Revenue Recognition – Constraining the cumulative amount of revenue recognised
The IASB and FASB (known hereafter as “the Boards”) 2011 exposure draft Revenue from Contracts with Customers (“the 2011 ED”) proposed a constraint on the cumulative amount of revenue recognised that would apply if the amount of consideration to which an entity expects to be entitled is variable (“the constraint”). The constraint was proposed in paragraphs 81 – 85 of the 2011 ED.
At the September 2012 meeting, the Boards tentatively decided to clarify the meaning of ‘variable consideration’ to indicate that the constraint should apply to a fixed price contract in which there is uncertainty about whether the entity would be entitled to that consideration after satisfying the related performance obligation. There were certain other areas that the Boards asked the staff to perform further analysis on, that were discussed as part of the November joint Board meeting:
- Constraining the cumulative amount of revenue recognised – application of the requirements
- Constraining the cumulative amount of revenue recognised – placement of constraint (step 3 v step 5)
Note that the November joint FASB and IASB meeting did not address the following:
- Scope and application of the constraint in paragraph 85 of the 2011 ED, which constrained the amount of revenue recognised when an entity licences intellectual property to a customer and the customer promises to pay an additional amount of consideration that varies on the basis of the customer’s subsequent sales of a good or service (for example, a sales-based royalty). The staff plan to bring these issues back to the Boards at a future meeting after tentative decisions are reached on the general constraint topics outlined above;
- specific disclosure requirements that might be useful to include related to the constraint. This will be addressed as part of the Boards’ discussions on disclosure requirements; and
- application to some types of transactions common in the asset manager industry. This issue will be incorporated into one of the broader topics that we are planning on bringing back to the Boards at a future meeting.
Constraining the cumulative amount of revenue recognised – application of the requirements
Possible improvements to the constraint on the cumulative amount of revenue to recognise were discussed previously in the September joint IASB and FASB Board meeting. At that Board meeting it was highlighted that there were concerns from some respondents and users that the guidance in the 2011 ED would allow entities to recognise as revenue variable consideration which would then be subject to reversal in a future period. These users highlighted that they would like a high degree of confidence by the entity before the entity recognises any portion of revenue related to variable consideration. Some regulators were also of the view that the constraint would not be applied consistently due to paragraph 82 of the ED providing some discretionary measures and requiring management judgement.
There were concerns raised by constituents (preparers representing industries engaged in long-term production and construction contracts) in the September staff analysis who commented that the staff’s recommended objective for the constraint appeared to change the application of the constraint so that an entity would need to have predictive experience for the entire transaction price rather than the cumulative amount of revenue recognised (they noted that the proposals seemed to over-tighten the constraint and would prohibit them from recognising revenue when this would provide useful information). They stated that this would make it more difficult to recognise revenue, particularly in some long-term service contracts and construction contracts where there is often uncertainty about the ultimate consideration to which the entity be entitled (i.e. the total transaction price) but less so on the cumulative revenue recognised at any point in time over the contract life. Preparers wanted to ensure that the amount of revenue recognised, especially in the construction industry, best depicted the performance of the entity.
It was noted that preparers had interpreted the determinative approach in the September staff analysis would preclude revenue from being recognised for long-term contracts because there is always a reasonable possibility that the transaction price could be significantly different from the entity’s estimate. It was noted that the preparers had a different understanding of the term “reasonable possibility” than the staff’s intended meaning. (As additional background the staff presented three options in the September joint Board meeting to address the above concerns of constituents and preparers on the application of the constraint. One of these approaches was to amend the approach in paragraph 82 of the 2011 ED to provide an objective and determinative methodology to ensure that revenue is not recognised when there is a reasonable possibility of an outcome that would result in a significantly different amount of consideration from that determined as the transaction price in step 3 of the revenue recognition model).
Due to the continued concerns of the constituents of the application of the constraint, the staff considered in the November joint FASB and IASB Board meeting the following issues:
- whether the revenue standard should specify an objective for the constraint; and
- whether the revenue standard should specify indicators or criteria to determine if revenue should be constrained in accordance with the objective.
Clarifying the Objective
In determining the transaction price, the 2011 ED proposes that an entity should use an estimation method that best predicts the consideration to which the entity will be entitled in exchange for its goods or services. Depending on the circumstances, that method would be either an expected value or the most likely outcome. The staff were of the opinion that the constraint was an extension of the measurement objective for determining the transaction price. They were of the view that the objective of the constraint should be to ensure that when a performance obligation has been satisfied (or partially satisfied), but there is a reasonable expectation that the amount of revenue that the entity is ultimately entitled to for that satisfied performance obligation could be significantly less than the amount of the transaction price allocated to that performance obligation, an entity should recognise revenue only up to the amount that the entity is confident will not be subject to significant revenue reversals. The staff proposed that the Boards should agree to allow specific mention of the objective of the constraint in the revenue standard and should embed the objective within the proposed criteria in paragraph 81 of the 2011 ED.
