IFRS 15 is a new accounting standard applicable to businesses applying IFRS in the financial statements beginning on or after 1 January 2018, many businesses will need to implement new processes and control systems to ensure they are compliant.
The standard will potentially have a huge impact on the financial reporting of revenue and applies to all customer contracts with only a few specialist exceptions. A significant change from the previous standards, IFRS 15 adopts a control-based model and much has been published about the accounting for revenue contracts and how this might change, ie the theory of the accounting change. However, focusing on this may be missing the largest implication of many of the subtle accounting changes in the practical implementation of the new standard.
Read on for real-life examples demonstrating that the major challenge is to make sure the necessary processes and systems are in place to ensure compliance with the new accounting standard.
Contract modifications and accounting implications
One notable area of the new standard relates to contract modifications, the standard requires companies to carefully consider whether these are treated as a separate contract, a change to the existing contract or the termination of the old contract and the start of a new one.
The principles in the standard are quite easy to understand and apply. The challenge is ensuring that finance have a chance to determine the right accounting treatment at an appropriate time. For example, in the construction sector, it is common for contracts to change over time due to changes in building specifications and related fees.
My experience is that companies in the construction industry often don’t have processes in place to enable finance to be appraised of contract modifications when they occur. Most project managers probably don’t realise that changes to the contract agreed with the customer might have accounting implications.
For instance, if a company is contracted to build a new tower block and subsequently the customer changes the specifications, finance will need to understand both the change to the contract in respect of the goods and services promised to the customer and also the impact on the transaction price.
It is easy to see that companies will need to plan ahead and put processes in place to consider contract modifications when they are made, reviewing them at year end will likely cause real issues for some businesses, most notably whether sufficient information can be gathered with hindsight to ensure the standard is applied appropriately.
A common aspect of contracts is the notion of variable consideration, where the fee is based on the outcome of certain conditions. Unlike its predecessors which simply focused on whether the revenue could be reliably measured and was probable, IFRS 15 requires businesses to estimate the variable consideration using a probability-weighted expected value approach or a most-likely approach, this is then subject to a constraint on the amount of revenue that can be recognised. Essentially, revenue can only be recognised if it is highly probable that a significant reversal of revenue will not occur. These judgements will require data to be able to justify the recognition of revenue. For example, certain technology, engineering and life sciences businesses where fees are earned by achieving a key milestone will be affected by this development as would manufacturing companies who operate under a rights of return policy.
Consider a manufacturer of kitchen appliances which allows customers the right to return goods under certain circumstances. In accounting for the sale of kitchen appliances, the company would need to hold a refund liability for the expected amount of revenue not recognised and would also need to hold a corresponding contract asset for its rights to the returned goods. This practice is different to the existing treatment where revenue is often not recognised at all if the significant risks and rewards of ownership have not been transferred. The company will need to research and justify previous rates of returns for similar products in order to try and value the liability and corresponding asset, including testing that asset for impairment. For some companies this measurement basis will bring a great deal of judgement into the financial reporting process and companies may find themselves trawling through historic data in order to assess the reportable revenue.
Identifying performance obligations
Retailers are another sector which can expect to see changes from the implementation of the standard with gift cards, loyalty schemes and warranties all under focus. Due to the sheer volume of transactions which retailers often enjoy there will be more dependence on a controls based approach than ever before and companies which fail to plan for the changes will have difficulties in reporting their income at the year-end. An overarching aim of the standard is to bring consistency in the reporting of revenue and gift cards are a prime example of where this applies and where companies had previously used a variety of different approaches. The new guidance stipulates that retailers using a gift card scheme need to defer a portion of revenue over time with the expected breakage, being the unused portion of gift cards, being recognised as revenue in proportion to the pattern of rights exercised. The difficulty in this approach will come for companies which do not have the systems to track gift cards and have no historic patterns of actual gift card redemption.
Auditing the changes
A number of the changes to the standard will require businesses to have a system, processes and controls to enable management to be comfortable that the financial statements are compliant with IFRS 15. A natural consequence of this is that auditors should be seeking to apply a controls-based approach to the audit of revenue in more circumstances than at present. It will be difficult to get substantive evidence that all modifications to contracts have been accounted for appropriately. It will be easier to ensure that there is a process and a control and therefore to assess whether the control is working. Management should engage early with their auditors for a constructive dialogue around the best approach for the audit and to avoid any nasty surprises.
The differences between IFRS 15 and its predecessors are abundant and the changes will affect companies in different ways, some feeling a real impact and others not noticing any significant change. One thing is for certain though; companies reporting under IFRS should be considering the standard well in advance. This will not be a standard which can be applied when management look to prepare the first set of IFRS 15 compliant financial statements. Implementing new systems and processes in plenty of time will substantially ease the transition, in some cases it will be the only way to ensure compliance with the new accounting requirements.