Revenue Recognition - A European Contribution - Dr. Mareike Kühne, DRSC Leipzig, 17. Oktober 2007-1- Leipzig, 17. Oktober 2007 - Why does EFRAG deal with Revenue Recognition issues? - Pro-active Accounting Activities in Europe - PAAinE: Revenue Recognition - The GASB view on Revenue Recognition - What s next? - 2- Leipzig, 17. Oktober 2007
Why does EFRAG deal with Revenue Recognition issues? - The IASB/FASB Project - - 3- Leipzig, 17. Oktober 2007 Background Joint Project IASB and FASB (since 2002) Purpose: IASB: (Conceptual) Revision of IAS 18 & IAS 11 FASB: Development of one single Statement on Revenue Recognition together: Convergence! Output: Discussion Paper end in 2008 (?) - 4- Leipzig, 17. Oktober 2007
IFRSs on Revenue Recognition: IAS 18 Revenue IAS 11 Construction Contracts IAS 17 Leases IAS 39 Financial Instruments: Recognition and Measurement IAS 41 Agriculture + recourse to US GAAP - 5- Leipzig, 17. Oktober 2007 IAS 18 Revenue Underlying Principle Definition Gross inflow of economic benefits during the period arising in the course of the ordinary activities (IAS 18.7) Recognition - Probable that economic benefits will flow to the entity - Amount of revenue can be measured reliably Measurement Fair value of the consideration received or receivable (IAS 18.9) - 6- Leipzig, 17. Oktober 2007
IAS 18 Revenue Underlying Principles (cont.) Critical Events for the Recognition of Revenue Sale of goods - Transfer of the significant risks and rewards to the buyer - Entity retains neither continuing managerial involvement nor effective control - Costs incurred can be measured reliably Rendering of services - Stage of completion can be measured reliably - Costs incurred can be measured reliably - 7- Leipzig, 17. Oktober 2007 Problems arising - From a conceptual perspective - Recourse to the realization principle in IAS 18 is said to be contradictory to the definition of revenues in the framework (income = measurable changes in assets and liabilities) - Application of IAS 18 can lead to recognition of deferred assets and deferred liabilities (which do not meet the definition of assets and liabilities) - From a practical perspective - Content of the realization principle often unclear (as evidenced by the need for extensive additional explanations in the appendix of IAS 18) - No sufficient guidance for accounting for multiple element arrangements - 8- Leipzig, 17. Oktober 2007
IASB/FASB Project Revenue Recognition - IASB addresses the issue of revenue recognition starting from the Framework definition of income - That is: Income is measurable changes in assets and liabilities (= Assets and Liabilities Approach) - This approach shall not be overridden by notions of realization and completion of the earnings process. - 9- Leipzig, 17. Oktober 2007 Revenue (under IASB Approach): Revenue shall reflect measurable changes in net assets under contracts with customers = Contractual Asset./. Contractual Liability = Expected consideration./. Performance obligation Resulting questions: - Does signing of a contract lead to (measurable) changes in net assets? - Recognition of selling revenue? - Measurement of performance obligations? - 10- Leipzig, 17. Oktober 2007
Approach discussed by IASB until June 2005 Revenue = Expected Consideration./. Performance Obligation Measurement of performance obligation: legal layoff amount (= fair value) Re-measurement: yes! Recognition: - Selling revenue at contract inception - Changes of value (re-measurement) - At extinguishment of performance obligation Information given includes: - Profitability of separate parts of a contract - Efficiency of entity in comparison with market - 11- Leipzig, 17. Oktober 2007 Approach discussed by IASB until June 2005 (cont.) Problems: - Identification of project segments - Fair value measurement of performance obligations Does this approach lead to - Recognition of executory contracts? - Revenue recognition at contract inception? - Fair value measurement of performance obligations? - Re-measurement of performance obligations? YES! But: IASB/FASB have decided against such an approach. - 12- Leipzig, 17. Oktober 2007
IASB has modified its revolutionary approach! Revenue = Expected Consideration./. Performance Obligation Measurement of performance obligation: customer consideration amount = price at which good/service can be sold to customer (fair value, if existent) Re-measurement: no Recognition: -Noselling revenue at contract inception -No changes of value (re-measurement) - At extinguishment of performance obligations - 13- Leipzig, 17. Oktober 2007 Modified IASB Approach Information given include: - Profitability of contract Problems: - Identification of project segments - When is performance obligation extinguished? Does this approach lead to - Recognition of executory contracts? - Revenue recognition at contract inception? - Fair value measurement of performance obligations? - Re-measurement of performance obligations? No! (Yes, if observable market value of performance obligation exists) - 14- Leipzig, 17. Oktober 2007
Current Discussion Two sub-groups: Legal layoff amount Customer consideration amount Meetings outside the boardroom! October 2007: Topic expected to be on the agenda of the IASB meeting - 15- Leipzig, 17. Oktober 2007 Pro-active Accounting Activities in Europe - 16- Leipzig, 17. Oktober 2007
PAAinE Proactive Accounting Activities in Europe (1) = Initiative of EFRAG and the 17 National Standard Setters Why? - Pooling some of their resources and working more closely together - Improving the input of Europe to the global accounting debate - Gaining greater influence on the global standard-setting process - Focussing on long-term pro-active work - Stimulating debate on important items on the IASBs agenda at an early stage in the standard-setting process - 17- Leipzig, 17. Oktober 2007 PAAinE Proactive Accounting Activities in Europe (2) Objectives of PAAinE Discussion Papers: To stimulate, carry out and manage pro-active development activities To encourage the development of common views To ensure that Europe gives consistent messages to the IASB Issued so far: Conceptual Framework, Equity/Liability, Pensions, Performance Reporting and Revenue Recognition - 18- Leipzig, 17. Oktober 2007