The staff noted that the revenue standard could be amended (paragraph 81 of the 2011 ED) to state that if the amount of consideration to which an entity is entitled to is variable, an entity would recognise an amount of variable consideration allocated to a satisfied performance obligation to the extent that both of the following are met:
- the entity has relevant experience with similar types of performance obligations (or has other evidence, such as access to the experience of other entities) to be able to estimate the cumulative amount of revenue for a satisfied performance obligation; and
- based on its experience and/or evidence, the entity does not reasonably expect a significant reversal (i.e. downward adjustment) in the cumulative amount of revenue recognised for a satisfied (or partially satisfied) performance obligation.
It was noted by the staff that clarifying the objective of the constraint this way would help address requests that the constraint be made more robust. The staff also noted that clarification would also try to provide clarity on what the wording in the 2011 ED was trying to say – i.e. whether or not the entity was able to make a good estimate or was the wording behind the constraint trying to say that the entity needs to be able to make a good estimate and the entity also needs to see whether or not they don’t reasonably expect a significant revenue reversal on that estimate. They noted that by providing a clear objective for an entity to follow when the application of judgement is required it will allow consistent accounting to be followed. The staff also highlighted that this increase in the level of confidence that an entity would need to achieve before recognising amounts of variable consideration as revenue may be seen as a current change in practice for those entities that apply IAS 11 or ASC 605-35. However it was also noted that this classification would not automatically result in those entities recognising revenue at a later point in time than under the current requirements as the existence and extent of any change to the amount and timing of revenue recognised would depend on the specific facts and circumstances.
In the November joint Board meeting, the staff also asked that if the Boards did not agree to the clarification of the objective of the constraint then would they agree to retain the objective in the 2011 ED (paragraph 81) but make the phrase “the entity does not reasonably expect a significant revenue reversal (i.e. a downward adjustment) in the cumulative amount of revenue recognised for a satisfied (or partially satisfied) performance obligation” into an indicator.
Some Board members had questioned the use of the word “confidence” and the staff noted that the use of the word “confident” in the final guidance may not be required. The staff explained that the use of the word confident was to illustrate that the entity would continue to revise down their estimates of revenue until they were reasonable confident that there would not be a significant revenue reversal.
One IASB Board member agreed for the need for the clarification but questioned whether the objective was written in the context of the guidance in step 5 or step 3 (see later Board agenda discussion). The staff clarified that the objective was written as if the constraint remained in step 5.
Another IASB member questioned what the staff were trying to achieve with the clarification. Some constituents argued that the original 2011 ED wording was too restrictive and some wanted a tightening of the application of the constraint. However the Board member appeared confused as to what position the clarification would get to – whether the staff were proposing greater judgement or were trying to be more prescriptive in the application of the clarification. The staff responded that what they were trying to achieve with the clarification is that each entity subjects itself to an assessment as to the exposure to a significant revenue reversal and the more exposure there is the less “comfortable” an entity will be in recognising the revenue.
Another IASB Board member was happy to support the proposals but noted that he would like to see greater guidance when the constraint was applied to partially completed performance obligation (for example on civil engineering or aerospace projects). He noted that at the start of a large project the level of confidence will be lower and will increase when the entity is nearer completion and the closer the entity gets to completing the performance obligation the more likely the entity is to have a reasonable level of assurance. The Board member noted that it may be the case that the level of assurance is revisited throughout the life of the project (for that particular performance obligation) and additional guidance should be included to this effect on partially completed performance obligations.
One other IASB Board member stated that he preferred the paragraph 81 as it was currently in the 2011 ED but that the most fundamental paragraph of the standard to keep was paragraph 49 of the 2011 ED which says that if the amount of the consideration is variable, the cumulative amount that the entity recognises shall not exceed the amount to which the entity is reasonably assured to be entitled. This Board member noted that if this was left within the standard then the guidance contained within paragraph 81 becomes almost implementation guidance for applying this principle.
Notwithstanding these concerns of some of the IASB Board members, the vote held identified that all IASB Board members tentatively supported the staff’s proposal.
The FASB members then provided comments on the staff’s proposal.
One FASB member generally agreed with the staff’s proposal and liked the uncertainty concept that was being proposed – i.e. the more uncertainty there is, the less likely you will be able to recognise revenue for variable payments and noted that he thought that this was similar to the concept in the 2011 ED. He voiced concerns about the term “reasonable expectation” being proposed by the staff and at what level that an entity would need to have a “reasonable expectation”. This member also voiced concerns regarding the use of terminology and that this should be consistent throughout the standard (specifically mentioned reasonably assured v reasonable expectation). He noted that maybe the staff could use existing IFRS terminology.
