The draft Revenue Recognition standard – Introduction and overview 

Welcome to this, the first in our series of videos looking at the new exposure draft “revenue from contracts with customers”.  This series of videos focuses on the potential impact of the revised proposals and the remaining challenges facing technology companies.

In November 2011, the IASB and the FASB published a revised joint exposure draft on revenue recognition.  The original proposals issued in June 2010 were revised to address a number of concerns expressed by constituents, including technology companies. While the Boards have addressed some of the technology companies' concerns, a question remains as to whether technology companies feel that the revised proposals are clear enough to be applied consistently across the range of multiple-element contracts entered into with customers.

In this first video we will take a look at an overview of the revised proposals.  So lets take a look at the model. 

The revised proposals retain the five-step model for determining when to recognise revenue, based on the core principle that revenue is recognised when or as a company transfers control of goods and services to customers.  In overview – it seems a straightforward model...

Step 1 is to identify the contract. This step would in seem simple...but companies will need to think about when to combine contracts and how to deal with contract modifications.

Current IFRS and US GAAP includes guidance on combining contracts but the current criteria are not identical to one another nor are they the same as the criteria in the ED.  This may result in different outcomes under the ED than under current practice.

Step 2 is to identify the separate performance obligations in the contract. Technology companies often have different components in a contract (for example a handset and ongoing rental, maintenance and support services) which may have previously been bundled together.

Under the 2011 ED, the key criterion for determining whether goods and services should be bundled in a single performance obligation is the degree of integration and customisation provided by a technology company.  In order to identify performance obligations that are accounted for separately, a technology company would consider whether the promised goods and services are 'distinct‘ and whether they are highly interrelated with significant integration services and whether the bundle is significantly modified or customised for the customer.

Current IFRSs do not provide comprehensive guidance on identifying separate components that applies to all revenue-generating transactions, although some guidance exists in specific circumstances.  Some technology companies apply this specific guidance by analogy to other types of contracts, including software and IT services contracts. Some technology companies apply by analogy aspects of US GAAP.

Step 3: is to determine the transaction price – again in many cases this may be straight forward, but complexities may arise around variable consideration, credit risk, and the time value of money which we will discuss in more detail later.

Step 4 is to allocate the transaction price to the individual performance obligations based on stand alone selling price (phone handset market).

The 2011 ED retains the proposal to allocate, at contract inception, the transaction price to separate performance obligations in proportion to their relative stand-alone selling prices. When stand-alone selling prices are not directly observable, a company would estimate them using a suitable approach, such as the adjusted market assessment approach, the expected cost plus a margin approach or, in limited circumstances, the residual approach.

US GAAP software companies will note the hurdle of VSOE and VSOE related deferrals are not included in the ED.

Step 5, the last step, is to recognise revenue when control passes - either over time or at a point in time.

The 2011 ED retains the core principle that revenue is recognised when or as performance obligations are satisfied through the transfer of control of a good or service to a customer.   It provides specific criteria to assess whether a performance obligation is satisfied over time or at a point in time. 

Lets take a look at the criteria for recognising revenue over time.

For revenue to be recognised over time EITHER the performance creates or enhances an asset that the customer controls, for example onsite improvements to customers IT systems  OR performance does not create an asset with alternative use to the entity and at least one of the following:

a) The customer receives & consumes benefit as entity performs – so perhaps maintenance or support

b) The task would not need to be re-performed.

c) The entity has right to payment for performance to date and expects to fulfill contract – for example a technology company develops customised software, expects to complete it and is entitled to payment for progress to date.

At present, to qualify for percentage of completion accounting under IAS 11 the software being developed needs to be sufficiently customised to meet the definition of a construction contract. Customisation is not the critical criterion for recognising revenue over time under the 2011 ED.

Under the 2011 ED a range of contracts may qualify for percentage of completion accounting, including a number of arrangements in the technology sector such as integration, outsourcing and consulting services. The analysis for software developers may be more challenging.

That’s the end of this video introducing the proposed revenue recognition model.

In the next videos we will take a more detailed look at each step and consider the potential implications for technology companies.

Thank you for watching this video.