Four Things You Need to Know About the Coming Changes to Revenue Recognition

April 24, 2017

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Revenue is pretty important to most businesses.  Without revenue most of a company’s activities are meaningless.  What’s often overlooked on a day to day basis is how the accounting for revenue impacts the business as a whole.  Investors may have quarterly earnings expectations, contracts may have clauses triggered by revenue milestones and debt covenants may depend on healthy revenue reporting. In IFRS 15, Revenue From Contracts With Customers, the new revenue recognition rules under International Financial Reporting Standards (IFRS) are changing effective 2018 and, as Rolls Royce has learned, the impact of these changes can have a very significant, and possibly negative, impact on many business’ revenue reporting.

The Rolls Royce example demonstrates a few things.  First, these new rules can indeed impact revenue recognition in a profound manner.  In their case, it would have resulted in a £700m-£1bn negative variance on their revenue if they had early adopted IFRS 15 in 2015, erasing more than half their pre-tax profit.  Second, analysts, investors and other stakeholders are very interested in the impact of this new standard on companies’ financial statements as it may require a fundamental adjustment to how the financial health of those companies are evaluated.  Finally, and to Rolls Royce’s credit for doing this well, it’s important to get the message out to stakeholders early in a demonstration of proactive and informed management.  This approach may turn a potentially catastrophic accounting adjustment into a positive display of corporate communication.

The question on many peoples’ minds is whether this impacts their company and the answer is very likely ‘yes, it does.’  All companies who generate revenue and report under IFRS are affected.  Further, the FASB has issued a U.S. GAAP revenue recognition standard which is substantially the same as IFRS 15 with an effective date of 2018 for public companies and 2019 for private companies.  Between the two standards, this impacts virtually all public companies globally and a great many private companies.  The extent to which the standard will affect your company will largely depend on the complexity of the contract terms under which goods and services are sold.  Suffice it to say, no industry sector is immune, although some will be more impacted than others.  

Before we get into the details, an important note on disclosures and implementation dates.  Although the standard doesn’t come into effect until January 1, 2018, Canadian regulators (and those in other countries) are warning companies not to underestimate the impact this standard will have on them and are strongly recommending qualitative and quantitative disclosures of the expected impact be disclosed in companies’ financial reporting now. The comparative period figures for fiscal 2017 may need to be amended on adoption of the new standard and the regulators are clearly seeing this information as useful to financial statement readers through 2017.  This is, of course, the minimum threshold, with proactive and transparent stakeholder communication being the best practice.

From a high level, some of the most significant ‘need to knows’ are as follows:

1. The complexity of revenue accounting is increasing.  A lot.

As it stands today, the IFRS revenue recognition guidance totals about 77 pages. The new guidance is 341 pages, including amendments to other standards.  The point being that evaluation of revenue recognition is becoming much more complex and the effort to adopt it should not be underestimated.  Those who start on their evaluation early will be in a much better position than those who don’t. 

2. The revenue recognition model is changing. 

The new standard is based on the concept of control. Entities must determine when the customer obtains control of the good or service in the context of when to recognize the related revenue.  This is a significant change from the current “risks and rewards” model, requiring a change in what may, for many, have been an inherent understanding of the accounting.  It will be key to refer back to the standard when evaluating revenue contracts to ensure old biases and assumptions are no longer applied.

3. Systems and processes will likely need to be reconsidered.

It’s very easy to get hung up on the accounting implications alone.  However, many companies will need to reconsider their existing accounting systems and processes to accommodate the new standard.  Particularly where a contract includes a number of ‘bundled’ elements, which may need to be unbundled to comply with the new standard, it is unlikely current information systems are granular enough to track and report this information.

4. A company’s reported revenue may change, even though the business didn’t.

Will the cash payments received for sales change on account of the new standard? Probably not.  This does not mean there are not commercial aspects to consider.  Revenue and EBITDA are often applied as triggering factors in contracts commonly entered into by many companies.  Examples include:

  • Covenants within loan agreements
  • Consideration payable in business combinations
  • Performance-based compensation, including stock options
  • Corporate tax obligations
  • Internal budgeting processes
  • Bonus structure and payments

BONUS: Impending changes to IAS 16 Property Plant and Equipment impacting revenue recognition

The International Accounting Standards Board (IASB) issued a Staff Paper in October 2016 proposing amendments to IAS 16 which would essentially prohibit the netting of incidental revenues realized against property, plant and equipment during the testing phase of those assets.

This amendment has been proposed in response to a common practice in certain industries of netting significant revenues against property, plant and equipment, sometimes in excess of the cost of testing, thus reducing the amortization cost that otherwise would be matched against future earnings derived from those assets.  The proposed approach is similar to that generally applied by entities following U.S. GAAP. For many entities, this will result in more revenue landing on the income statement during the testing phase than in the past and lower net income in future periods as a result of higher depreciation expense.  

Discussions by various groups continue on how this change would be applied in practice, however, it appears likely that this change will be brought into the standard.  Management of entities that would be significantly impacted by this change should begin considerations on the impact to their future financial reporting.  

Thank you for reading my article – I hope you’ve found it insightful.  It’s key to remember that you’re not alone if you find adoption of new accounting standards to be a daunting task and there are professionals available to ensure it’s done right and on time.  Once you’re ready to get some professional input, our Accounting Advisory team will be there for you.

Bryndon Kydd, CPA, CA
Partner, Assurance & Accounting Service Line Leader
National Natural Resources Industry Leader