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Revenue recognition (IASB and FASB)

Date recorded:

The Boards discussed three aspects of revenue recognition: collectability, accounting for contracts that do not meet Step 1 of the revenue model, and constraint-minimum requirements.

Collectability

The Staff had prepared a paper considering how assessments of a customer’s credit risk should be reflected in accounting for contracts with customers without a significant financing component.

The core principle of the revenue model 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. As part of their redeliberations on the 2011 ED, the Boards considered possible approaches for addressing customer credit risk in accounting for contracts with customers without a significant financing component. In the November 2012 Board meeting, the Boards reaffirmed that revenue would be recognised at the entitled amount (that is the amount on the invoice) and that any impairment losses would be presented prominently as an expense. This was a change to the 2011 ED where it was proposed that impairment losses should be presented adjacent to the revenue line. 

A consequence of measuring revenue at the amount of consideration to which the entity is entitled is that the amount recognised as revenue is not adjusted for the risk that the entity will not ultimately collect that amount because the customer does not have the ability to pay. In other words, under the revenue model, customer credit risk does not directly affect the measurement of revenue.

However, paragraphs 50 and 53.1(b) of the 2011 ED consider circumstances where collectability is taken into account in the measurement of the transaction price, and hence revenue. The intention of paragraph 50 is to clarify that the stated contract price will not necessarily be the enforceable price in a contract if an entity has an established past practice of enforcing a lower amount because the entity routinely offers price concessions to its customers. Paragraph 53.1(b) requires an entity to consider whether the facts and circumstances related to the contract indicate that the entity is expected to offer a discount or price concession on the consideration promised in exchange for the goods or services transferred to the customer. For example, when entering into a contract with a customer who has significant credit risk, the entity may be seen to have implicitly granted a price concession.

Feedback indicated that respondents were confused about how to determine whether something was a variable consideration and therefore a price concession, or if something was an impairment event, and how these should be treated. The staff had prepared three alternatives:

Alternative A: Retain the approach in the staff draft and add guidance to clarify the distinction between price concessions and impairment losses. Under this alternative, the key distinction is how the uncertainty about the entity’s future cash flows arises. The uncertainties that make consideration variable are reflected (either explicitly or implicitly) in the negotiated and agreed terms and conditions of the contract (eg indexation or bonuses) or offered unilaterally by the entity to the benefit of the customer (eg price concessions). In other words, concessions are provided to maintain a relationship with a customer. In contrast, the uncertainties about the customer not meeting its obligations under the contract to pay the promised consideration (that is, customer credit risk) arise irrespective of the negotiated terms and conditions of the contract.

Alternative B: Present impairment losses adjacent to revenue (based on 2011 ED). Consistent with the 2011 ED proposals, the requirement to present impairment losses adjacent to revenue would apply only to contracts with customers without a significant financing component. This is because customer credit risk is already included in the measurement of the transaction price for contracts with a significant financing component and any impairment losses related to the financing component (ie the loan) would be presented together with other financial instruments as an expense.

Alternative C: When an entity enters into a contract that has significant credit risk, the entity is deemed (emphasis ours) to have offered discounts or price concessions to the customer (thus the consideration promised in the contract is variable). Any re-measurement of the customer’s ability to pay is deemed to be a reassessment of the variable consideration and will be reflected in the re-measurement of the transaction price and therefore revenue. Therefore, under Alternative C, there will be separate impairment expense line as all adjustments goes against the revenue line.

The staff did not make a recommendation and asked the Boards which alternative they would prefer.

Several members noted that they prefer Alternative B. However, they acknowledged that Alternative B was decided against in the Boards’ deliberations in November 2012 and that going back down that route would be re-opening the discussions around the issues in that area. Further, the majority of respondents were against this approach. Given these circumstances, there would therefore accept Alternative A. If the matter was opened for re-debate, then they would prefer Alternative B.

One member suggested applying Alternative B only where there was a high credit risk at inception of the contract.

Several members noted that the key distinction between Alternatives A and C was that Alternative A is principles based, whereas Alternative C is a rule. It was noted that to choose Alternative C would be going down the path of re-introducing a threshold concept that was present in the old standard and that the Board is trying to move away from with the new standard. It was noted that Alternative C was clearly advantageous though because it was a rule and it treats explicit and implicit price concessions consistently. One member was concerned that Alternative A would not be consistently applied across entities as its reliance on judgement may be complicated.

