FINANCIAL REPORTING AND IR

The effective date for the new revenue standard, IFRS 15, is just around the corner and while companies will begin applying the new standard next year, they will also have to start disclosing the impact in this year’s annual report. For some companies the impact may be significant, potentially uneven during the transition period, and challenging for investors to understand.

It’s no secret that investors are struggling to get their heads around the impact this new revenue standard will have on a company’s key performance indicators (KPIs), disclosures and financial trends. IROs need to get engaged now to avoid surprising investors. In upcoming annual reports, companies are expected to announce anticipated revenue and profit impacts and investors will undoubtedly have many questions. 

While some companies may see little change in the timing and amount of revenue recognized, many others will have very significant impacts – particularly those that have long-term services contracts or contracts with bundled goods or services. At the best of times accounting changes can create challenges for analysts and investors – but this will be exacerbated under the new revenue standard due to a number of well-intended but confusion creating transitional options and certain practical expedients that the standard permits. Peer-to-peer comparisons and period-over-period comparisons may be difficult for analysts and investors to perform with confidence.

What will investors be focused on? IROs need to be prepared to answer questions concerning changes to the timing of revenue recognition and a number of new subjective judgments that management will now be required to make. IROs will need to understand and be prepared to explain the transition adjustments, the amount of revenue recognized and the new disclosures being made. 

Timing of revenue recognition

IFRS 15 changes how and when companies recognize revenue. Some revenues may be pulled forward and others pushed back for later recognition than under current standards. Revenues may become more uneven, as certain contract activities will give rise to revenue recognition and some will not. Consider the following: 

• Separating out performance obligations: IFRS 15 places greater emphasis on the separation of different components or performance obligations than is required presently. As the profit margins on different components of a customer’s contract can vary significantly, this can create more volatility in reported profit margins.
• Revenues pulled forward: Upfront products and services (e.g. mobile handsets offered in connection with telecom service contracts) are no longer treated as ‘freebies’, as revenue now needs to be allocated to them.
• Revenues pushed back: Fees will need to be deferred if they do not represent services delivered to the customer (e.g. mobilization and activation fees charged by telecoms).
• Long-term contracts: Revenues from manufactured goods may historically have been recognized on delivery to the customer. Now, if the contract meets the ‘over time’ test, revenue would be recognized as the manufacturing happens – akin to current long-term contract accounting. 

While the impacts may largely average out for a business in a steady state, this may not be the case on transition, particularly for a growing business. Impacts can vary significantly by revenue stream.

Increased subjectivity

Under IFRS 15, increased management judgment is involved in identifying the individual components of the contract (performance obligations) and how consideration is allocated to each. 

The emphasis IFRS 15 places on transfer of control means that invoicing does not drive revenue recognition. More accounting judgement is needed to determine the components of a contract, the point at which goods and services have been transferred for each component, and the revenue to be allocated. For some companies, IFRS 15 will lead to fluctuations in margins and investors will need to understand the impacts on this important KPI.

IFRS already requires the disclosures of significant estimates and key judgments. The adoption of IFRS 15 will result in new or amended disclosures in this area and analysts will be comparing your judgments to those made by your peers.

Transition surprises

The transitional provisions of IFRS 15 were intended to provide some measure of relief to companies relative to the cost and effort required to adopt the new standard. However, there is, in our view, a risk that transition adjustments could obscure underlying trends in companies’ KPIs.

For instance, companies can choose whether or not to adjust their 2017 comparative results when they adopt the new standard in 2018. However, they are not required to do so. Transition adjustments may therefore create some hard to understand surprises for investors, particularly when 2017 results are not restated. The lack of comparable information will make it difficult for investors see a clear trend. For example, for those that choose not to restate:

• Some revenues may bypass the income statement altogether: Revenues and margin pulled back, as they would have been recognized earlier under IFRS 15, will never hit the income statement, but might instead be buried as an adjustment to opening retained earnings in 2018.
• Some revenues are double counted: Revenues and margin pushed forward, as they would have been recognized later under IFRS 15, would appear twice – in the 2017 income statement and again in the 2018 income statement.

Companies are required to explain their transition adjustments in the year of transition. A clear understanding of how these adjustments affect the revenue track record will be key and investors will be looking for these answers.

Amount of revenue

IFRS 15 impacts the timing of revenue recognition, but in some cases the amount of revenue recognized over the life of a contract may change. The most common circumstances are likely to include the following:        

• Limitations on circumstances when revenue can be reported on a gross basis, as the indicators for evaluating whether a company is acting as a principal or agent have changed.
• Nonperformance penalties (e.g. price adjustments for failure to meet service level agreements) will generally be deducted from revenue rather than charged as an expense.  
• Cash received more than a year in advance is seen as a loan – the related ‘financing cost’ is recorded as an interest expense, increasing reported revenues.

Increased disclosures

IFRS 15 promises much greater transparency over revenue mix – companies may need to publish new analyses of revenues by geography, market or type of customer, sales channel and/or contract type. There is no exemption for commercially sensitive information. Investors will be carefully examining this information and looking for details that shed new light on the nature of the company’s operations, business practices and its exposure to risks.

With IFRS 15 adoption coming quickly, IROs need to be connected to their finance teams to understand the impacts of this critical new accounting standard. Investor concerns are rising as they look to understand how companies will be impacted – now and in the future.

Andy Brown, CPA, CA is a Senior Manager, and Rob Brouwer, FCPA, CPA is Canadian Managing Partner, Clients and Markets, for KPMG LLP in Canada.