IFRS 15 revenue from contracts with customers

Intro:
Welcome to the CPA Australia Podcast.

Ram Subramanian:
Hello and welcome. I am Ram Subramanian, Policy Adviser and Reporting at CPA Australia. Joining us today is David Hardidge, a financial reporting expert who has spent much of his professional career dealing with practical implementation issues when preparing IFRS-based financial statements. Both as a practitioner within large accountancy firms, technical accounting department and an independent consultant, David's experience in financial reporting issues spans the listed and non-listed corporate sector, the public sector and the private not-for-profit sector. For many years, David was a member of CPA Australia's External Reporting Centre of Excellence and until recently, he was chairman of this group of technical accounting specialists, providing support to CPA Australia on a number of external reporting issues.

Following completion of three major accounting standards setting projects, the International Accounting Standards Board issued IFRS 9 financial instruments, IFRS 15 revenue from contracts with customers and IFRS 16 leases. David is here today to talk to us about the new accounting standard IFRS 15 revenue from contracts with customers. IFRS 15 becomes effective for accounting periods commencing on or after 1st of January 2018. The reasons for the International Accounting Standards Board undertaking a major project on revenue was two-fold. One to achieve convergence with the United States generally accepted accounting principles or US GAAP as it's more commonly referred to. And two to address the difficulties in understanding and applying the previous standards on revenue IAS 18, revenue and IAS 11, construction contracts. David, do think the resulting standard IFRS 15 delivers on the original objectives?

David Hardidge:
I guess so and I think that they have. The US had a lot of guidance, hundreds of pages, very detailed, industry-based it's often inconsistent between those industries. The ISB on the other hand had very little guidance or requirements and now we've got a lot more and we basically ended up with the science standard almost word for word.

Ram Subramanian:
Okay. How does the approach to revenue recognition in IFRS 15 differ from the previous approach under IAS 18?

David Hardidge:
Well, basically we've got a model now. It's what's called the Foskett model and we've got lots of examples and guidance. So the standard is described as principal space which sort of gives you a general objective and then you have to apply it to your circumstances without having lots and lots of rules. However, having said that, there are some rules that you need to follow in applying this principle state standard.

Ram Subramanian:
So what are the five steps then?

David Hardidge:
Well, step one is what is the contract? And that also deals with contract modifications. Step two is what are the performance obligations? And this is fairly key. It's one you're promising. And there might be more than one promise in a contract. Step three is what is the transaction price? Step four is allocating that transaction price against the various promises or performance obligations that we mentioned. And step five is recognising the revenue when you satisfy that particular promise or performance obligation.

Ram Subramanian:
In Australia, IFRS 15 or it's Australian equivalent WSP 15 will apply to not only the private sector for-profit entities, but also to public sector and private sector not-for-profit entities, what do you think will be the impact of the new standard on public sector and not-for-profit entities?

David Hardidge:
Well, I think that could be a big change. At the moment there's essentially a separate standard for the not-for-profit sector and the public sector and in Australia we'd try to have the same standards for both areas. So what the AASB is working on is a separate project to essentially work out how to apply the IFRS 15 standard which was developed for the private sector and work out how to apply it for the not-for-profit and public sector. And I think it's very hopeful that we're going to get an improvement. And what I mean by improvement is that most of the revenue being recognised in the not-for-profit sector is often recognised upfront. And that gives you a mismatch between upfront revenue and the expenses and costs when the activities take place.

So I think that we'll get sort of good at matching from one of the better words. It's not sort of technically a concept that's in the standards anymore but a lot of people like it. I think we're going to get closer to it. And also the sector is moving from blocked sector funding, upfront funding for a variety of activities to see the services like the National Disability Insurance Scheme. And so the sector needs to deal with that and I think having the standards advices has gotten to help them.

Ram Subramanian:
Okay. And looking at the five step model, where do you usually start when trying to explain how the standard works?

David Hardidge:
Well, a lot of people start with step one. I actually start with transition. And there's a number of transition choices. And it's a little bit circular because how you're affected by the standard may affect your particular transition choice. And those transition choices are fairly unique. It's different to the other standards that you mentioned, financial instruments and leases that started at the same time. So the starting point is that revenue is very important. It directly affects profit. So the International Accounting Standards Board wanted you to have two years based on the science system sort of apples with apples. So if we looked at applying the standard in the first year, assuming that people leave it to the last possible time, that would be starting in 2018, Website 30 the junior company that would be starting in 1st of July, 2018. And the normal approach for standards if you go back and retrospectively applied so that would be starting 1st of July, 2017.

And if you go to 31st of December balanced sheet, that would actually mean 1st January, 2017. And it's not very far wide. If you get the calendar out and actually count the number of months, it's not many. So that's one choice, which is to do the current year, 2018, the new system and change 2007 into the new system. And so they've introduced IF assistant called the Modified Retrospective Approach. And what that means is that you can start applying the new standard from 2018.