One member noted that they preferred Alternative A based on the above and clarifications will get to the principle more clearly, and that Alternative C appeared to be coming from an anti-abuse precedent. They would not object to Alternative C, but the better standard setting approach is Alternative A. Having said that, the more logical approach is actually Alternative B, and that revenue should be measured at the fair value of the consideration taking into account time value and credit. However, the member acknowledged that after exposing Alternative B in the 2011 ED, respondents did not like having revenue being measured at other than the invoiced amount, or having impairment adjacent to the revenue line and therefore that discussion has been closed.

One member queried how Alternative C differed to paragraph 53.1(b) given that one of the questions put to the Board is to remove the wording of paragraph 53.1(b). The staff clarified that in the feedback, people thought that 53.1(b) was applied to all contracts. Alternative C will only apply to contracts where there is a significant credit risk. Additionally, paragraph 53.1(b) wording is ‘indicates’, whereas Alternative C proposed wording is ‘deemed’, highlighting the more rules-based approach.

One member noted that they preferred Alternative A as Alternative B does not provide much value to readers. They noted that investor analysts will look at the net figure, not the total figure. Secondly, income statements should be a high level snapshot and should not be cluttered with more line items. They further noted that Alternative C is less transparent and users will not see the offset to revenue as a result of the price concession.

One member noted that it was counter-intuitive to enter into a contract with high credit risk but not show subsequent re-measurement as a bad debt expense (Alternative C). For this reason, they would support Alternative C modified to show subsequent re-measurement as a bad debt expense. If this was not possible, then default preference is Alternative A.

One member noted that the discussion was demonstrating that there is a need about better disclosures about what is occurring when you book revenue and whether or not you have a price concession or an assessment of impairment, otherwise an entity will not really be communicating what its revenue is.

One member queried what happens when an entity has a customer contract with a significant financing component, does the model still work? For example, if an entity has a contract due in 1 year and 1 day with a contract price of 100 and a price concession of 40, so 60 is recognised, what discount rate do we apply to the amount recognised and what impact does it have on the impairment proposals? There is a risk that we are triple counting the credit risk as we have used it in measuring revenue of 60, then we discount the 60 at a credit risk adjusted discount rate (consistent with impairment proposals), then the IASB applies a 12 month allowance and FASB applies a lifetime allowance, which is essentially triple counting the credit risk. The staff clarified that to the extent that you’ve taken the credit risk into your expected value calculation of what you are entitled to, that is the 60, then you would discount that using a credit risk free rate. The member agreed with this application and requested that the drafting reflect this. Another member noted that they would prefer not to use the term ‘credit risk free rate’ but rather that the ‘credit risk is zero’.

The IASB and FASB tentatively agreed with Alternative A.

The staff then asked the Board whether they agree with the proposed clarifications which were:

  • Clarify the objectives of paragraph 14 and remove indicators paragraph 14(e)(1-3) as it makes the assessment more complicated.
  • Eliminate selected wording from paragraph 50 and 53.1(b), clarifying that the wording will not be removed entirely as the staff will be capturing the concept of Alternative A in the new draft.

Several members clarified that paragraph 14 is a gateway into the revenue standard and once an entity’s transaction is in there, then they apply paragraphs 50 and 53.1(b) to determine the amount. 

One member requested drafting of paragraph 14 include wording consistent with the following: The conclusion of paragraph 14 will determine if there is a contract between an entity and its customer. The conclusion from this paragraph does not determine the amount that is to be recognised under the contract. Paragraphs 50, 51, and 52 provide guidance in determining the amount to be expected to be entitled under the contract.

The staff clarified that their draft will include this observation.

One member noted that paragraph 53.1(b) was what people found the most useful when making the assessment of whether credit risk was a price concession at inception and was relevant to Alternative A, therefore why were we deleting this line? The staff noted that this was the genesis of Alternative A and that its concept would still be included in the drafting.

The Boards tentatively agreed with the changes proposed, clarifying that the drafting includes clarification in paragraph 14 about the qualitative assessment.

Accounting for contracts that do not meet Step 1 of the revenue model

The Staff had prepared a paper addressing the need for issuing guidance in respect of accounting for contracts to which the revenue model cannot be applied because they do not meet the first step requirement in paragraph 14 Identify the Contract. The staff proposed the following alternatives:

Alternative A: Staff draft with clarifications. This alternative would largely retain the wording from the staff draft (see Appendix A) while attempting to address the concerns raised through the feedback process by including clarifications.