The concern regarding the use of the term “reasonable expectation” was also shared by another FASB member and questioned how this would be interpreted in practice. This member shared the view of an IASB Board member who stated that for long term contracts the current direction of the standard may mean that variable consideration is recognised immediately due to the current criteria in paragraph 81 – he noted that he would like to see a higher hurdle to apply the constraint. Another FASB member noted that he thought the staff meant that there is a reasonable chance that the revenue would get reversed and this threshold would be below 50%. Another FASB member interpreted this to mean that there is more than a remote chance that there could be a significant reversal – if this is the case then variable consideration cannot be recognised immediately.
The IASB staff commented that if “more than remote” were used then this would be considered an even greater tightening of revenue recognition policies for certain industries such as those involved in long-term construction contracts.
The FASB Board tentatively agreed that if there was a more than remote expectation that there could be a significant reversal then the constraint applies – hence the threshold for applying the constraint would be low. The FASB Board members also tentatively agreed with the staff’s proposal that the objective of constraint should be clarified. The FASB Board members also noted that the words of the clarification will need to be potentially different in the IASB and FASB environments as the current words “reasonable expectation” do not have a meaning in the US environment.
No decisions were made regarding the best way to articulate reasonable expectation at this meeting. It was noted that the staffs could respond at a later date with further draft words.
Applying the constraint – indicators or criteria
Having clarified the objective, the staff proposed two options for the Boards’ consideration for how an entity could meet the objective:
- Option 1 – Indicator approach: Supplement the improved objective outlined above with the indicators that were proposed in paragraph 82 of the 2011 ED.
- Option 2 – Criteria approach: Replace the indicators in paragraph 82 of the 2011 ED with a determinative methodology that would require an entity to assign probabilities to alternative possible outcomes or provide something of a similar nature.
Option 1 - Indicator approach
This would provide indicators an entity should consider when assessing if the constraint should apply. The indicators that an entity should consider would be broadly the same as the indicators proposed in the 2011 ED, which were:
- The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors include volatility in a market, the judgement of third parties, weather conditions and a high risk of obsolescence of the promised good or service.
- The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
- The entity’s experience (or other evidence) with similar types of performance obligations is limited.
- The contract has a large number and broad range of possible consideration amounts.
It was highlighted that this approach is principles based with a clear objective and supporting indicators and there was no objection from the respondents to the 2011 ED on these indicators. However, arguments against were that this may not address the concerns (noted above) regarding the robustness of the application of the constraint.
Option 2 - Criteria approach
This approach would prescribe how an entity determines if the objective of the constraint is met. Without prescribing the method that an entity should follow, an entity might apply different methods to determine if there was a reasonable expectation that the revenue recognised might be subject to significant reversals in the future. Option 2 attempts to reduce the possibility that different entities might reach different conclusions as to whether the constraint should apply by standardizing the way in which an entity would make that determination.
The indicators that were proposed in paragraph 82 of the 2011 ED would be replaced with a requirement (quantitative assessment) that an entity should be able to demonstrate the following in complying with the objective:
- it has experience (or similar information) that enables it to make an estimate, based on relevant information, of the amount to which it is entitled for the satisfied performance obligation;
- it has considered the probabilities of the other reasonably possible outcomes based on its relevant experience; and
- it has assessed the significance of the possible revenue reversal if one of those reasonably possible outcomes occurred.
The staff noted that this approach would address the robustness issues with the application of the constraint and would allow consistent application. The staff also noted that this approach may be more complex and costly to apply.
It was the staff’s view that option 1 should be agreed by the Boards for an entity to use to assess if the constraint should apply as the incremental benefit of prescribing a standardised approach would be outweighed by the cost of application each time. However, they did not that both methods would require a level of management judgement in application.
One IASB member noted that a criteria approach would bring discipline to the process and the indicator approach would lead to great variability in application. He was in support of the criteria approach.
A FASB Board member noted that the indicator approach did not address variable consideration that might be caused by the entity’s own actions (granting of discounts, granting payment terms, for instance) and highlighted that the indicators should address this – she proposed amending the third indicator to say “The entity’s own experience or practices….”. All FASB Board members tentatively agreed with this proposal to amend the indicator.
Another FASB Board member highlighted that a change was required to the first indicator to say “…the judgement and actions of third parties”. The staff agreed to make this modification.
Another FASB member asked what would happen to the words in paragraph 83 of the 2011 ED if the indicator approach was adopted (with the agreed amendments as noted above). This member specifically highlighted the second sentence of paragraph 83 which did not now fit in with the objective for the constraint tentatively agreed by the Boards. The staff noted that the words in paragraph 83 were probably not required.