PAAinE: Revenue Recognition - 19- Leipzig, 17. Oktober 2007 Background - Established in June 2004 - Joint working group of EFRAG and DRSC - 11 members (academia, standard settíng, auditing, preparer) - Rejection of revolutionary IASB Assets and Liabilities Approach - How to solve the problems addressed by IASB without completely changing IAS 18 but still employing an assets and liabilities approach? - First draft of discussion paper rejected by TEG, GASB and the majority of the working group - Set up of a task force to re-draft the original paper - TEG and GASB have decided to focus on assets/liabilities approaches - Discussion paper in 2006-20- Leipzig, 17. Oktober 2007
REVENUE is an important number! but there are significant weaknesses in existing standards No sufficient guidance on Multiple Element Arrangements Conceptual inconsistencies: two different approaches used IAS 18 sale of goods transfers of risks and rewards IAS 11 construction contracts, services as work progresses (percentage of completion) - 21- Leipzig, 17. Oktober 2007 Consider the following cases: A real estate company sells Case A a building, which it owns. Transfer of title will be in 15 month time. = sale of goods: Revenue is recognized 15 month from now Case B a building, that it has to build. Contract says it has to be ready 15 month from now. Construction work starts right away. = long-term construction contract: Revenue is recognized as construction progresses - 22- Leipzig, 17. Oktober 2007
Form over substance?? NEED FOR A COMMON SET OF PRINCIPLES THAT APPLY TO ALL TRANSACTIONS - 23- Leipzig, 17. Oktober 2007 IASB/FASB project Revenue Recognition - IASB/FASB address the issue of revenue recognition starting from the Framework definition of income - That is: Income is measurable changes in assets and liabilities Assets/Liabilities Approach - 24- Leipzig, 17. Oktober 2007
The PAAinE Paper on Revenue Recognition: - The GASB view - - 25- Leipzig, 17. Oktober 2007 Key questions to be answered - What shall revenue reflect? - Performance towards fulfillment (as in IAS 11)? - Fulfillment (meaning completion, as in IAS 18)? - Existence of a claim against the customer as a result of past action? - One approach for all types of transactions? - Choice of approaches depending on context? - 26- Leipzig, 17. Oktober 2007
Assets/Liabilities-Approach = revenue is measurable changes in assets and liabilities Critical events approach (similar to IAS 18) revenue = arises when the supplier fulfils the performance obligations arising under a contract Continuous approach (similar to IAS 11) revenue = measured progress towards contract completion (percentage of completion) Approach I A Approach I B Approach I C Approach II fulfils all performance obligations fulfils all performance obligations under a part-contract (part-contract as defined by contract) substantively fulfils performance obligations of part-contract (part-contract as defined by economic measures) recognised continuously over the course of contract, as the contract progresses and the entity perfoms - 27- Leipzig, 17. Oktober 2007 When does revenue arise? Sale of goods (Supermarket, ) Services (cleaning, painting, ) Manufacturing (chair, table, ) Long term construction work (bridge, ) Critical events approach at point of sale when contractual obligation is fulfilled as manufacturing is completed as construction is completed Continuous approach at point of sale as service is performed as manufacturing progresses as construction progresses - 28- Leipzig, 17. Oktober 2007
Quest for one single approach to be applied to all transactions! Sale of goods (Supermarket, ) Services (cleaning, painting, ) Manufacturing (chair, table, ) Long term construction work (bridge, ) Critical events approach at point of sale when contractual obligation is fulfilled as manufacturing is completed as construction is completed Continuous approach at point of sale as service is performed as manufacturing progresses as construction progresses No PoC for construction contracts and services! No changes for simple sales transactions and PoC remains in place! - 29- Leipzig, 17. Oktober 2007 If one approach is to be chosen: Continuous Approach! Revenue should be recognised when activity undertaken pursuant to a contract with a customer gives rise to an asset that reflects performance towards completion. No changes in accounting for over the counter sales transactions Revenue follows performance of the entity, that is PoC for services and construction contracts Focus on economic substance (and not on legal form) In line with notion of assets/liabilities approach - 30- Leipzig, 17. Oktober 2007
Why is the continuous approach an assets/liabilities approach? Revenue = measurable changes in assets and liabilities FW.49(a) asset = resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity Assets: raw material, inventory, customer lists, newspaper mastheads, non-competition agreements, not only receivables! If the entity expects to fulfil the contract and it expects the customer to pay, performance of the entity results in a resource controlled by it as a result of past events and from which future economic benefits are expected to flow to the entity. - 31- Leipzig, 17. Oktober 2007 How to account for Multiple Element Arrangements? There are basically two alternatives: No disaggregation of the contract Disaggregation of the contract - Recognition of revenue according to costs incurred - No disaggregation necessary - Continuous approach is applied to the elements of a transaction - Criteria for disaggregation needed - Disaggregation should follow economic substance - 32- Leipzig, 17. Oktober 2007
How reliable is the resulting revenue number? Starting point for application of the continuous approach: There must be a binding contract with a customer. The approach is only applicable, if entity has reliable projections regarding contract fulfillment, if entity expects to fulfil the contract and if entity expects customer to pay. - 33- Leipzig, 17. Oktober 2007 What s next? - 34- Leipzig, 17. Oktober 2007
Invitation to Comment Comment deadline: 10 December 2007 Round Table Discussions will be held 24 October 2007 in Berlin - 35- Leipzig, 17. Oktober 2007 Zimmerstr. 30 10969 Berlin Tel. 030 20 64 12 0 Fax 030 20 64 12 15 www.drsc.de info@drsc.de - 36- Leipzig, 18. Oktober 2007