David Hardidge:
Now, the problem with that is that you end up with two sets of figures. One based on the new rules, 2018 and one with the old set for 2017. So what BI is based at is we both do apples and apples comparison, so they said that if you apply that approach, then you have to recalculate the new financial year, the 2018 onwards to be under the new system and disclose that in the notes. It's a fairly critical change because normally when you start a new accounting standard, you just drop your old one and don't have to worry about it, this is one you're going to have to carry over for another 12 months. So you get this apples and apples with the old system for 2017. And in the notes, you've got the old system for 2018 to compare to.

Ram Subramanian:
Okay. And you mentioned earlier about performance obligations, I think under step two, they seem to be a key concept in the new standard and how does this work?

David Hardidge:
Well, this is key. It's what we call the unit of account, which as its name implies is the unit that you account for. So it determines how much revenue you recognise and when. And that might be upfront, it might be over time or it might be at a later point in time. So the key step in this is determining the performance obligations as you've mentioned and it's working out what did you promise to do with the good services or combination of both? So one of the underlying test is to work out what is distinct. So it's a new term that a lot of people won't be familiar with. So let's look at a building, so you're going to build a building. So in theory, you might say that every brick is distinct and every nail is distinct and that would obviously have a fairly stupid outcome in trying to account for every brick and every nail.

So there's a concept of combining the distinct items that you might find to get something a little bit more distinct and together. So using the building example a little bit further, you might look at functions, such as design of the building, site clearing, procurement, construction of the building, installing the electrical and water facilities massive landscaping as well.

So when you put those together, you might find that each of those are distinctive or it might be together. And one from a safe, not only do you look at distinct, you have to look at it as distinct in the context of the contract. So from the customer's perspective, you might get a building as a whole and they built all those things would be one promise and one performance obligation. Another area that we look at where you might want to look at the different promises as distinct is selling a good or a licence where there's some sort of installation and modification involved. So the question is, should they be combined or separated? If they're separated, then generally you get the style of the licence or the good upfront and the recognition of the beautification services other time. If they're together, you might have to wait until everything's finished before you recognise the revenue.

Ram Subramanian:
You mentioned the model having five steps and you've just provided us with some insight into step two, what's next?

David Hardidge:
I want to go back to putting them into orders. So step three, what is the transaction price? And [inaudible 00:10:54] of well, isn't it what it said there in the contract? What the standard requires, these full long-term contracts, you have to separate out a financing component if it's significant. And even if you haven't put an interest component or financing component in the contract, you have to separate one out and recognise it separately. The main issue with this is likely to be variable consideration. That's another new term new concept. It's basically to do with bonuses, penalties, discounts, concessions. So at the start of the contract, you might think you're going to get the bonus. And the question is, when do you recognise it? What the standard does is it introduces a constraint and that is it limits how much revenue you can recognise to that amount, where there's a high probability that it won't be a significant reversal of what you've recognised.

Ram Subramanian:
So why did the ISP introduce this constraint?

David Hardidge:
Well, basically the use is one of the constraints they didn't want people to recognise bonuses and then make reversals when they change the view on the estimate of getting that bonus or the probability of getting that bonus. So it's really fully users. [inaudible 00:12:13] I said is being inconsistent with how much face value we have these days with the face values changing profit up and down when a lot of people might think about face value having a high probability of a significant reversal, but that's what we've got. Look up the constraint in the standard.

Ram Subramanian:
Okay. And moving in sequence, how about step four?

David Hardidge:
Well, step four is allocating the transaction price to the various performance obligations. So it's quite important when we talked about step two identifying the particular performance obligations because if you've got more, you've got more to allocate and it costs more to account for. So let's look at one of the main problems that we have when we allocate the transaction price to a number of different performance obligations and that's when we go to bundling and discounts.

David Hardidge:
So let's look at an example of going to the electrical store. You buy a TV, a DVD player and maybe get an extended warranty. And then you get a discount because you got all three together. So the question is, how much do you recognise for each item because they weren't sold at their normal retail price. So the standard has some rule for this and the particular rule on this is allocating the transaction price based on relative par values of the particular promises that you've got. Another issue is orders of some penalties. And we spoke about before about the constraint that something will on the line you're going to need to recognise the bonus or the penalty. And the question is, can you allocate that bonus or penalty against one particular promise or would you have to allocate it against all of the promises?

Ram Subramanian:
You mentioned step five is to do with the recognition of revenue and how does that work?

David Hardidge:
Well, this is sort of once you've worked out your promise, you've got to mark-up wind, do I recognise the revenue from performing that promise? So that's step five. So the main question with this one is, do you recognise the revenue at a pointing time or at a later point in time or over time? And if you're recognising revenue over time, you need to be able to look at where you are in that contract, sort of like a percentage of completion approach.

Ram Subramanian:
And can we now go back to step one, which we haven't covered yet?