Another IASB member noted that the indicator approach provided more robust challenge as to whether the constraint applies and would be a broader assessment.
A vote was held and the majority (14) (only one member tentatively agreed with option 2) of IASB Board members tentatively agreed with the staff’s proposals.
The FASB Board members voted and all of the FASB Board members tentatively agreed to the staff’s proposal for the indicator approach option 1.
Constraining the cumulative amount of revenue recognised – placement of constraint (step 3 v step 5)
The 2011 ED proposed that the constraint apply at step 5 of the revenue model which was a change from the proposal in the 2010 ED that proposed that the constraint apply at step 3 of the model.
The Boards decided to move the constraint to Step 5 in the 2011 ED so that it applies to constrain the cumulative amount of revenue recognised because:
- constraining the transaction price at Step 3 would result in some performance obligations being incorrectly identified as onerous. This is because, in determining whether a performance obligation is onerous, amounts of variable consideration might be excluded from the amount of consideration that is compared with the cost of fulfilling a performance obligation; and
- there were unintended revenue recognition patterns for some types of service arrangements where the consideration is uncertain at contract inception, but that uncertainty progressively resolves over the service period. For instance, this is a common occurrence in contracts in the asset management and hotel management industries.
At the November joint FASB and IASB Board meeting, the staff noted that feedback on the 2011 ED raised issues regarding the location of the constraint at step 5. The staff noted that some respondents highlighted that there was complexity of assessing the constraint at step 5. The respondents commented that the complexity arises because, in principle, an entity would be required to estimate variable consideration in order to determine the transaction price (step 3), only for the entity to be constrained from recognising as revenue those amounts of variable consideration when the entity satisfies the related performance obligation. The staff noted that these respondents thought that the constraint should be assessed at step 3.
The staff also noted that feedback on the 2011 ED highlighted that the constraint could produce patterns of revenue recognition that did not faithfully depict period to period performance under the contract if the consideration promised by a customer includes both fixed and variable amounts. It was noted that this was the case as the proposals in the 2011 ED could result in revenue hitting a ceiling (due to the constraint) so that even though the entity continues to perform no more revenue would be recognised until the uncertainty is resolved.
In light of the above issues raised by respondents, the staff presented to the Boards, at the November joint FASB and IASB meeting, their paper and justification on which step they considered the constraint should be placed.
In forming their conclusion the staff considered whether the constraint was a measurement or recognition issue and also whether the location of the constraint could affect the timing and amount of revenue recognition. The staff considered that the constraint is a concept that includes both measurement (where it was argued would locate the constraint at step 3) and recognition (where it was argued would locate the constraint at step 5) considerations. Hence they did not feel that the determination of whether or not the constraint was a measurement or recognition issue was a critical step in deciding at which step to locate the constraint.
The staff considered that the objective of the constraint (as noted above) could be achieved by placing the constraint in either step 3 (in this case the transaction price would be limited if the entity reasonably expects a significant reduction of the estimated transaction price) or step 5 (in this case the cumulative amount of revenue recognised could be limited if the entity reasonably expects a significant reversal of the cumulative revenue that would be recognised). Hence it was considered that there was no difference in considering the constraint at either the transaction or cumulative amount of revenue stage.
The staff highlighted other considerations that would influence where the constraint was placed. One such issue highlighted in the 2010 ED (where the constraint was at step 3) was around unintended revenue recognition patterns for some types of service arrangements where the consideration is uncertain at contract inception but that uncertainty progressively resolves over the service period. The staff highlighted to the Boards that they felt that the basis of allocation in paragraph 76 of the 2011 ED may solve this issue identified in the 2010 ED and hence this would not be a barrier to proposing for the constraint to be at step 3.
The staff also noted that the issue identified by constituents that the constraint could produce patterns of revenue recognition that did not faithfully depict period to period performance under the contract if the consideration promised by a customer includes both fixed and variable amounts could be solved even if the constraint is located at step 5. The staff highlighted that in these situations, at step 3 of the model the transaction price would be split between a fixed “minimum” portion and a “variable” portion for the purposes of applying the constraint at step 5. The staff noted that the revenue standard would need to clarify that if the fixed portion of the transaction changes, the entity would allocate that change entirely to those distinct goods or services that have transferred to the customer if it is clear that, in accordance with the allocation principle in paragraph 76 of the 2011 ED, the consideration relates to those distinct goods or services.
The staff concluded that they thought the constraint would serve its purpose whether it is located in step 3 or step 5. However, the staff did propose that the location of the constraint be at step 3 although accepted that moving the constraint at this stage of the revenue recognition project may have unintended consequences. It was noted that regardless of where the constraint was located they did not feel that it would alter the amount of revenue recognised when a performance obligation is satisfied. The staff noted that the Boards should consider placing the constraint where it will be most easily understood by those applying the revenue standard and based upon the comments from the constituents, considered that this be best at step 3.
