Revenue from Contracts with Customers - Essay Example

IFRS 15 Revenue from Contracts with s Introduction According to the International Accounting Standard Board (IASB), a new framework for revenue recognition, IFRS 15 revenue from contracts with customers will replace the IAS 18 revenue and IAS 11construction contracts in 2017 (Wagenhofer,2013). This present essay is aimed at discussing the relevance of the revenue recognition practices to performance reporting. The discussions will examine the importance of revenue in informing capital markets, highlight on the issues with the current standards ( IAS 18 revenue) and further justify the need to change the current standard. In addition, discussion of the key elements of the IFRS 15 and challenges facing entities will be undertaken. In conclusion, potential improvement in global performance reporting as a result of implementing the IFRS 15 will be identified. According to Wagenhofer (2013), effective and comprehensive revenue recognition framework plays a pertinent role in the provision of financial information to capital markets and facilitation of performance evaluation. Wagenhofer (2013) therefore noted that the information of revenue was important for the following purposes; informing capital providers, facilitation of performance evaluation and in the management of earnings. Revenue information underpins the effectiveness of the decision-making framework of capital providers (Holt 2013b). Information on revenue provides the basis of performance measurement by major companies thereby serving as the fundamental indicator of the financial status of the company. McConnell (2014) noted that the reporting on revenue provides the company’s financial information that includes gross income, gross profit and net income. Vis a vis, revenue provides capital marketers with vital valuation information within a given period. Assessment of the revenue by financial analysts provides information on the size of the company and the trajectory of the growth pattern of the company. Additionally, revenue enables financial analysts to project future performance and growth of the company based on financial records such as market demand for the goods and services of the company. Therefore, comprehensive revenue information adequately advices investors and financial analyst on the current status of the company. Revenue information is further crucial in the management of the operations of a company. Revenue serves as a key tool in the evaluation of the performance of a company. According to Holt (2013c), most companies are guided by the statistics of their revenue in setting performance targets and formulation of strategic management policies. Managerial decisions on the performance of the company either lead to sustenance of the current financial outcome if it’s profitable or reformulation of strategic alignment of the company in case of loss incurrence. Revenue thus provides an effective feedback system on the performance of the company. Revenue information facilitates the assessment of the performance of the firms by either comparing the current financial records of the company with the set targets or with records from the previous financial period. Similarly, Wagenhofer (2013) added that revenue was a key integral of the earning management in a company. Earning management by companies directly depended on the revenues generated. Vis a vis, elaborate revenue records provided adequate information on the extent value addition activities that a company had successfully undertaken. Through watertight revenue recognition system, incidences of revenue and earning exaggerations by firms in order to achieve appealing financial reporting is highly deterred. Stringent revenue recognition practices therefore plays significant role in the prevention of fraudulent reporting by companies. The revenue recognition practice is underlined with key concepts which include the economic earning cycle, the information aggregation procedure, alternative concepts of revenue recognition and the measurement bases (Wagenhofer, 2013). The prime concept of effective revenue recognition is based on the identification of the activities and transactions of a company and their related financial statements through the economic earnings cycle. The cycle highlights on the expenditure for capacity, technological capacities, research and development and marketing aspects of the company. The revenue recognition practice is further characterised with information aggregation procedure. The procedure primarily analyses the large number of financial records and aggregates the transactions into useful sets of information that are crucial in performance measurements. Additionally, the revenue recognition system is underlined by implementation of the alternative concepts of revenue recognition which includes the revenue-expense system and the asset-liability approach. Ultimately, the revenue recognition practices are primarily measurement-oriented systems hence the need for a measurement base of fair valuation system for the revenues. According to IFRS (2014c) one of the adopted measurement base is the fair value model. IFRS (2014a) noted that the current revenue recognition framework standard of IAS 18 revenue has been criticised over its profound weakness in terms of inconsistencies, limited guidelines and inadequate requirements for disclosure. The IAS 18 revenue has been criticised over its revenue recognition standards. According to IFRS and IASB (2014), the provisions of previous standards erroneously lead to identification of amounts in the financial statement that do not qualify as economic undertaking. The provisions of the previous standard erroneously underpin revenue recognition based on the transfer of risks and rewards of ownership to a customer thereby leading to consideration of the goods as inventory in cases where risks and rewards have not been timely transferred to the customer. The conflict of asset and liability definitions of the IAS 18 revenue further arises in cases where the subject transaction relates to a good and services pertaining to the same good. The standard stipulates that the transfer of the risks and rewards is characterised with wholesome transaction of the goods. However, in such a case, an entity is forced to encapsulate all revenues on delivery without consideration of pending obligation for the remaining services related with the good. IASB (2008) added that the previous standard was further limited by its lack of guidance on transactions that entail the delivery of two or more goods and services. IASB (2008) noted that the IAS 18 guidance for transactions involving multiple elements does not indicate comprehensively when and how an entity should divide a unit transaction into components. Similarly, the IAS 18 also fails to specify unique measuring approaches for the multiple components separated from a single transaction. The downside of the case is that different entities employ different measuring approaches for the same transaction thus limiting the quality of revenue comparison between entities. Furthermore, the standard suffers from unelaborated distinction between goods and services. There lacks clear demarcation between industries dealing with goods and services particularly in the case of real estate and