For companies reporting under the International Financial Reporting Standards (IFRS) there could be a significant impact on their financial standards following the introduction of the IFRS15: Revenue from Contracts with Customers which is mandatory from 1 January 2019.
What is changing?
The existing standard (IAS 18: Revenue) bases the recognition of revenue on the transfer of risks and rewards to the customer. The new standards place more focus on the transfer of control to the customer.
The revised standards centre on a five step approach:
- Identifying the contract
- Identifying performance obligations
- Determining the transaction price
- Allocating the transaction price to the performance obligations; and
- Recognising revenue when a performance obligation is satisfied.
This means a transaction need to be considered on a standalone basis as individual contracts with customers may involve additional, separately identifiable transactions known as ‘performance obligations’. Contracts can be written, oral or implied by an entity’s customary business practices.
Prices for contracts are based on the amount that a company is expected to be received and is allocated to each performance obligation based on the stand-alone price for each component. Revenue is then recognised as and when each performance obligation is fulfilled.
There is a practical expedient which says an entity can apply the standard to a portfolio of contracts with similar characteristics if the entity expects it would not differ materially from applying the standard to individual contracts.
What will be the key considerations?
As these represent a right to receive goods, a liability for the prepaid amount is recognised. However, gift cards are not always redeemed in full which results in ‘breakage’ which is recognised as revenue either in proportion to the pattern of rights exercised by the customer or when redemption of the gift is remote if not redeemed.
Because of the emphasis on the principle of control under these standard, shipping terms may need to be considered when determining that point in which control passes to the customer. If control is deemed to pass at shipment, but where it is common practice to compensate the customer for lost or damaged deliveries, then part of the transaction price may have to be allocated to the shipping risk element of the transaction.
The revised standards makes a distinction between warranties that provide assurance that a product meets agreed-upon specifications and a warranty that provides an additional service. The latter may be treated as a performance obligation and may require a transaction price to be allocated to these services.
Return and refund rights
Where companies have return policies, expected returns need to be taken into account when estimating the transaction price. These should be estimated using the ‘probability-weighted expected value’ or ‘most likely amount’. A refund liability and a return asset should then be recognised and revisited at each year end to account for any changes in expected returns.
Payments to customers
Many retailers make payments to customers in the form of slotting fees, rebates or co-operative advertising agreements. Consideration therefore needs to be given as to whether the payment is a payment for a separable product, service or a reduction in transaction price or a combination of all.
Time value of money
There is more emphasis on the time value of money. Where there are financing arrangements such as ‘buy now, pay later’ the financing element will need to be treated separately from revenue if the element is significant and due in more than 1 year.
Customer loyalty programmes
The treatment of customer loyalty programmes is similar to current standards, except a proportion of the transaction price is allocated to the points awarded based on the ‘stand-alone’ selling price.
What challenges does this bring?
For some retailers, the criteria may require a significant amount of estimates and judgements which will need to be applied consistently across transactions such as:
– Determining an appropriate discount rate to be applied to financing arrangements;
– Variable elements of a transaction price must be estimated using either a probability-weighted expected value or most likely amount used both of which require judgement;
– Stand-alone selling prices must be determined using observable information, or estimates based on information reasonably available if observable information is not available.