One FASB member believed that if the objective was to make the constraint as transparent and understandable as possible then step 3 would be best. However this member was concerned about any unintended consequences and highlighted to the staff that he would like to be made aware of any should they arise in the finalisation of the decision.
Another FASB member highlighted that if step 3 was chosen then the entity would always have to allocate variable consideration to performance obligations. He noted that it may be difficult to allocate variable consideration to performance obligations where variable consideration was needed to be allocated to more than one performance obligation.
One IASB member noted that the staff should be allowed to follow step 3. He noted that if the staff encounter any issues with moving the constraint back to step 3 then they would be able to come back to the Board with sweep issues for consideration.
The FASB members all tentatively agreed to follow this process – i.e. tentatively agreed step 3 for now and tentatively agreed that if the staff encountered issues they would revert back to step 5.
The majority of IASB members tentatively agreed to follow step 3 unless there were unintended consequences identified by the staff, in which case step 5 would be followed. Only one of the IASB members tentatively proposed the staff to follow step 5.
Revenue Recognition – Collectability
At the September 2012 Board meeting, the Boards did not reach a tentative decision on how collectability should be addressed in the revenue standard. It was noted that many capital market participants (including users, auditors and regulators) place a lot of attention on assessing the quality of the revenue recognised. As one measure of assessing the quality of revenue is the ultimate collectability of the promised consideration in exchange for the goods or services that have been transferred to the customer, it was necessary for the revenue recognition standard to address this issue and importantly to ensure that the collectability proposal will be able to be universally applied.
The core principle of the 2011 ED is that an entity should recognise revenue to depict the transfer of goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
At the November 2012 joint FASB and IASB meeting, the staff considered three alternatives for the Boards deliberation as to how collectability should be addressed:
- retain (subject to some refinements) the collectability requirements that were proposed in the 2011 Exposure Draft Revenue from Contracts with Customers (‘2011 ED’);
- revise the 2011 ED collectability proposals by modifying the proposed presentation of the impairment loss line, either for contracts with customers without a significant financing component or for all contracts with customers; or
- introduce a different approach to addressing collectability concerns, including the introduction of a revenue recognition threshold for collectability.
These approaches were those that the Boards were unable to reach a tentative decision on in the September 2012 joint Board meeting. In November 2012, the staff brought these back to the Boards after further analysis and user outreach.
In the November 2012 joint Board meeting the staff presented four alternatives (alternatives 2 and 3 fall into category (b) above) for the Boards’ consideration:
1. Presentation – 2011 ED proposals
The staff noted that this alternative represented the collectability proposals in the 2011 ED. The 2011 ED proposals differentiated between contracts with customers without a significant financing component and those with a significant financing component. For those contracts without a significant financing component the transaction price would be measured at the amount that the entity is entitled and then any subsequent credit risk impairment would be presented in a line item adjacent to the revenue line item. For those contracts with a significant financing component, the transaction price would be measured at the amount of the promised consideration adjusted at a customer specific discount rate, the initial credit risk impairment would be reflected in the rate used to discount this promised consideration and then any subsequent credit risk impairments would be presented as an expense.
It was noted that there were some concerns identified with recognising the revenue at the entitled amount such as this approach may allow entities to recognise revenue on contracts that have a high risk of non collection. There were also concerns identified with the proposal to present the impairment loss line item adjacent to the revenue line item such as the fact that this would affect the calculation of the gross market calculations and also would imply a correlation between current period revenue and impairment losses that is not true (i.e. some impairment losses may be for non-current period revenue but would be shown together with current period revenue). The staff noted that many standard setters had raised concerns that this approach was too prescriptive for a line item that may be immaterial.
2. Presentation – prominent expense
This approach is consistent with approach 1 except that impairment losses on contracts with customers that do not contain a significant financing component would be presented prominently as a separate line item in expenses in the statement of comprehensive income.
The staff noted that this approach addressed the concerns regarding the presentation of impairment losses identified in approach 1 and the approach would also create less of an incentive for entities to structure contracts to contain a significant financing component to allow the separate disclosure from the revenue line. The staff also noted that feedback from their outreach with users on the IASB’s Capital Markets Advisory Committee and National Standard setters generally favoured this approach.
3. Presentation – all contracts with customers treated similarly
Approach 3 is consistent with Approach 1, except that impairment losses arising from all contracts with customers (i.e. contracts with or without a significant financing component) would be presented adjacent to the revenue line item.
The staff noted that the rationale for this approach would be to address the concern raised in approach 1 that an entity might extend the payment terms for some contracts so they would be deemed to have a significant financing component and any impairment loss would no longer be presented adjacent to the revenue recognised. However, the staff noted that this approach failed to present financing contracts (loans and contracts with customers that contain a significant financing component) consistently.