David Hardidge:
Yes. And this is the one to work out well, do you have the contract and are you in the standard? So IFRS 15 is all about revenue from contracts with customers and also deals with contract modifications. So in contract modifications the main issue for that is it a revision or modification of the initial contract or do you account for the modification as a separate contract and for that you might get different answers.

Ram Subramanian:
You mentioned earlier transition and it being circular, would you please expand on this?

David Hardidge:
Yes. So there's a couple of transition choices that I've mentioned. And the one that you choose may be affected by how you're actually affected by the standards. So we've talked about in concepts like performance obligations, the revenue constraint, allocating the transaction price, contract modifications. So if you're affected by these, it could be difficult to go back in the past and rework those numbers. So, that might affect your choice of, let's say, moving to the modified version and starting in 2018 or your inventors, they might want the two years under the new standard. And that would mean that you'd have to go back one more year and that gives you less time to rework your numbers.

Ram Subramanian:
You mentioned additional guidance and what are some of other areas covered by the standard?

David Hardidge:
Yes. So there's lots of application guidance and examples for the five steps that I mentioned but the standard also covers a number of all the areas like you mentioned. So some examples include, network towards them, licences, principal versus agent, which is also called gross versus net, rights to return. So someone can return the goods. You have to wait until the expiring period for that return is completed. Warranties, payments to customers that are also called rebates, material rights and options. So there's data about more than this five steps and people need to look at these other issues as well.

Ram Subramanian:
The ISP established a transition resource group to help with the transition to the new standard, would you explain a bit more about the transition resource groups, purpose and work?

David Hardidge:
Yes, it was set up by the ISP in the U.S. FASB. As we talked about before was a joint standard, so they got together to go to the experts in revenue recognition to help with transition issues. So the public providers who started early were able to submit issues that they had difficulty in applying the standard and this group of experts would have a talk about it. And then we would say, "Yes, we think that there is a problem or that you could actually work it out from the standard. And these are the way that we thought about how you'd work it out." There were some problematic areas and they've actually made some amendments to the standards. So the TRG as we call it another acronym, they looked at about 50 issues and you could probably implement the standards without looking at what they did. Although personally, I found it quite useful in some of the practical issues.

Ram Subramanian:
Earlier you mentioned some subsequent amendments to the standard, what are these?

David Hardidge:
Well, in the ISP world they're called clarifications. And that's really to highlight that there's been no substantial change to the standard. And these amendments or clarification's have a reason because of problems that people had in applying the standards. One of the areas is performance obligations and looking at what is distinct and what is distinct in the context of the contract. An example of that was a computer printer and toner cartridges. You can't use the printer without the toner cartridges. So did you have to account for them combined or could you account for them separately? So they've issued some guidance for that. Other examples that they've clarified are licences, principal versus agency. The good news is that these clarification's had been made affective from one of the standard stuffs so we don't have to deal with one standard now and then the clarification's later. We just deal with them all at the same time, when we apply the standard.

Ram Subramanian:
Turning to disclosures, how have the disclosure requirements being changed in IFRS 15?

David Hardidge:
A big improvement. So basically the disclosures you see many companies accounts for are pretty pathetic, but they really don't tell you very much at all and ethics about the Australian company regulator, some securities investments commission have been accounting a number of companies on this but generally they're not fairly good. So the standard has a disclosure objective and has some items that they suggest that you disclose. But you need to look at it in the context of that disclosure objective and the concepts of the bias based disclosure initiative, which is also called streamlining and disclosure effectiveness. But essentially companies will be disclosing more. They'll be disclosing more relevant information, such as key judgments and key estimates.

Ram Subramanian:
And do you have any final takeaway points for listeners who are likely to be affected by IFRS 15?

David Hardidge:
I think a lot of companies that are going to end up where they are now, but then a lot of companies. So a lot of the issues that companies have come across... So if you've got a problem with the current standard and uncertain if to have a plot, that's got apply under the new standard, what you might find is how you resolve that issue is going to be different. And revenue is key. And essentially almost all companies have revenue. So it's a key standard that accountants are going to have to understand. I don't think they're going to be able to sort of brush it to the side and just have an overview understanding. I think they're going to have to look at the standards in depth and they've got to sort of also keep an eye on when the standard starts. Like 2018, 2017 recalculated the numbers, well, that's our life. And the standards thing after two years, we've already used that more than half the time that we had available to get ready to apply the new standard.

Ram Subramanian:
And today David has been giving us a good overview of IFRS 15 revenue from contracts with customers. Thank you very much David for that very good overview.

David Hardidge:
Thanks Ram. It's a pleasure to talk to you.

Ram Subramanian:
And for listeners who found this podcast useful, we've also recorded two other podcasts with David, one covering IFRS 9, financial instruments and another that covers IFRS 16, leases.

Outro:
Thank you for listening to this episode of the CPA Australia Podcast.