The draft Revenue Recognition standard: Steps 1 and 2 

Welcome to this, the second in our series of videos on the new exposure draft “revenue from contracts with customers”.

In our first video we introduced the 5 steps in the proposed revenue recognition model.  Lets just look at a reminder of the 5 step approach

So we have the 5 step approach shown here and in this second video we will take a more detailed look at steps 1 & 2 on the left hand side

Step 1 is to identify the contract.

The ED looks for a legally enforceable contract, which need not be written.  The ED sets out detailed criteria as follows:

1.  that the contract has commercial substance (i.e. the company's future cash flows are expected to change as a result of the contract);
2. the parties to the contract have approved the contract and are committed to satisfying their respective obligations;
3. the company can identify each party's enforceable rights regarding the goods or services to be transferred; and
4. that the company can identify the terms and manner of payment for those goods or services.

Current US guidance looks for ‘persuasive evidence of an arrangement’ which is defined based on an entity’s normal business practices.  In some cases this might be a higher hurdle than enforceable legal contract.

Current IFRS looks to the transfer of risks and rewards and in many cases this would be aligned with the transfer of legal title.

Lets look at two particular aspects – combining contracts and modifying contracts.

Firstly combining contracts - Technology companies often sign several contracts with customers, for example for delivery of hardware or software licences, and for provision of support and post-contract services.  Assessing whether several contracts should be combined is the first step in determining the unit of account for revenue recognition purposes under the ED.

Two or more contracts would be combined if entered into at or near the same time with the same customer, or related parties, and:

• the contracts are negotiated as a package with a single commercial objective;
• the amount of consideration in one contract depends on the other contract; or
• the goods and services in the contract are a single performance obligation.

Current IFRS and US GAAP already include guidance on combining contracts;

however, 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.

And for contract modifications - The ED requires companies to account for modification as separate contract if it adds separate performance obligation at commensurate price, otherwise, the contract and the modification is re-evaluated together for the separate performance obligations and the transaction price is re-allocated to each separate performance obligation.

Step 2 in the model is to identify the performance obligations in the contract.  The key here is when do you separate and when do you bundle performance obligations.

A company would account separately for performance obligations to transfer goods or services that are distinct.  A good or service is distinct if it is regularly sold separately by the company or if it provides a benefit to the customer.

However, a good or service is not accounted for separately if the good or service is bundled with other goods or services in the contract that are highly interrelated and the company promises to integrate those goods or services into an item(s) for which the customer contracted.

Current IFRSs do not provide comprehensive guidance on identifying separate components that applies to all revenue-generating transactions, although there is guidance 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. Most IFRS technology companies will need to carefully asses the separate performance obligations in the contracts.

US GAAP reporters will see less of a change although under the 2011 ED although the terminology is different.

The proposals apply to all revenue-generating transactions, including software.  Under current US GAAP, the key criterion for separating components in a multiple-element software contract is whether there is Vendor Specific Objective Evidence (VSOE) of fair value for the undelivered elements. Under the 2011 ED, the ability to measure reliably the fair value of each individual component is not a hurdle for separating components. Instead, the goods and services are accounted for separately if they are 'distinct'.

Under the 2011 ED, software licences delivered upfront may be considered distinct if the customer would be able to use the software on its own, separate from the post-contract support. In such cases, the recognition of revenue related to the software licence could be accelerated compared to current practice.

Similar considerations may apply to specified upgrades of software licences. At present, some software companies may not separate those components if they are not able to measure reliably their fair value on an individual basis and the resulting revenue profile is similar to a subscription basis.  Under the 2011 ED, each of these components is likely to have benefit to the customer with the delivered licence, and therefore may be considered distinct.  This may result in a significant change for those companies that currently have a subscription based revenue model.

That’s the end of this video looking at the first two steps in the model.

In the next video we will discuss step 3: Determining the transaction price and

Step 4: Allocating the transaction price to the separate performance obligations and consider the potential implications for technology companies.

Thank you for watching this video.