4. Collectability threshold
The staff noted that this approach would introduce a collectability recognition threshold into the revenue standard. The collectability threshold would preclude an entity from recognising revenue until it could demonstrate that the likelihood of collectability from the customer meets a specified confidence level (for example, reasonably assured or probable). Once that threshold had been met and revenue recognised, any subsequent impairment losses would be shown as an expense (regardless of whether the contract contains a significant financing component or not).
The staff noted that this approach would preclude revenue from being recognised when there is significant uncertainty about the customer’s ability to pay and therefore avoids “grossing up” the statement of comprehensive income for the revenue recognised and the corresponding impairment loss. The staff highlighted that this approach may reduce transparency for users into an entity’s sales and receivables management activities and would also require the Boards to define a common threshold and articulate their intent in light of different revenue recognition thresholds in existing IFRS and US GAAP.
The staff also noted that introducing a collectability threshold would affect a number of areas of the revenue model, especially the core principle of the model that states that revenue is recognised when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer. The staff noted that with a collectability threshold an entity would have to satisfy a separate performance obligation by transferring goods or services to the customer and determining that the entity is reasonably confident of collecting the transaction price allocated to that satisfied performance obligation. The staff noted that, if approach 4 is followed, revenue recognition would consider both the entity’s actions and the customer’s ability to pay.
The staff recommended to the Boards that approach 1 be followed and asked the Boards whether they agreed.
One FASB member favoured approach 3 and noted that this approach best addresses the concerns raised from investors for those contracts with significant financing with significant credit risk. By displaying the credit risk impairment on the contracts with a significant financing component adjacent to revenue it will allow investors greater information in terms of the connect between impairment losses and revenue (i.e. what is the amount that the entity expects to collect from the revenue recognised on that contract).
Approach 3 was also supported by another FASB member. He noted that it was important to recognise that in the first three approaches there was the removal of the recognition threshold for collection and he supported the removal of such a recognition threshold as he did not think it was consistent with the rest of the revenue recognition model – hence this member dismissed approach 4. Another FASB member also supported approach 3.
Another FASB member noted that even though approach 1 proposed by the staff did remove the collectability threshold there would still be some collectability threshold inherent in this method as the entity before recognising revenue would still have to evaluate whether they have a valid contract and hence were entitled to consideration. This Board member also highlighted that he did not think that where there are contracts without a significant financing component there would be a significant credit risk impairment to be displayed adjacent to revenue (companies would not usually sell goods without the expectation that they will not receive the majority of consideration value). This Board member also expressed the concern that under approach 1 entities may structure contracts to contain a significant financing component to allow the separate disclosure from the revenue line (so shown as an expense rather than adjacent to revenue). This Board member favoured approach 2 and noted that he felt that analysts could track the revenue v impairment for contracts and would be able to, over time, obtain the same information as they would have obtained had the impairments been shown adjacent to revenue. This view was shared by another IASB Board member.
Another FASB member favoured approach 2 and stated that for manufacturers and retailers the gross margin line is a very important measurement. Hence he did not favour approach 1 or 3 due to the effect that this would have on the gross margin calculation.
Another FASB member stated that ultimately day 1 impairments should be shown adjacent to revenue and then subsequent impairments presented as other expenses. However, as the staff acknowledged, this treatment is not viable as entities find it difficult to separate the day 1 and day 2 impairments. He noted that in order to allow the best assessment of the quality of revenue the impairments would be required to be shown adjacent to revenue, especially with the removal of the collectability threshold. This member favoured approach 3. He stated that he could live with view 1 but was concerned regarding the entity’s ability to manipulate contracts to ensure that they contained a significant financing component.
The FASB Board members voted and four members tentatively agreed with approach 3 and three tentatively agreed with approach 2.
The discussions of the IASB Board members followed similar lines to that of the FASB Board members and the IASB Board members shared the concerns of the FASB members.
One IASB member agreed that there was no need for the collectability threshold. He noted that he would like the impairment information to be displayed in a consistent place and hence was open to approaches 2 or 3. However, to be consistent with the model that was being built in the impairment project, this member favoured approach 2. This approach was agreed by another IASB member.
The majority (12) of the IASB Board members tentatively agreed to approach 2. There was only one IASB Board member that had a preference for approach 1.
Following the IASB Board member vote, the FASB Board members revoted and the outcome was that 4 of the 7 FASB members tentatively agreed to support approach 2 with one of the original approach 3 voters changing their tentative decision. This member changed his decision as it was tentatively agreed that the impairment would be displayed prominently and separately as an expense line item for all contracts with and without significant financing components.
The staff then recommended to the Boards that, where material, impairment losses should be presented (rather than disclosed) in the entity’s primary financial statement.
