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Ramesh Ruben Louis takes a look at a new standard that should rectify weaknesses in previous revenue recognition requirements
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This article was first published in the April 2016 Malaysia edition of Accounting and Business magazine.
The Malaysian Financial Reporting Standard 15, Revenue from Contracts with Customers (MFRS 15), sets out principles for reporting information related to the nature, amount, timing and uncertainty of revenue and cashflows arising from an entity’s contracts with customers.
Revenue is important to users of financial statements in assessing an entity’s financial performance and position. However, previous revenue recognition requirements within the International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (GAAP) frameworks were in need of improvement because they included limited guidance for complex transactions and even multiple-element arrangements, as well as other inconsistencies and weaknesses.
MFRS 15 supersedes the following standards:
- MFRS 111, Construction Contracts
- MFRS 118, Revenue
- IC Interpretation 13, Customer Loyalty Programmes
- IC Interpretation 15, Agreements for the Construction of Real Estate
- IC Interpretation 18, Transfers of Assets from Customers
- IC Interpretation 131, Revenue – Barter Transactions Involving Advertising Services.
The effective date of MFRS 15 has been deferred to annual periods beginning on or after 1 January 2018 (rather than 2017) following confirmation by the International Accounting Standards Board (IASB) of a one-year deferral of IFRS 15, Revenue from Contracts with Customers. However early application of MFRS 15 is still permitted.
Underlying tenet
The core principle of MFRS 15 is that an entity recognises revenue to reflect the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
Even though MFRS 15 prescribes accounting for an individual contract with a customer, an entity may apply the standard to a portfolio of contracts (or performance obligations) with similar characteristics if the entity reasonably expects that the effects of applying the standard to the portfolio would not differ materially from applying the standard to the individual contracts (or performance obligations) within that portfolio. When accounting for a portfolio, the entity shall use estimates and assumptions reflecting the size and composition of the portfolio.
Revenue recognition
Revenue recognition in accordance with the underlying principle of MFRS 15 encompasses the following considerations:
- Identify the contract(s) with a customer A contract is an agreement between two or more parties that creates enforceable rights and obligations. The requirements of MFRS 15 apply to each contract that has been agreed with a customer and meets specified criteria – contract approved, rights of each party identified, payment terms identified, contract has commercial substance and consideration will be collected. Where contracts are negotiated as a single package, or where consideration is dependent on another contract, or where contracts have a single performance obligation, MFRS 15 requires an entity to combine contracts and account for them as one contract. MFRS 15 also provides requirements for the accounting for contract modifications.
- Identify the performance obligations in the contracts A contract includes promises to transfer goods or services to a customer. If those goods or services are distinct, the promises are performance obligations and are accounted for separately. A good or service is distinct if the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer and the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. If a promised good or service is not distinct, an entity shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation.
- Determine the transaction price The transaction price is the amount of consideration in a contract to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. The transaction price can be a fixed amount of customer consideration, but it may sometimes include variable consideration or consideration in a form other than cash. The transaction price is also adjusted for the effects of time value of money if the contract includes a significant financing component, and for any consideration payable to the customer. If the consideration is variable, an entity estimates the amount of consideration to which it will be entitled in exchange for the promised goods or services. The estimated amount of variable consideration will be included in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
- Allocate the transaction price to the performance obligations in the contract An entity typically allocates the transaction price to each performance obligation on the basis of the relative standalone selling prices of each distinct good or service promised in the contract. If a standalone selling price is not observable, an entity estimates it. Sometimes, the transaction price includes a discount or a variable amount of consideration that relates entirely to a part of the contract. MFRS 15 specifies criteria for the allocation of discount or variable consideration to one or more, but not all, performance obligations (or distinct goods or services) in the contract.
- Recognise revenue when the entity satisfies a performance obligation
An entity recognises revenue when it satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). The amount of revenue recognised is the amount allocated to the satisfied performance obligation. A performance obligation may be satisfied at a point in time (usually in transfer of goods to a customer) or over time (usually in transfer of services to a customer). For performance obligations satisfied over time, an entity recognises revenue over time by selecting an appropriate method for measuring the entity’s progress towards complete satisfaction of that performance obligation.
Contract costs
An entity shall recognise as an asset the incremental costs of obtaining a contract with a customer, which are costs that would not have been incurred if the contract had not been obtained (for example, a sales commission), if the entity expects to recover those costs. However, costs to obtain a contract that would have been incurred regardless of whether the contract was obtained is expensed-off when incurred.
An entity shall recognise an asset from the costs incurred to fulfil a contract only if those costs meet all of the following criteria:
- The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (example – direct labour, materials, allocated costs such as insurance and depreciation, payment to subcontractors);
- The costs generate or enhance resources of the entity that will be used in satisfying performance obligations in the future;
- The costs are expected to be recovered.
Costs recognised as an asset shall be amortised on a systematic basis consistent with the transfer to the customer of the goods or services to which the asset relates. It is also subject to impairment when the carrying amount of the capitalised cost exceeds:
- the remaining amount of consideration that the entity expects to receive in exchange for the goods or services to which the asset relates; less
- the costs that relate directly to providing those goods or services and that have not been recognised as expenses.
Presentation
The contract is presented in the statement of financial position as a contract asset or a contract liability, depending on the relationship between the entity’s performance and the customer’s payment. An entity shall present any unconditional rights to consideration separately as a receivable.
The aim of the disclosure requirements is for entities to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cashflows arising from contracts with customers. For this, an entity shall disclose qualitative and quantitative information about all of the following:
- Revenue recognised from contracts with customers, including the disaggregation of revenue;
- Contract balances, including the opening and closing balances of receivables, contract assets and contract liabilities;
- Performance obligations, including when the entity typically satisfies its performance obligations and the transaction price that is allocated to the remaining performance obligations in a contract;
- Significant judgements, and changes in judgements, made in applying the requirements to those contracts;
- Assets recognised from the costs to obtain or fulfil a contract with a customer.
Ramesh Ruben Louis is a professional trainer and consultant in audit and assurance, risk management and corporate governance, corporate finance and public practice advisory.
Article
"Revenue is important to users of financial statements in assessing an entity’s financial performance and position"