construction sector. Notable entities reported revenues for real estate as for construction contracts thereby limiting the accuracy of the revenue comparison analysis. Additionally, standard stipulations of the IAS 18 conflicted with the provisions of the IAS 11 in the definition revenue. IAS 11 states that revenue constitutes activities that encompass the completion of contract while IAS 18 relates revenue to the transfer of risks and rewards of goods to a customer. In light of the identified weakness, consistency and lack of guidelines, there developed a need to address the concerns associated with the standards of the IAS 18 and GAAP. Findings from the public feedback on the three due process document, the a discussion paper, exposure draft and the revised exposure draft indicated overwhelming support for the key the principles of the IFRS 15. Key highlights of the exposure draft included shareholders’ feedback and IASB response on the following issues. Performance obligations satisfied over time, identification of performance obligation, collectivity, constraining estimates of variable consideration, disclosure requirements, transition and financing component. Majority of the respondent highly supported the inclusion of time aspect when entities satisfy performance obligation while in response the board further clarified application of the standard to each scenario. Similarly, respondents welcomed the use of the distinctiveness of the goods and services in the identification of the performance obligations. However, respondent requested further clarification on the varied aspect of distinct character of goods. The board respondent by clarifying the minimum requires for goods to be distinct. Assessment of the feedback from the respondents on the subsequent subject highlighted support for the changes effected on the 2011 exposure draft in terms of the revenue recognition at the gross level and the inclusion of constraint when measuring revenues. However, the subject of disclosure requirements and consideration of the time value for money when determining the transaction price elicited further questions. In light of the identified concerns, IASB responded by offering clarification on the subjects on the disclosure requirements and expected adjustment by companies while determining the transaction price. The identified feedback showed extensive recognition of the limitations of the previous standards by respondents and their subsequent support for the newly adopted features of the IFRS 15. In their part, the IASB has fundamentally maintained the foundational specifics of the IFRS 15, only redefining minor aspects and offering further clarification on complex subjects. The key elements of the IFRS 15 are underlined by the 5 step model of implementing the standard. According to IFRS (2014b) the prime elements of the IFRS 15 include the identification of the contract with the customer, identification of the performance obligations in the contract, determination of the transaction price, allocation of the transaction price to the performance obligation and the recognition of the revenue when the entities satisfy the performance obligation. The first step entails assessment whether the contract with the customer meets the set conditions IFRS (15: 9). The second step entails identification of the distinct performance obligation by showing that the goods and services subject to the contract can benefit the customer and the transfer of the goods and services can be separately identified from other promises in the contract. Stage 3 involves the determination of the extent of consideration that a firm expects to be entitled after transferring goods and services to customer as promised. Subsequently, the company allocates the transaction price to each performance obligation on the basis of the individual price of the goods and services in stage 4. The final stage encompasses the recognition of revenue by a company after satisfying a performance obligation by transferring the goods and services a customer. Under the IFRS 15, performance obligation may be satisfied at a given time or over time. Based on the responses from the 2011 Exposure draft, entities still faced numerous challenges with respect to revenue recognition. Entities were concerned that the onerous test would lead to false identification of performance obligation as onerous while it was profitable (IFRS, 2014c). The entities further were further faced with problem of providing excessive access to information that would wrongly profit investors due to the disclosure requirement of the IFRS 15. Holt (2013a) also noted that under standards of the IFRS 15, companies would be forced to report more assets and liabilities in their financial statements than at the present. Firms would hence be forced to list their leases as asset for their right of usage and subsequently equal liability on the quantity of the lease payments expected to be paid. The implementation of the IFRS 15 will undoubtedly transform the global concept of revenue recognition. The recommended revenue recognition standard will result to improvement in the global capital market reporting quality and comparability of the reporting across identical sectors. Vis a vis, the adoption of the IFRS at a global scale will facilitate global comparability and accurate assessment of state economies. Additionally, the global comparability of revenue information will further enable investors and creditors to have globe information on the international markets on the same framework. Similarly, the disclosure requirement by IFRS 15 allows for the provision of more information to financial analyst therefore enabling revenue related decisions in the capital markets. Similarly, the proposed disclosure requirements for companies provide investors with access to information on the financial performance of companies thereby triggering investments. Through a robust and comprehensive revenue recognition system, the IFRS 15 will potentially lead to upsurge of government taxes due to increased taxation on company transactions that were initially neglected. It is hence projected that universal adoption of the IFRS 15 will have equal impact on the global capital market as in the national capital market. References Holt, G. (2013a). Lease Accounting. Technical. Holt, G. (2013b). Realigning the framework. Technical : Conceptual framework. Holt, G. (2013c). Five Step Change. Technical : Revenue Recognition. IASB (2008). DISCUSSION PAPER : Preliminary Views on Revenue Recognition in Contracts with Customers. London: IASB. IFRS and IASB, (2014). IFRS 15 Revenue from Contracts with Customers. Basis for Conclusions International Financial Reporting Standard. IFRS, (2014a). Basis for Conclusions International Financial Reporting Standard ®. IFRS 15 Revenue from Contracts with Customers. IFRS, (2014b). Deloitte Luxembourg Newsletter on IFRS 15. Luxembourg: IFRS centre of Excellence. IFRS, (2014c). IFRS 15 Revenue from Contracts with Customers. Project Summary and Feedback Statement. London. IFRS, (2014d). International Financial Reporting Standard 15. IFRS 15 Revenue From contracts With customers. McConnell, P. (2014). Revenue Recognition: Finally, A Standard Approach For All. Investor Perspective. Wagenhofer, A. (2013). 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