Both the FASB and IASB Board members tentatively agreed to the staff’s proposal.
Revenue Recognition – Implementation guidance: Licences
Proposed clarifications were discussed in the July joint Board meeting where the staff Board paper suggested clarifying in the implementation guidance that not all agreements that include a licence would result in revenue being recognised at a point in time, but rather an entity would need to assess the terms of the agreement and apply the principles in the 2011 ED to determine the amount and timing of revenue recognition.
No decisions were made at the July 2012 joint Board meeting. It was noted that a number of constituents misinterpreted the application of the implementation guidance and hence there was a need for clarification and improvement.
In the November 2012 joint Board meeting, the staff presented to the Boards improvements that could be made to the implementation guidance for licences that were proposed in the 2011 ED. Specifically, at the November 2012 joint Board meeting the staff recommended the following improvements/clarifications:
- (a) determining the nature of the entity’s promise in a license arrangement; and
- (b) clarifying how the revenue model would apply to license arrangements.
Determining the nature of the entity’s promise in a licence arrangement
The staff highlighted to the Boards that, among other things, the entity’s promise related to the licence would need to be considered as part of the analysis of determining when revenue should be recognised for a licence arrangement.
The 2011 ED defined the promise in a licence as a promise to provide a right to use, but not own intellectual property of the entity. However, in BC315(b) of the ED an alternative view was also presented that acknowledged that licences may represent a promise to provide a service (i.e. a promise to transfer an asset over time).
The staff noted that it was important to determine whether the nature of the promise represented a promise to provide a right or a promise to provide access because this will affect whether the transfer of a licence (absent other promises in the contract) represents a performance obligation satisfied at a point in time or over time.
The staff presented three alternative views to the Boards to determine the nature of an entity’s promise in a licence:
The staff explained that this view was based upon the 2011 ED proposals which defined the promise in a licence as the promise to provide a right. Upon transfer of this right (typically at the inception of the licence agreement) the customer can direct the use of, and obtain substantially all of, the remaining benefits from the right.
It was noted that under this view, an entity could not conclude that the promise represents a performance obligation satisfied over time because none of the criteria in paragraph 35 of the 2011 ED could be met. It was also noted that the transfer of a right is more akin to a good than a service and, therefore, upon transfer of the right, the entity’s performance is complete.
The staff highlighted that view A is consistent with the tentative decisions reached in the leases project and is broadly consistent with the principles in many existing standards in US GAAP. (such as Subtopics 985-605 Software, 952-605 Franchisors and 926-605 Entertainment-Films.
- View B – a right when specified indicators are met otherwise access to the entity’s intellectual property
The staff noted that this view expands view A and acknowledges that the timing of the transfer of resources may differ for different types of licences. This view acknowledges that the two alternative views (promise to provide a right and a promise to provide access to an entity’s intellectual property) of the nature of an entity’s promise in a licence outlined in paragraph BC315 may be appropriate for different types of licences. The staff noted that these different types of licences may be distinguished based on the nature of the promised asset in the licence.
The staff noted that to determine whether a licence represents a promise to provide a right or the promise to provide access, the implementation guidance should include indicators of when a licence may represent a promise to provide a right. When these indicators are not met, an entity would conclude that the licence represents a promise to provide access. The staff noted that these indicators could be:
- The right transferred to the customer in the form of a license represents an output of the entity’s underlying intellectual property, similar to a tangible good.
- The license can be easily reproduced by the entity with little or no effect on the value of the underlying intellectual property.
- The customer can determine how and when to use the right (that is when the benefits from the asset can be consumed) and the customer does not require any further performance from the entity to be able to consume those benefits.
The staff noted that view B differentiated the accounting for different licences based upon the promised asset in the arrangement but also may be difficult to apply in practice as the entity would have to differentiate the nature of promises within licences (some may find it difficult to differentiate between a licence that provides a right and one that provides access as in both cases the customer is receiving the same thing – a right to use the entity’s intellectual property.
- View C – access to the entity’s intellectual property; unless the terms of the licence give the customer control of the underlying intellectual property, such that the entity has in effect sold that intellectual property.
The staff noted that under this view, a licence represents a promise to provide access to the entity’s intellectual property. In this view, the customer is unable to control the portion of the intellectual property (defined by the licence) at the inception of the licence arrangement but obtains the benefits over time as access is provided by the entity.
The staff noted that unless the term of the licence effectively gives the customer control of all of the underlying intellectual property, the nature of the promise will be to provide access and the performance obligation to transfer the licence will be satisfied over time. It was also noted that under view C, where the terms of the licence give the customer control of the underlying intellectual property, the performance obligation will be satisfied at the point in time that the customer obtains control of the licence based on the indicators of control in paragraph 37 of the 2011 ED.
