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Revenue recognition

26 June 2017 by John Stittle

Accounting: Revenue recognition - read more

The new IFRS15 rules could seriously impact many companies’ reported profit

How companies recognise revenue in their financial statements does not immediately appear as one of the more enthralling aspects of company reporting. However, if anyone is in any doubt about the importance of revenue recognition then have a word with Tesco. This spring, the supermarket chain suffered severe financial penalties and reputational damage arising from the manipulation of revenue recognition.

All companies, and not just Tesco, will soon need to heed more complex and prescriptive revenue recognition rules with the introduction of new accounting rules in IFRS15.

Superficially, the concept of revenue recognition seems straightforward, but sometimes the topic becomes deceptively complex. The issue is particularly problematic when commercial contracts have revenue, and associated costs, spread over more than one financial year.

In most cases, it is relatively easy to determine the timing point at which sales revenue is included on the income statement. When most goods are sold, it is evident when there is a legal contract of sale that creates either a cash or credit transaction.

However, when business services contracts overlap several financial years, there are often significant profit implications – particularly when the revenue must be matched with the associated costs of the transaction in each financial period.

There can also be taxation consequences, depending on when and how the revenue is recognised. In addition, the accounting principles and rules used for recognition can affect the profit available for distribution, and also affect director and employee incentive and bonus compensation schemes.

Recognise or delay

Historically, some companies have been tempted to increase reported earnings by recognising revenue early and delaying recognising and matching the associated costs. The current rules in IAS18 Revenue have sometimes been misused and can be difficult to apply to some business models.

IAS18 largely adopts an overall principle-based approach to revenue recognition. However, many IAS18 requirements are very general and have been criticised because companies can, in practice, interpret and apply the principles in different ways and use different recognition criteria.

It became increasingly clear to accounting regulators that the weaknesses of IAS18 needed to be addressed. In particular, critics of IAS18 pointed to accounting rules and principles introduced by US regulators.

Collaborative standards

The International Accounting Standards Board (IASB) believed that the more detailed and rules-based approach of US Generally Accepted Accounting Principles (GAAP) would be an improvement over existing international practice. The US approach would be adopted and improve on the more uncertain revenue recognition criteria found in international rules.

As a result, the IASB teamed up with the US Financial Accounting Standards Board to issue jointly a new reporting standard – IFRS15 Revenue from Contracts with Customers. In future, US GAAP and IFRS15 will have a far more converged framework for revenue recognition.

The new rules

The core principle of IFRS15 is that a company will recognise revenue to depict the transfer of goods and services to customers in a defined (monetary) amount. This transfer reflects the consideration a company expects to be entitled to in exchange for those goods or services.

That core principle is relatively straightforward and means that companies with lengthy and complex contracts will need to recognise revenue when it is received – linking profit more closely to cash flows. However, the reporting requirements then start to become considerably more technical, as this core principle will be delivered in a ‘five-step model framework’.

The five detailed steps require a company first, to identify the contract with the customer; second, to identify the specific performance obligations; and third, determine the transaction price. Then there is the allocating of the transaction price to the performance obligations in the contract; and finally recognising revenue when the performance obligation has been met.

Variable consideration

Many of IFRS15’s terms and conditions are intricate, detailed and far from easy to understand – let alone apply to some business models. The new rules are considerably more complex, more highly defined and more regulated than its IAS18 predecessor.

In particular, the new standard has explicit provisions for contracts with ‘elements of variable consideration’. Such contracts can consist of terms and provisions where there are, for example, rebates or performance bonuses, or indeed, refunds for failure to meet targets.

IFRS15 particularly notes that ‘variable consideration’ may be present where a company has a right to receive revenue that is contingent on a future event. For example, suppliers of products to a supermarket group may be contractually required to make payments, termed ‘commercial income’, to ensure stores prominently display and promote these goods.

However, if sales later exceed targets then additional bonuses may become payable to the retailer. Equally, lower-than-expected sales may oblige the supermarket to refund suppliers. The use of variable consideration terms in contracts therefore means companies still need to exercise judgement to estimate the amount of net revenue they include in each period’s financial statements.

Tesco’s overstatement

In 2014, the revenue recognition methods went seriously awry for Tesco Stores Ltd, a wholly owned subsidiary of Tesco plc. An internal whistleblower claimed the parent company had considerably overstated its earnings because its subsidiary had accelerated the recognition of its commercial income and delayed accounting for its costs to match against this revenue.

In order to prepare statutory accounts, companies are required to adopt accrual-based accounting. Revenue is included when earned and then matched against costs when they are incurred.

However, companies frequently need to make judgements about the timing and amount of its revenue and costs. Making judgements can potentially lead to errors, or indeed can sometimes open up the possibility of manipulation in order, perhaps, to meet company profit forecasts or individual bonus targets.

In Tesco’s case, although the issue centres on revenue recognition, there appears to have been some evidence of manipulation of revenue and costs in 2014’s first half-year profit. The final impact was significant with profit being overstated by £284 million.

Tesco plc was blunt about the conduct of its errant subsidiary; it confessed to an overstatement of its expected profit ‘principally due to the accelerated recognition of commercial income and delayed accrual of costs’.

As a result, the Financial Conduct Authority ruled that Tesco’s 2014 half-yearly accounts ‘contained information that gave a false or misleading impression’, the outcome of which was the creation of a ‘false market’ in Tesco plc’s shares. It was not just a case of sloppy accounting – there would now also be serious legal consequences.

Warning signs

Under section 384 of the Financial Services and Markets Act 2000, the FCA required Tesco to ‘pay restitution to those investors who suffered a loss’. However, Tesco accepted a deferred prosecution agreement with the Serious Fraud Office, this means it agreed to a financial penalty of £129 million to avoid prosecution for the earlier false accounting of revenue.

There were signs in Tesco’s 2014 annual report – published just months before its revenue problems arose – that the recognition of commercial income was an area of potential concern.

Tesco’s audit committee highlighted that ‘commercial income was an area of focus for the external auditors based on their assessment of gross risks’. However, the audit committee noted that although ‘commercial income is significant income’ for Tesco and involves ‘an element of judgement’, it was considered that the company had ‘an appropriate control environment which minimises risk’.

In comments that Tesco will now undoubtedly regret, its audit committee concluded that it does not ‘consider that this is a significant issue for disclosure in its report’.

Other businesses impacted

Other businesses will also be significantly affected when IFRS15 is introduced next year. Rolls-Royce, the aerospace group indicated that IFRS15 would have reduced its 2015 earnings by £900 million if the new rules had been adopted.

Aftersales engine servicing and maintenance generate significant profits later in the contract for Rolls-Royce; however, IFRS15 will prohibit bringing forward earnings on future servicing contracts. The company will now need to recognise revenue when it is received – and try to ensure the cash inflows more closely match earnings.

Similarly, many credit card companies will also be affected by the new reporting rules. These companies attract customers by offering interest-free cards for an introductory period, but later charge a higher rate. Essentially, these companies calculate the ‘effective interest’ rate and average out the interest on the cards, assuming customers will later stay with the higher rates.

As a result the credit card companies can recognise more revenue at an earlier stage. However, IFRS15 will require them to recognise revenue on a more cash-based accounting model. The new policy is estimated to reduce some credit card companies’ reported earnings by up to 20%.

Although IFRS15 does not directly affect a company’s cash flow position, it can have seriously consequences on reported profit levels. The impact of IFRS15 will affect a variety of sectors – however, even the best reporting standards in the world will be of no benefit whatsoever if companies are later found to have deliberately manipulated their reporting of revenue.

John Stittle is a Senior Lecturer at the University of Essex

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