replace a number of existing standards and interpretations. These include IAS 18 Revenue, IAS 11 Construction Contracts, SIC 31 Revenue – Barter Transaction Involving Advertising Services, IFRIC 13 Customer Loyalty Programs, IFRIC 15 Agreements for the Construction of Real Estate, and IFRIC 18 Transfer of Assets from Customers. It is based on the core principle that ‘an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to.’ Essentially, as a spokesman of the International Accounting Standards Board further explained, ‘The standard requires a company to recognize revenues once the customer obtains control over a good or a service,’ thus making it harder for firms to accelerate or delay revenues.

In order to apply the principle, entities must go through a five-step model in recognizing revenue. The first step is identification of the contract with the customer. IFRS 15 will occasionally necessitate that one entity combine contracts and account as one. IFRS 15 also provides guidance on accounting for contract modifications. Parties must determine whether they actually have a contract that fits IFRS 15 criteria. Can the customer pay, and are the rights understood and agreed by all parties?

In step two, parties must identify the performance obligations in the contract and their ability to fulfil the terms of provision. If there are multiple deliverables under a contract, IFRS 15 provides guidance on determining whether there are multiple goods or services promised in the contract or whether they should be accounted for as separate obligations.

Step three focuses on determining the transaction price. The transaction price is defined in IFRS 15 as ‘The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.’ This can be a fixed amount, although it could also include variable or non-cash considerations. It also considers the time value of money, something not considered in IAS 18.

Step four will set out guidelines for allocating the transaction price to the performance obligations in the contract. The transaction price is allocated to each distinct performance obligation on the basis of the relative stand-alone selling prices distinct good or service based on adjusted market assessment, expected cost plus margin, and in certain circumstances, a residual approach can be taken.

In step five, recognizing revenue is covered, one of the most important areas of business and likely the most impactful change for IFRS 15. Revenue is recognized as control is passed, either over time or at a point in time. It provides guidance on the satisfaction of the performance obligation and ensures that its use is not directed by others or for an alternative purpose.

According to experts such as Phil Barden from Deloitte, the industries most likely affected will be telecoms, software development, contract manufacturing - essentially any industry in which long-term contracts are commonplace.

Telecommunications, in particular, will face challenges. The majority of telecoms customers buy prepayment plans and IFRS 15 means companies will have to recognize revenue earlier than under previous standards as the transaction price has to be allocated to the individual performance obligations in the contract and recognized upon fulfilment.

Companies have already been affected by the new standard. UK car and engine giant Rolls-Royce last month reported that their profits will fall dramatically as a result of IFRS 15, with 2015 profits £900m lower than the £1.4bn it reported if the standard had not been in place.

Rolls-Royce’s problem is its business model. The company usually sells large aircraft engines at a loss of about £1 or £2 million and relies on the contracts servicing them to make a profit. Any losses on the balance sheet have been compensated by booking this servicing revenue early. According to broker Hargreaves Lansdown, when aftermarket revenues were booked upfront, much of the cash never materialized because some customers retired aircraft rather than having them serviced. This is a practice IFRS 15 prohibits. Instead, losses must be recognized immediately and revenue cannot be booked until the work has been provided, which should provide greater clarity.

However, David Smith, Rolls-Royce CFO, also acknowledged the benefits: ‘The new standard provides a number of benefits to the business. As it brings profit performance for original equipment (OE) more in line with cash generation, it will put a sharper focus on improving productivity across our manufacturing activities. At the same time, the change to aftermarket accounting, particularly in Civil Aerospace, reinforces our focus on cash flows, as we look to improve further our strong reputation for customer service by maximising engine availability while minimising cost.’

IFRS 15 has significantly more guidance on a number of issues that IAS 18 was relatively weak on. The scale of the task is not to be underestimated. The new standard is not just about timing of revenue and profit, it’s about systems and processes, which will likely mean a huge amount of work, not only from accountants but departments across the organization, and they will need to work together to ensure the requirements are met. 

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