The staff highlighted that view C would mean that for most licences (absent other promises in the contract) revenue would be recognised over time. They also noted that the forward looking assessment that would be required to determine whether the terms of the licence represent a significant portion of the underlying intellectual property may be a challenge.
The staff recommended view A to the Boards – the licence represents a promise to provide a right. They noted that this was simpler to apply than view B and view C and felt that it would result in similar outcomes when other parts of the revenue model are applied. It was also highlighted that this approach was supported by a large number of respondents.
One IASB Board member agreed that if the entity could identify that a performance obligation has been met and the customer does not require any further performance from the entity then there has been the transfer of a right and hence revenue recognised. This member noted that the entity would need to look to the substance of the legal rights and obligations of the parties to the licence to determine whether there are any further service obligations on the entity to provide access. The member also noted that view A or B are consistent with the overall revenue model as they require the specific performance obligations in a contract to be analysed. He noted that to say that licences only have one performance obligation and that is access to the right in incorrect and does not look at the substance of the legal rights between the two parties to the licence. This Board member was of the view A or B.
Another IASB member preferred view A. He viewed the promise within a licence as a right. He noted that view A was simpler and easier to understand and was supported by most constituents. Another IASB member strongly supported view A.
One IASB Board member preferred view C rather than view A. He noted that he thought that the main substance of a licence contract was to provide access to the intellectual property owned by the seller. Hence if the seller has intellectual property, he thought that they would be allowing access to the intellectual property and hence, this respect, view C was more preferable.
Another IASB member highlighted that the consumption rate of the intellectual property should be considered. If the entity is selling all of the consumption of the intellectual property then there was an argument for recognising revenue at a point in time but if the entity is not selling all of the consumption of the intellectual property then there was an argument for recognising revenue over time. Another IASB member disputed this view and stated that the amount of consumption was not a key factor. He stated that if an entity has no other performance obligations and provides a licence for a period of time (but not the full expected life of the intellectual property) then at the transfer of the licence the entity has satisfied the performance obligation (as there are no further obligations in respect of the asset) and hence should be able to recognise revenue at a point in time rather than over time – in this respect the customer can control the asset for the period they are granted for their own benefit –there is nothing left for the seller to perform. This latter view was also shared by another IASB and a FASB member.
A FASB member agreed with view A. He noted that this method was consistent with the revenue model and noted that in his opinion view C was inconsistent with the model.
Another FASB member preferred view C. He noted that he thought that the asset the seller has is their own intellectual property. He noted that for contracts where the entity has effectively sold the intellectual property then the revenue on these should be recognised at a point in time but, where the seller is effectively getting back the intellectual property then, in these situations, revenue can only be recognised over a period of time. Unlike some of the IASB views, this FASB Board member could not, in the latter situation, get to the position where the seller would be able to recognise revenue upon the inception of the licence based on the reasoning that, although the seller will get the “asset” (intellectual property) back, the seller has satisfied their performance obligations and has passed full control to the buyer for the certain period of time.
One FASB member noted that she did not think that there was a single answer to the problem but had a preference for view C. A number of other FASB member also shared a preference for view C.
An IASB member noted the need to find a middle ground and was willing to move to view B. This need to reach a middle ground with FASB and IASB members was also shared by the FASB Board members. It was emphasised that this was a critical issue that both Boards needed to be converged on.
A vote was held by the FASB Board members and 2 Board members tentatively preferred view A and 5 Board members tentatively preferred view C. All 7 FASB members tentatively agreed to view B with further exploration by the staff.
An IASB Board member sought clarity from the staff as to whether the indicators to determine whether the promise in a contract is a right or not would lead to conclusions that brands, trademarks and patents being treated as access (and hence revenue recognised over time and software, movies, music and publishing would be rights (and hence revenue recognised at a point in time). The staff clarified that this was their intention when drafting the indicators.
A vote was held by the IASB Board members and 12 Board members tentatively preferred view A and 2 Board members tentatively preferred view C. All 14 IASB members tentatively agreed to view B with further exploration by the staff. It was noted that the staff will work to try to make view B operational and should issues be encountered during drafting then these issues would be brought back to the Boards as part of sweep issues.
Clarifying how the revenue model would apply to license arrangements.
The staff presented to the Boards the other parts of the revenue model that would need to be applied to licences to determine when revenue should be recognised.
The staff recommended that the following steps of the revenue model be clarified in the implementation guidance to illustrate the application of them to licence arrangements:
- Assessing other goods or services promised by the entity
- Applying the separation criteria
- When are the performance obligations satisfied
- Applying the constraint on revenue recognised
All of the IASB and FASB Board members tentatively agreed to the staff recommendation that the implementation guidance for licences be clarified to illustrate the application of the revenue model to licence arrangements.