Alternative B: Address only the revenue related aspects in the revenue standard. This alternative would result in requirements in the final revenue standard that state how an entity should account for consideration received in cases where the criteria in paragraph 14 are not met. However, the revenue standard would not prescribe the asset derecognition requirements (and cost recognition), these would be dealt with by existing IFRSs and US GAAP and will be addressed in the codification amendments for US GAAP for transfers of nonfinancial assets (see Appendix B for proposed drafting changes to the revenue standard).

Regardless of which alternative is chosen by the Boards, the staff think that the criteria in paragraph 14 should be reassessed if they are initially not met. However, once the criteria have been met and an entity determines that a contract meets the criteria in paragraph 14, the entity shot not continue to reassess that conclusion unless a contract modification has occurred.

The staff recommended Alternative B and asked the Boards whether they agree that the final revenue standard should provide guidance for entities to apply when a contract does not meet the criteria in paragraph 14, but that guidance should be limited to addressing revenue recognition (consistent with Alternative B)?

The Boards tentatively agreed with Alternative B.

Constraint-minimum requirements

The Staff had prepared a paper considering the application of the constraint, specifically how the requirements to include some (but not all) of the amount of variable consideration in the transaction price should be applied (the “minimums requirements"). Specifically, when an entity can’t recognise the full amount, how do they determine the minimum amount.

At the December 2012 Board meeting, the Boards discussed the requirements related to variable consideration and sales-based royalties (Agenda paper 7D/165D). Those discussions focused on paragraph 85 of the 2011 ED, which required that an entity licensing intellectual property to a customer, where the consideration is in the form of a sales-based royalty, should recognise revenue only when the customer’s subsequent sales occur.

At the December 2012 meeting, the Boards tentatively decided to delete paragraph 85 of the 2011 ED. The Boards tentatively decided that for all performance obligations (including licences of intellectual property where the consideration is a sales-based royalty), an entity should rely on the general principles of the constraint, including the requirement to include a portion (ie a minimum amount) of the variable consideration in the transaction price if the entity would not expect a significant revenue reversal as a result of including that portion of consideration in the transaction price. However, the Boards also tentatively decided that the minimum amount may, in some cases, be zero. The staff understood from the discussions at the December 2012 meeting that the Boards intended the sale of a license where the consideration is a sales-based royalty to result in a similar outcome to that of applying paragraph 85 of the 2011 ED in most cases. Consequently, the staff considered whether there was a principle underlying the requirement in paragraph 85 of the 2011 ED that could be applied more generally in determining when the minimum amount included in the transaction price should be zero.

The staff presented the Board with two Alternatives:

Alternative 1: Draw a distinction between point in time and over time performance obligations (Proposed in Appendix A); or

Alternative 2: Apply a 2011 ED approach for royalties on licences similar to paragraph 85, that is where there is a licence for IP and there is variable consideration, the variable consideration would not be included in the TP until the uncertainty was resolved, ie when the sales occur (proposed in Appendix D).

The staff recommended Alternative 1 and asked whether the Boards agree with the staff recommendation.

One member raised the example that if they were a successful author, because it’s a point in time sale, they would not recognise revenue despite the fact they would have recognised cost of sales. The staff clarified that under Alternative 1, if an entity believes that it can come up with an estimate and they can prove that there will not be a significant reversal of that estimate, then you can recognise that estimate. You would only recognise zero when you cannot provide that there will be no significant reversal of revenue. Under Alternative 2, it was clarified that Alternative 2 applied to licences of IP and in this example, books are not IP. Therefore the entity will estimate its consideration and recognise a minimum amount of that estimation.

One member clarified that under Alternative 1, if an entity does not have sufficient confidence over the whole amount, then they cannot book anything at that point in time. For example, using the book example, if the entity estimates it can sell 1 million books but only has confidence that it will sell at least 200,000, then it cannot book any revenue.

One member disagreed with Alternative 1 as it is difficult to distinguish between a point in time and over time. They noted that ‘over time’ is a series of consecutive points in time and could not identify any concept of basis to distinguish between the two. They noted that they could accept Alternative 2, but questioned why it would only apply to IP. For example, mineral deposits recognition is similar to IP, so why not apply the treatment also to mineral deposits? However, the member recognised the fact that there are issues with Alternative 2 such as difficulties with estimates. Therefore, they concluded that Alternative 1 is the more sound decision.

The members introduced an Alternative 3, reflected in paragraph 15 of Paper 7C (rejected by the staff), which is an entity will record the amount that they have sufficient confidence in. The staff clarified that this reflects concepts in the 2010 ED that caused concern for respondents and therefore that was why paragraph 85 was introduced for the 2011 ED, and that this would likely open the floor back up for comments.

The IASB and FASB tentatively agreed with Alternative 3.

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